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FCA feedback statement on liquidity mismatch and open-ended property funds

  • United Kingdom
  • Financial services and markets regulation
  • Investment funds and asset management
  • Financial services

27-05-2021

 

FCA feedback statement FS21/8 “Feedback to consultation paper on liquidity mismatch in authorised open-ended property funds”, considers the responses to FCA consultation paper CP20/15 “Liquidity mismatch in authorised open-ended property funds”.  CP20/15 consulted on reducing the potential for investor harm arising from property funds being subject to frequent (typically daily) dealing in units.  Being required to be subject to frequent dealing means the investment and redemption obligations of property funds are not aligned with the time it takes to buy or sell the buildings in which the funds invest. 

This mismatch has forced property funds to maintain substantial liquid reserves in cash or other liquid assets and, in extreme circumstances, to rely upon suspension of dealing.  The most recent example of such suspensions being during the COVID 19 pandemic.  Some funds, having built up sufficient cash reserves, have now re-opened, but the process has taken nearly a year.  

In CP20/15 the FCA suggested a notice period for redemption requests of between 90 and 180 days for property funds and asked for alternative proposals.  Amongst other benefits, it is thought that such notice periods would improve protection for investors and encourage them to think of such funds as “longer term” investments.

Those opposed to the proposals thought they would reduce investor demand for authorised property funds, forcing them to consider REITs, arguably not a good substitute.  Only a small number of respondents fully agreed with the current proposals, however roughly half of the respondents were in favour of the proposals in principle if subject to these conditions:

  • the mechanisms for the distribution of the funds (including platforms’ and advisers’ systems) being upgraded to be capable of supporting notice periods
  • investments in funds with notice periods remaining eligible for inclusion in ISAs

Read our client briefing on CP20/15, “Six month notice periods for property funds? A closer look at CP20/15”.

Overview

The provision of appropriately designed and managed investment vehicles for investing in illiquid assets, including property, is key to supporting the UK government’s plans, as discussed in the Patient Capital Review, for greater investment infrastructure and the transition to a low carbon economy.

The FCA’s proposals for property funds overlap and interact with its proposals for a long term assets fund (“LTAF”), currently the subject of its consultation paper CP21/12 “A new authorised fund regime for investing in long term assets”.  The FCA will take into account responses to that consultation when determining how to progress its property fund proposals.

Distribution issues

The FCA’s Productive Finance Working Group (“PFWG”) is working on proposals to create the operational infrastructure necessary to support the distribution of the LTAF, and other non-daily dealt funds.

ISA eligibility

In October 2020 HMRC consulted on “ISAs and authorised open-ended property funds”.  The FCA recognises that the loss of ISA eligibility could offset the other benefits of applying the proposed notice periods and will take the effect on ISA eligibility, and policy statement PS19/24 “Illiquid assets and open-ended funds and feedback to Consultation Paper CP18/27”, into account in their final decision.  HMRC proposes that existing investments in property funds would remain ISA eligible whilst prohibiting the inclusion of ‘new’ investments in such funds.

Alternative solutions

A number of alternative solutions were suggested, including notice periods for large trades or institutional investor trades.  For various reasons the FCA rejected all the alternatives, with longer notice periods for larger trades or institutional investors, but not retail investors, rejected on the basis that this would involve unequal treatment of investors and because the trading decisions of institutional investors may well be determined by the collective trading decisions of retail investors.

Reducing cash drag

Some respondents thought that the notice periods were insufficient for funds to reduce their cash and liquid holdings significantly below the current 15-20%, however the FCA disagreed.

Dealing structure

The consultation proposed that relevant funds would operate the following dealing structure:

  • Each investor’s redemption request would be received and recorded, then processed at the end of a notice period
  • The investor would receive the value of their investment, based on the unit price of the fund at the first valuation point following the end of their notice period
  • Redemption requests would be irrevocable, so that investors cannot place orders and withdraw them before the end of the notice period if market conditions change

This proposal divided the respondents for and against.

90 or 180 days’ notice

The majority of respondents favoured 90 days.  The FCA notes that 180 days better deals with liquidity mismatch issues but takes note of market sentiment and the market risk 180 days imposes on investors.

Interaction of suspensions and notice periods

There was consensus that a period of suspension should be counted as part of the notice period.  If the FCA does proceed with implementing notice periods, it believes that including the suspension time as part of the notice period is a means to manage redemption demands.

The FCA appreciates that transfer agents and platforms will need time to upgrade their systems to include order queues during suspensions.

Interaction with funds investing in illiquid assets (“FIIA”) rules

There was a broad consensus that if notice periods are introduced, the funds within scope of the proposal should continue to be caught by the FIIA rules.

Impact and Next Steps

In terms of a definitive steer on any proposed rules, the feedback statement is very much a plea for more time due to the cross-over with the proposed new LTAF structure.  The FCA has essentially postponed its decisions on property funds until Q3 2021 and will take account of feedback to CP21/12, due by 25 June.  The delay shows how difficult it is to resolve the issues of investors suddenly leaving open ended property funds and how more illiquid asset classes (such as property) are not always compatible with a daily dealing authorised fund structure.  Delaying the decision pending the broader LTAF review is unfortunate but makes sense as a coherent approach, and it will be interesting to see how the full package of measures comes together once the LTAF proposals are firmer.

If the FCA does introduce mandatory notice periods for property funds, it will allow an implementation period of 18 months to 2 years before the rules come into force to allow firms to make the required operational changes.

How can Eversheds Sutherland help?

Eversheds Sutherland is widely recognised as one of the leading advisers to the investment funds industry, with one of the leading fund, asset management and regulatory teams.  We have over 40 years' experience of investment funds work and, in particular, authorised funds.

If you would like further guidance on the impact of the feedback statement on your business, please get in touch.