The FCA has published Policy Statement PS19/24 in which it has confirmed new rules which apply to certain types of open-ended funds investing in inherently illiquid assets such as property. The new rules will apply to Non-UCITS Retail Schemes (“NURS”), but will not apply to other funds such as UCITS which are already subject to restrictions relating to such assets.
The new rules come into force on 30 September 2020.
This rules update is relevant to the following:
- Operators and investment managers of NURS;
- Depositaries;
- Ancillary service providers;
- Intermediaries, such as platform service providers, or those, like wealth managers or financial advisers, whose retail clients invest in funds holding illiquid assets; and
- Firms communicating financial promotions to retail clients for funds investing mainly in illiquid assets.
FCA Proposals
- The FCA is introducing to the FCA Handbook a new category of “funds investing in inherently illiquid assets” (“FIIA”). NURS that fall into this category will be subject to additional requirements, including enhanced depositary oversight, standard risk warnings on financial promotions, increased disclosure of liquidity management tools and liquidity risk contingency plans.
Classification as a “Fund Investing in Inherently Illiquid Assets”
- The FCA is introducing a new category of fund to the FCA Handbook, being “Funds Investing in Inherently Illiquid assets” (“FIIA”).
- A fund will be classed as an FIIA in one of two circumstances:
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- NURS that have disclosed to their investors that they are aiming to invest at least 50% of their scheme property in inherently illiquid assets.
- NURS that have invested at least 50% of the value of their scheme property in inherently illiquid assets for at least three continuous months in the past 12, whether or not they have disclosed their intention to do so.
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- Additionally, where feeder funds, multi-asset funds and funds of funds that have at least 50% of their scheme property invested in FIIAs would also meet the definition of an FIIA, due to their holdings in other funds.
Definition of “Inherently Illiquid Assets”
The FCA has proposed the following definition, which will be included in the FCA Glossary, which in summary is:
- An immovable;
- An investment in an infrastructure project;
- A transferable security that is not a readily realisable security;
- Any other security or asset that is not listed or traded on an eligible market and has particular features that make the process of buying or selling difficult or time consuming; or
- A unit in a FIIA or another fund with substantially similar features.
- The FCA is also introducing a requirement that NURS must suspend dealing in fund’s units where the Standing Independent Valuer (“SIV”) expresses “material uncertainty” regarding the value of 20% of the scheme property. The FCA will allow an authorised fund manager (“AFM”) to continue to deal where it has agreed with the fund’s depositary that this is in the fund’s best interests. This change is being introduced to ensure that AFMs (in conjunction with depositaries) have the ultimate say if a fund suspends dealing, thereby reducing reliance on the SIV and protecting consumers by avoiding suspension where this would not be in investors’ interests.
- NURS that apply limited redemption arrangements will be excluded from the new requirements that the FCA proposes to apply to FIIAs. The FCA proposes that where a NURS applies limited redemption arrangements that reflect the typical time needed to dispose of its assets, the fund will be less exposed to liquidity issues at times of market turbulence than is the case for funds that deal more frequently. The additional measures associated with classification as a FIIA (i.e. enhanced disclosure and liquidity management) are not necessary for funds which already have limited redemption arrangements. The FCA’s view is that this is because such funds have already taken steps to mitigate the liquidity mismatch that poses a risk to investors.
Where AFMs managing NURS choose not to manage the liquidity mismatch directly, for example by adapting the redemption arrangements to be more similar to the liquidity of the underlying assets, the fund will have to be classified as a FIIA and become subject to the additional requirements such status brings.
FCA Changes
Suspension
Mandatory Suspensions due to material uncertainty
The FCA will require that NURS holding property and other immovables suspend dealing when there is “material uncertainty” about the valuation of at least 20% of the scheme property.
The FCA Rules will provide that where the SIV has expressed material uncertainty about the value of immovables that constitute more than 20% of the scheme property, the fund manager should suspend dealing in a fund. However, a fund manager may continue to deal if it has a reasonable basis for determining that it is not in the best interests of investors to suspend dealing, but only with the agreement of the depositary. The decision to continue dealing would need to be taken as soon as possible and in any event by the end of the second business day after the day on which material uncertainty applies to at least 20% of the scheme property.
Any decision to not suspend dealing in the fund must be reviewed by the fund manager at least every two weeks.
Funds with indirect exposure to immovables
For funds with significant indirect exposure to immovables, such as multiasset funds holding units in property funds, or feeder funds of property alternative investment funds (“PAIFs”), mandatory suspension of such funds will occur where the funds have at least 20% of the value of their scheme property invested in one of the funds that themselves have suspended trading due to material uncertainty. A proposed look through approach was rejected by the FCA.
