Illiquid assets and open-ended funds: What are the big issues for firms?

The Brexit referendum result in June 2016 exposed some potential structural vulnerabilities in the asset management sector. It highlighted that open-ended funds invested primarily in illiquid assets can struggle to satisfy high demand for redemptions under stressed market conditions, at least without being forced to sell those underlying assets very quickly at a significant discount. While the existing liquidity management measures avoided major problems, the Financial Conduct Authority (FCA) has now consulted on proposals to mitigate the risk in case of a repeat event. While the industry supports the regulator’s focus on this, the more engaged firms have identified a series of challenging implementation issues among the proposed requirements. So which aspects of the proposals have triggered most debate across the industry so far and are likely to have the most significant impact?

Mandatory suspensions have attracted particularly close attention. Under the regulator’s plans, fund managers would need to suspend dealing in retail funds invested in so-called ‘immovables’ when the Standing Independent Valuer (SIV) expresses ‘material uncertainty’ about how to value at least 20% of the assets in the portfolio. It would be a significant industry shift to move the decision about fund suspension out of the hands of the fund manager and into those of the SIV. Some firms are concerned about what impact this might have, as they believe they are best placed to consider the specifics of the scenario and whether suspension would ultimately advance the interests of investors. This shift by the regulator is particularly interesting given recent focus on the importance of management oversight and ownership of the entire valuation process. Also being debated in the market is whether this proposal might result in multi-asset funds reducing investment in illiquid assets to avoid the 20% threshold.

Other notable points of discussion on the mandatory suspension proposal relate to the intended scope of the requirement. For example, although the rules explicitly refer to ‘immovables’, in reality might the FCA expect firms to apply this to a wider range of illiquid assets? Do funds containing other funds invested in immovables fall in scope? The regulator has made clear that it expects all immovables to fall within scope, not just real estate valuations that follow RICS. There is also uncertainty around whether it is the fund or SIV which is expected to hold ultimate responsibility for determining a fair and reasonable value for assets being sold to satisfy redemption demand in a ‘distressed sale’ scenario.

Separately, the proposed obligation on fund managers to label funds as ‘inherently illiquid’ has been a big issue for the industry. While firms recognise the role of better disclosure in helping investors understand liquidity risks, some have questioned whether drawing attention to funds invested in illiquid assets creates a perception that they are high-risk, which may not be true and could ultimately be confusing for investors.

The high level of engagement so far by some firms is a clear signal that this is a key priority for the asset management sector. However, with the consultation period for the proposals having just drawn to a close, it leaves open questions as to how firms will be expected to respond should there be a significant market shock leading to uncertain values and high liquidity demands in the coming months. More broadly, given that these proposals are likely to mark the beginning of greater regulatory scrutiny of liquidity management in open-ended funds, all affected firms would be wise to use this opportunity to take a holistic look at their controls in this area, beyond those prescribed in the FCA’s latest proposals.  

Katrina Hallpike

Katrina Hallpike | Director, UK Deals
Profile | Email | +44 (0)7715 035153

Lucas Penfold

Lucas Penfold | Manager, FS Risk and Regulation Centre of Excellence
Profile | Email |  +44 (0)7483 407581

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