FCA opens discussion on illiquid assets and open-ended investment funds

Out-Law Analysis | 21 Feb 2017 | 10:25 am | 4 min. read

ANALYSIS: The Financial Conduct Authority (FCA) has now published its discussion paper on illiquid assets and open-ended investment funds.

The FCA has been conducting a supervisory review of the activities of property managers of both authorised and unauthorised funds since last summer, looking in particular at how they dealt with liquidity in the run-up to, and after, the UK's referendum on leaving the EU. The discussion paper is the next stage of this process, and the FCA is seeking input from affected fund managers, life assurance companies, platforms, pension plan operators and other service providers until 8 May 2017.

The regulator has not suggested that there have been any significant failings uncovered. On the contrary, it found that fund managers acted in the best interests of all investors in their funds, and that there was "no evidence of a spillover effect in the wider economy". Further, the discussion paper notes that the use by fund managers of tools such as fair value pricing adjustments and suspension of redemptions helped to avoid an uncertain situation developing into a crisis. Nevertheless, in the interests of meeting its market integrity objective, the FCA feels it is necessary to investigate whether fund liquidity poses a risk to financial stability, and how such risk might be mitigated through regulatory measures.

What is the liquidity issue?

One of the main characteristics of open-ended schemes is that investors expect to be able to redeem their investment at reasonably short notice and at or close to net asset value. This redemption expectation has led to daily dealing in funds becoming the norm, almost regardless of the liquidity of the underlying asset.

Where there is a run on redemptions, the fund manager is faced with the problem of how to balance that investor expectation against the ability to dispose easily of non-readily realisable assets such as property, which perhaps can only be disposed of at a significant discount to their market value.

In its review of the post-Brexit fund suspensions, the FCA found that only four out of the nineteen authorised funds offered monthly or quarterly dealing. The other 15 all operated on a daily dealing basis.

In the paper, the FCA set out a list of characteristics typical of illiquid assets:

  • they are not traded on an organised market, so there is no market maker or central pricing mechanism;
  • there may be a significant imbalance between supply and demand, making it difficult to match buyers and sellers;
  • the terms of the trade are likely to take time to negotiate;
  • valuation is likely to be complex, often requiring specialist advice;
  • physical assets cannot be bought – or sold – in portions in the same way as units in funds, unless purchasers are willing to buy jointly
  • the time taken to complete a transaction can be lengthy.

It is clear that daily dealing in funds holding assets with these characteristics would not be appropriate in many cases.

Why would additional regulatory measures be necessary?

When it was announced that the FCA would be publishing a discussion paper, Megan Butler, the FCA's director of supervision for investment, wholesale and specialist, said that managers needed to think carefully about the mismatch between investors' expectations and their ability to meet daily redemptions from a pool of largely illiquid assets. So it was inevitable that protection of investors, especially retail investors, would be high on the agenda in the discussion paper.

The discussion paper covers a broader range of illiquid assets than just property; for example private shares, unlisted securities, special purpose vehicles and infrastructure. The paper looks not only at how effectively the mechanisms to manage liquidity are used, but also at whether investors understand their exposure risk to such assets - especially when invested indirectly, for example through contributions to pension schemes. The discussion paper concludes with suggestions of possible approaches for developing regulation in this area.

Although it did not find the fund managers to be especially at fault, the FCA is naturally keen to ensure that retail investors are protected from inappropriate investments - even to the point of proposing a possible ban on retail investment in certain non-UCITS retail scheme (NURS) funds that hold illiquid assets in the discussion paper. It seems unlikely that the FCA will go quite that far, but it may look at ways in which retail and professional investors can be treated differently within the same fund, perhaps through different share or unit classes.

These proposals are among a range of suggestions made by the FCA in the discussion paper, including:

  • portfolio structure and liquidity buffer - imposing rules on portfolio diversification and holding uncommitted cash;
  • valuation of assets – clarity on fair value pricing and the introduction of anti-dilution measures and guidance;
  • the use of specific tools – closing the gap between the regulatory intention behind liquidity management tools and their use in practice;
  • direct interventions by the FCA – regulatory power to step in to make the call on whether to suspend or not;
  • enhanced disclosure – ensuring potential investors are made aware of the nature and risks of investment in funds holding illiquid assets;
  • secondary market provision – permitting the listing of such funds so that investors may transfer holdings rather than redeem them.

There may not be the expertise among investors to fully understand the implications of their investment in funds holding illiquid assets. It is worth remembering that in its recent asset management interim report, the FCA raised concerns about the relative inexperience of pension fund trustees in investment management. So fund managers should be expected to encourage investors that daily dealing it perhaps the wrong expectation to have; and that investment in such funds be entered into with a longer term view in mind.

Nevertheless, the discussion paper does not seem to suggest that the FCA is looking to discourage investment in illiquid asset types. It is interesting to note that the FCA comments about 'new' asset classes, such as infrastructure for projects which are actively seeking broad investment often through government initiatives. However, the FCA cannot encourage competition and investment in an area without first laying down appropriate regulation, notwithstanding government support.

Anita Ives is a financial regulation expert at Pinsent Masons, the law firm behind Out-Law.com.