September Liquidity Deadlines: Reminder on Funds Investing in Inherently Illiquid Assets

The 30 September compliance deadline is fast approaching for a number of liquidity developments. Including:

ESMA’s new guidelines on liquidity stress testing in UCITS and AIFs
The FCA’s new rules for certain open-ended funds investing in inherently illiquid assets
FCA and Bank of England survey to review the liquidity mismatch in open ended funds
Article 37 MMF Reporting for both Q1 and Q2

Over the next couple of weeks, we’ll be taking a look at these requirements and where fund managers need to be by the end of September.

Last year, in the wake of the collapse of the LF Woodford Equity Income Fund (WEIF) due to liquidity issues, the FCA announced new rules for NURS funds. As a UCITS fund, the WEIF was prohibited from investing more than 10% of its property in assets that are unlisted, and thus usually more illiquid, securities. This is in contrast to NURS, which can invest up to 20% of their scheme property in unlisted securities, and up to 100% of their scheme property in immovables, such as real estate.

During the FCA’s initial consultation, there were concerns the investors already had a significant number of acronyms to navigate and that this particular category would not be easily understood. Indeed, last month, due to the impending changes to the NURS rules, Church House Investment Management converting its Tenax Absolute Return Strategies fund to a UCITS structure. Church House IM director Sam Liddle said the decision to convert Tenax was made as the FCA’s new NURS liquidity requirements “might have caused some doubts in the minds of investors and their advisers about the suitability of that type of fund structure“.

The new FCA rules aim to reduce the potential for some investors to gain at the expense of others, and reduce the likelihood of runs on funds leading to ‘fire sale’ of assets which disadvantage continuing fund investors.

What are Funds Investing in Inherently Illiquid Assets?

The new rules include a new category of ‘funds investing in inherently illiquid assets’ (FIIA). A fund would be classed as a FIIA in one of two circumstances:

NURS which have disclosed to their investors that they are aiming to invest at least 50% of their scheme property in inherently illiquid assets.
NURS which have invested at least 50% of the value of their scheme property in inherently illiquid assets for at least 3 continuous months in the past 12 months, whether or not they have disclosed their intention to do so.

It should be noted that NURS that apply limited redemption arrangements will be excluded from the new requirements imposed on FIIAs and the definition of ‘FIIA‘. The inclusion of this exemption for funds that tackle the liquidity mismatch through reduced dealing frequency is in line with IOSCO’s February 2018 recommendations on liquidity management in open-ended funds.

What are Inherently Illiquid Assets?

To assist in the correct interpretation of FIIAs, the FCA has defined ‘inherently illiquid assets‘ which, in summary, comprise of:

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
a unit in a FIIA or another fund with substantially similar features

What do the New Rules Mean for Fund Managers of FIIAs?

In particular, the FCA are changing the COLL Sourcebook in 3 areas:

Suspension of dealings in units

The FCA will require NURS holding property and other immovables to suspend dealing when there is ‘material uncertainty’ about the valuation of at least 20% of the scheme property.

The rules do allow an authorised fund manager (AFM) to continue to deal where they have agreed with the fund’s depositary that to do so is in the best interests of investors. However, the decision to do so must be taken within two business days from when the material uncertainty arises.

Improving the quality of liquidity risk management

Managers of funds investing mainly in illiquid assets will have to produce contingency plans for dealing with liquidity risks. Depositaries will also have a specific duty to oversee the processes used to manage the liquidity of the fund.

The rules currently require fund managers to have liquidity management systems and procedures, and to identify when these tools and arrangements may be used in both normal and exceptional circumstances.

Due to shortcomings identified by the FCA, they have introduced new rule in COLL 6.6.3CR to require managers of FIIAs to draw up and maintain contingency plans for exceptional circumstances with regards to their liquidity management.

The contingency plans would:

Describe how the fund manager will respond to a liquidity risk crystallising.
Set out the range of liquidity tools and arrangements which they may deploy in such exceptional circumstances, any operational challenges associated with the use of such tools and the consequences for investors.
Include communication arrangements for internal and external concerned parties and explain how the fund manager will work with the depositary, intermediate unitholders, third party administrators and others as necessary to implement the contingency plan.

Increased disclosure

Additional disclosure in a fund’s prospectus of the details of their liquidity risk management strategies, including the tools they will use and the potential impact on investors will be required.

A standard risk warning will also be required in financial promotions to retail clients for such funds. This will apply to all firms communicating a financial promotion, not just the fund manager.

When do the New Rules Enter into Force?

The new rules come into effect on 30 September 2020.

Summary

In anticipation of the new rules entering into force, firms affected by these changes will need to ensure they are taking effective measures to ensure liquidity risk is managed effectively. Our liquidity risk management and investment compliance monitoring solutions are being used by leading global asset managers, banks, management companies, fund administrators and custodians to automate their regulatory compliance through industry-leading cloud technology.