Role of Depositary in suspensions
Whilst a fund manager may continue dealing in a fund despite the existence of material uncertainty, the FCA assumes suspension will generally be the appropriate course of action in such circumstances. For the suspension to take place as quickly as possible, and in any event, within two business days of a fund being subject to material uncertainty, the fund manager will not need the depositary’s agreement to suspend. However, where the fund manager wishes to continue dealing, to ensure this is in the interests of investors, the depositary’s consent will be required. Where the depositary disagrees with the fund manager’s judgement, or fails to agree within the time limit, dealing in the fund must be suspended.
Liquidity Management
Improving the quality of liquidity risk management
The FCA will require managers of funds investing mainly in illiquid assets to produce contingency plans for dealing with liquidity risks. The FCA is also giving depositaries a specific duty to oversee the processes used to manage liquidity of a fund.
The FCA is also making further specific guidance to clarify:
- The circumstances in which it may be appropriate to suspend dealing. For a fund investing mainly in illiquid assets, the fund manager may suspend dealing before running down the liquidity in the fund, if this is in the unitholders’ best interests;
- The process for arriving at a fair and reasonable value for an immovable, where it needs to be sold quickly to ensure that the fund can continue to meet redemptions requests as they fall due.
Liquidity Contingency Plans
The FCA is including a requirement for FIIA managers to have contingency plans covering both normal and exceptional circumstances, and to disclose these in each fund’s prospectus, with an additional requirement to have relevant agreements in place with third parties. The fund manager must have written confirmation from any relevant third parties identified in their contingency plans.
Where fund managers distribute a significant number of units in FIIAs through platforms, those platforms must be able to implement contingency plans as and when needed. This suggests that fund managers should only distribute their funds through platforms that have appropriate contingency plans.
Rapid Sales and Use of Price Reductions
Where daily dealing funds investing in illiquid assets experience significant redemption demand in a short time frame, the funds may not hold sufficient amounts of cash to meet their obligations to redeeming investors. In such circumstances, rather than suspend dealing, some fund managers may choose to sell assets more quickly than normal at less than the full open market value of the assets, and to apply a downward adjustment to the unit price accordingly.
Fund managers wishing to have the option to undertake “fire sales” during difficult market conditions will be required to disclose this intention in the fund’s prospectus. Additionally, where a fund manager decides to sell an immovable quickly to meet redemption requests, FCA guidance will suggest that fund managers should “consult and agree with the SIV a fair and reasonable price (Complyport’s emphasis) for the immovable to reflect a rapid sale”. Use of the term “price” is designed to reflect the difference with “value” as the price may be less than the value where a rapid sale is required.
Depositary Oversight of Liquidity Management
Whilst the depositaries of authorised funds are required to provide cash flow monitoring, oversight duties and safekeeping or verification of assets, the FCA will require depositaries of FIIAs to assess regularly the liquidity profile and liquidity risks presented by the fund’s scheme property. Depositaries will also need to develop procedures for overseeing the liquidity management of the fund manager. The amended rules aim to ensure appropriate liquidity risk management across managers of FIIAs and more consistency on depositary oversight.
Disclosure
Increased Disclosure
The FCA will require:
- Additional disclosure in a fund’s prospectus of the details of the liquidity risk management strategies, including the tools that will be used and the potential impact on investors.
- A standard risk warning to be given in financial promotions to retail clients for such funds. This will apply to all firms communicating the final promotion and not just the fund manager.
Disclosures in Prospectus
The FCA has proposed that an FIIA Prospectus must disclose how the fund
manager will manage the fund where liquidity issues arise, and that the
prospectus should include:
- An explanation of the risks associated with the scheme investing in inherently illiquid assets and how these might crystallise;
- A description of the tools and arrangements the authorised fund manager would propose to use, including those that FCA Rules require them to use to mitigate the risks of investing in inherently illiquid assets; and
- Details of the circumstances in which these tools and arrangements would typically be deployed and the likely consequences for investors.
Standard Risk Warning
FCA Rules will say that FIIAs will need to include the following risk warning in certain financial promotions to retail clients:
“[Name of Fund] invests in assets that may at times be hard to sell. This means that there may be occasions when you experience a delay or receive less than you might otherwise expect when selling your investment. For more information on risks see the Prospectus and Key Investor Information Document”.
Other Funds
The FCA is considering whether the rule changes in relation to NURS should apply more widely than NURS and is working with the Bank of England’s Financial Policy Committee to assess how funds’ redemption terms might be better aligned with the liquidity of their assets to minimise financial stability risks without compromising the supply of productive finance. The FCA is exploring various options and where the FCA review results in potential changes to FCA Rules, the FCA will set these out in a further consultation paper.
In Force
As stated at the beginning of this article, the new rules in relation to NURS will come into force on 30 September 2020. Of course, fund managers and depositaries are able to introduce some of the measures in advance of the in force date if they wish, providing that they do not conflict with any rules applicable until that time.
