Liquidity in property funds – what is FCA worrying about?

Is the FCA simply on a fact-finding mission, or does it have deeper concerns about investor protection that may eventually lead to greater supervision?

Investors in regulated open-ended schemes expect to be able to redeem their investment at reasonably short notice and at, or close to, net asset value. The redemption expectation has led to daily dealing in funds becoming the norm almost regardless of the liquidity of the underlying asset. This leads to the problem, when there is a run on redemptions, of the manager being able to balance that investor expectation against the ability to dispose easily of non-readily realisable assets, which perhaps can only be disposed of at a significant discount to their market value.

It is also worth noting that the FCA's rules, set out in its Collective Investment Schemes Sourcebook (COLL), only require fortnightly dealing.

Liquidity has been an issue for a while, and the FCA had already raised concerns about the management of fund liquidity before the recent suspensions. In February 2016, it issued a set of guidelines for liquidity management of funds in which it referred to problems highlighted by the global financial crisis in 2008. Although discussing issues in fixed income funds, much of the guidance it contains applies equally to the management of liquidity in other asset classes.

In the guidelines, the FCA highlighted three areas of focus for firms to evaluate when assessing their liquidity management:

• tools, processes and underlying assumptions: these require continuous re-assessment and updating to ensure they remain suitable for market conditions;
• operational preparedness: a high degree of reassurance that tools, particularly extraordinary measures, can be implemented smoothly;
• disclosure: clear and full disclosure to fund investors on liquidity risks and the tools being utilised to manage those risks.

Liquidity management is also a requirement under the Alternative Investment Fund Managers Directive (AIFMD). Among those requirements are that managers regularly conduct stress tests under both normal and exceptional liquidity conditions and ensure that the investment strategy, the liquidity profile and redemption policy are all consistent. Regulations specify that the liquidity management systems and procedures should enable managers to cope with illiquid assets in order to respond to redemption requests.

What are the options available to fund managers?

There are a range of mechanisms available to fund managers for managing liquidity when there is a higher than usual demand for redemptions.

Suspensions

Suspending dealing in a fund should be the option of last resort.

FCA rules on suspensions in authorised funds require managers and depositaries to consult and make the decision to suspend only once other options have been dismissed. Any suspension must be in the interests of all investors in the authorised fund concerned. A suspension is subject to on-going 28 day reviews during the suspension, the outcomes of which must be reported to the FCA.

Limited redemptions

Provided that it is permitted under the fund's constitution, a manager can put in place limited redemption arrangements. Such arrangements must provide for sales and redemptions at least once in every six months, although different arrangements may be operated for different classes of investor as long as there is no prejudice to the interests of any investor.

Guidance on the FCA's provisions cautions that for all authorised fund structures, limited redemption should be considered in conjunction with chapter 9 of the FCA's Perimeter Guidance Manual (PERG) and the 'expectation test' in the 2000 Financial Services and Markets Act (FSMA) referred to above.

The guidance is not particularly helpful; but perhaps indicates that limited redemption is not suitable for all asset classes since an investor will have higher expectations regarding redemptions for liquid assets, such as listed securities. Limited redemption could, however, be considered for illiquid assets such as real estate.

Fair value pricing adjustments

Some property fund managers adopted fair value pricing adjustments rather than going for a full suspension. The valuation of property funds is subject to rules in COLL which require that properties are independently valued. In uncertain markets, fund managers might consider it appropriate for the benefit of investors to make an adjustment to the valuation and/or increase the frequency with which valuations are made.

Treating customers fairly underpins a lot of the FCA's thinking about how regulation is applied and, with property funds, the treatment of investors is linked to concerns that the FCA has expressed about whether investors' expectations can be met by investment in such funds. This leads to questions about the systems and controls firms have in place to ensure that investors are given suitable advice about investing in property funds.

"We also have to ask whether this increasingly important element of market-based finance, as a whole or in large part, would under stress transmit pressure to the rest of the system, for example through the sale of assets," Jon Cunliffe, the Bank of England's deputy governor for financial stability, said in a recent speech. "And whether there needs to be a stronger link between a fund's promise of liquidity to its investors and the nature of the assets in which it is invested."

Although the regulators clearly have concerns about investors being able to redeem their investments, is liquidity in the property markets really such an issue for financial stability in the grand scheme of things? Other types of fund, for example, money market funds and their role in the shadow banking system, might raise greater concerns when it comes to systemic risk.

However, it is clear that liquidity management is something that is currently occupying the FCA, and individual firms should not wait until 2017 to find out what the regulator has to say on the matter. Rather, they need to be carrying out assessments of how robust their systems and controls are right now for the circumstances in which they will be put to the toughest tests.

David Heffron and Elizabeth Budd are financial regulation experts at Pinsent Masons, the law firm behind Out-Law.com.