Overview

Scrutiny of illiquid assets and open-ended funds is a familiar theme; as is the context of these funds being forced to suspend dealings in times of stress, either to deal with the high volume of redemption requests (for instance following the June 2016 Brexit vote), or more recently to protect fund liquidity in light of the material uncertainty qualifier applied to valuations on account of the COVID-19 pandemic. Repeat suspensions can impact market confidence and raise questions about the appropriacy of fund structures. In quick succession to the FCA’s Policy Statement PS19/24 that comes into effect on 30 September 2020, the FCA has published a Consultation paper CP20/15: Liquidity mismatch in authorised open-ended property funds (the Consultation) that would introduce a notice-period model so that risks of suspension can be reduced by better aligning redemption terms with the liquidity of assets – by avoiding offering daily dealing where this may not be sustainable without loss of value.

Although the proposed changes impact Non-UCITS Retail Scheme (NURS), ie those authorised open-ended funds available to the retail market and that can invest substantially in illiquid assets, it will be of interest to all types of property funds, including other authorised funds such as Qualified Investor Schemes (QIS), and those working in the unregulated open-ended funds space, where there is a potential knock-on effect. Indeed, the FCA invites wider views on whether the introduction of notice periods for other types of funds would be welcomed; as well as views on what rule changes could be considered to facilitate the development of an efficient secondary market.

The FCA wants to tackle the unfairness risk created by liquidity mismatch, and draws attention to two key points on this. Firstly, that in stressed market conditions investors that redeem ahead of others may gain at other investors’ expense (‘first mover advantage’), by either receiving a better price for their units, or avoiding being temporarily trapped in a suspended fund. Secondly, that the rule changes could potentially improve investment returns by allowing increased property exposure/reduced ‘cash drag’ as managers would not need to retain cash buffers for long periods in order to meet unanticipated high levels of redemption requests.

The Consultation remains open for feedback until 3 November 2020 with a policy statement and final rules expected to follow in early 2021. The industry will want to continue to engage with the proposals, as well as being alive to further developments in this area, for instance from the FCA and Bank of England, alongside any developments in industry initiatives such as the Investment Association’s Long Term Asset Fund (which the Consultation endorses).

We have set out below the key proposals in the Consultation.

Notice period for redemptions to address structural risks of property funds

The FCA is proposing that investors give notice to redeem (mooted to be between 90 and 180 days, to reflect the estimated time needed to sell commercial property). The units of redeeming investors will then be redeemed at the unit price at the first valuation point following the end of their notice period. Investors can continue to submit redemption requests as frequently as daily. Redemption notices will be irrevocable once accepted by the manager, which would exacerbate the market risk for redeeming investors (retail clients will receive fuller disclosure) should conditions change for the worse during the notice period. The FCA state that this is to be balanced against managers being able to better plan sales of property assets to meet redemption requests at a fair price, which is in all investors’ interests. No changes are proposed to the rules on subscriptions, where no notice period would apply.

The FCA acknowledges that not all suspension risk will be eliminated. Indeed, the mandatory suspension rule in PS19/24 - where there is material uncertainty of the value of at least 20% of the scheme property (subject to the carve out where the manager has agreed with the fund’s depositary that continued dealing is in the investors’ best interests ) – will still apply to property NURS come September 2020. In this scenario, any period during which a fund is suspended would count towards the notice period (and if the fund was still suspended at the end of the notice period for the investor’s redemption request, the manager would need to redeem the investor at the first valuation point following the end of the suspension).

Funds within scope are those that do not operate redemption arrangements that reflect the typical time needed to sell the underlying assets

A new definition (for FCA navigation purposes only) of ‘funds predominantly investing in property (FPIP)’ will apply – capturing funds structured as a NURS that intend to invest at least 50% of their scheme property in inherently illiquid assets (being ‘funds investing in inherently illiquid assets (FIIA)’ under the provisions of PS19/24). However, unlike the FIIA definition that excludes pure property funds structured as NURS with limited redemption rights, FPIPs will also include those funds that operate limited redemption arrangements where dealing in units can be more frequent than the length of the notice period, ie where there is a liquidity mismatch. For example, quarterly dealt funds will be within scope if the redemption notice period is over 90 days. Existing NURS that have no more than monthly dealing will be excluded from scope. However, depending on the final shape of the rules, NURS established after the rules enter into force that have monthly or potentially quarterly dealing will fall within scope and be subject to the new notice requirements.

Application of the FIIA rules to the new FPIP

Except for the mandatory risk warning for retail investors, all of the FIIA rules will apply to FPIPs (for example, enhanced depositary oversight, standard risk warnings on financial promotions and liquidity risk contingency plans). The FCA still expect disclosures on market risk, redemption notice periods and irrevocable nature of redemption requests, but (unlike for FIIAs) these will not be in a prescribed format.

Other points of interest

• Managers will need to obtain FCA approval to implement the new dealing structure in the fund/any feeder fund constitutional documents; as well as consider any additional fund-specific requirements and notify investors in advance. The FCA has framed the new rules as a ‘significant change’ which means that prior investor approval is not needed. The FCA proposes that any investors who choose to exit the fund before the rules take effect will still be subject to the redemption notice period.
• The proposed rules do not mandate any form of fund pricing, and managers can choose whether to operate a single or dual price to address liquidity risks.
• The FCA is engaging with HM Treasury and HMRC to confirm that these funds would be eligible for ISA investments. It is also consulting on a transitional rule so that the introduction of notice periods for existing client holdings in these funds within SIPPs would not automatically lead to a capital surcharge for existing SIPP providers pursuant to capital adequacy rules.

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