Industry participants will be pleased to hear that the FCA is not advocating broad structural changes, such as banning open-ended funds from holding illiquid assets or preventing retail investors from investing in open-ended property funds. The Discussion Paper is rather about gauging whether improvements might be made to existing liquidity management tools in order to enhance investor and market outcomes in a cost-effective and proportionate way.
At the time of last summer’s fund suspensions, the FCA indicated that it would be investigating further the circumstances leading up to the suspensions. Regulators have also been looking more generally at the risks associated with open-ended funds investing in illiquid assets and the possible impact on financial stability. Real estate is perhaps the best understood illiquid asset class but it is by no means the only one and it is not the sole focus of the Discussion Paper, which lists a number of other illiquid asset classes, including private equity and infrastructure.
Many open-ended funds investing in illiquid assets are available to retail investors through non-UCITS retail schemes (NURS). Retail investors may not fully understand the risks inherent in open-ended funds investing in illiquid assets and indeed may not be aware of those risks, despite the disclosures available in fund prospectuses and other documents.
The Discussion Paper represents the FCA seeking to gather more evidence as to whether more, or different, rules and guidance are needed to support market stability and protect consumers, without preventing them from having access to a diversified range of investment opportunities.
What changes is the FCA suggesting?
The areas for potential change identified in the Discussion Paper are:
• Different investors, different share classes
Helping to balance the different needs of professional and retail investors by requiring funds to have different unit classes for these different categories of investor. This might enable authorised fund managers to continue to offer retail investors a high degree of liquidity (on the basis that the impact of suspension of dealings requests by retail investors is likely to be relatively low and easily managed) while imposing longer notice periods or less frequent dealings to institutional investors.
The FCA also posits the possibility of an authorised fund manager having to manage the diversity of its investor base more actively. The intention behind this would be to ensure that no single investor, or bloc of investors, represented such a significant proportion of the fund that a decision to redeem would be difficult to manage without selling illiquid assets.
• Liquidity buffers
The Discussion Paper also considers the merits of setting limits around a fund’s portfolio structure. It gives the examples of limiting the proportion of the portfolio that could be held directly in illiquid assets or a minimum amount to be held in cash, near cash or uncorrelated securities. However, the FCA acknowledges that this could unfairly favour exiting investors since it would reduce the value of the fund’s assets actually invested in accordance with investors’ chosen investment objective.
There is also a suggestion that there could be requirements as to the eligibility of the assets to be held. The implication is that higher grade investments are more liquid and can be sold without having to mark the asset significantly down. Alternatively, there could be further diversification requirements, so that funds are not over-exposed to a few large assets. It is acknowledged that this may be more difficult for smaller funds and newly-launched funds.
• Valuation and pricing rules
The FCA is also looking at valuation and anti-dilution measures. In particular, the FCA considers whether more guidance should be given on the governance process a fund manager should employ in reaching a fair value.
It is also open to fund managers to impose a liquidity discount as happened in July 2016. These discounts can be perceived as a penalty on investors seeking to exit but in reality are an acknowledgement that price discovery on the underlying asset has become difficult and therefore the latest published net asset value of the fund may overvalue the assets. It is open to investors to redeem their units at the discounted price but they may prefer to remain invested until conditions normalise, making valuation more reliable and allowing the manager to lift the discount.
• Regulator-mandated liquidity tools
The FCA considers the merits of specific tools, such as imposing less frequent dealings, longer notice periods or a “queuing system” that enables managers to hold suspension of dealings requests over and therefore benefit from increased visibility of the need for liquidity in the future. The Discussion Paper acknowledges the possible downside of these tools and seeks stakeholder feedback, particularly from intermediaries, on their workability.
• Direct regulator intervention in fund suspensions
The spectre of direct regulatory intervention is also raised in the Discussion Paper. Specifically, the FCA, understandably, is doubtful that direct intervention – i.e. the regulator directing that funds be suspended - would be the right solution, despite the fact that some industry participants would prefer the FCA to give this direction, thus removing concerns about competitive disadvantage from considerations about whether to suspend dealings. The FCA thinks that the decision to suspend has to be taken by each manager based on its knowledge of the fund, its assets and its investors. For example, not all open-ended property funds suspended dealings in July last year. The FCA also notes that it does not have the specialist knowledge of the underlying asset class to know whether suspension is the right solution or, having suspended, when the best time is to lift the suspension.
• Better disclosure to retain investors
One concern raised at the time of the post-referendum suspensions was that some investors, particularly retail investors, had not understood that suspension of dealings were possible. There is a wider question about how well retail investors understand the risks of investing in illiquid asset classes. Although these risks will be disclosed in the fund prospectus, many investors do not read the full prospectus and, in some cases, the prospectus is not easily available. The FCA acknowledges the limitations of increased disclosure in changing consumer behaviours but seeks views on whether enhanced or better-targeted communications might help investors to appreciate the impact of fund liquidity problems on their own position.
• Secondary market solutions
Finally, the discussion looks at the role of secondary markets, noting that open-ended funds could bolster liquidity through a listing that added secondary market liquidity to the liquidity offered by the authorised fund manager. Short of a listing, the FCA also acknowledges the role of a less formal market place such as an investor/seller matching service (which some authorised fund managers currently offer).
The FCA also seeks view on whether more could be done to facilitate open-ended funds converting into closed-ended structures, such as REITs.