Democratising Illiquid Investments – FCA proposed pragmatic approach
Traditionally, illiquid investments, whether direct property or private equity, have been accessible only for the few privileged, wealthy investors. Those wealthy investors like such illiquid investments for a number of reasons: amongst others they can provide diversification to other asset classes, and often demonstrate good downside protection and lower market volatility. One of the few exceptions are direct, open-ended property funds. Such funds hold property directly, bundle them into fund units that retail savers can invest in without the need for a large mortgage or prohibitive minimum investment amounts.
However, following the Brexit vote in 2016, some commercial property funds experienced significant client withdrawals, which led to a suspension of redemptions. This resulted to some reputational damage for such funds, and an FCA consultation on such investments, labelled FIIA (Funds investing in inherently illiquid assets). Encouragingly, the FCA review and consultation concluded that overall, the current rules and procedures around liquidity management worked well in 2016. And whilst the FCA proposes a number of enhancements, none of them are seismic compared to the regulations and practices already in place.
This should provide a good basis to ensure that such funds, investing directly in commercial or residential property, remain an option for every retail investor trying to benefit from illiquid investments, in the same way as some wealthier investors do.
Below, we outline our thoughts on the FCA’s “Consultation on illiquid assets and open ended funds and feedback to Discussion Paper DP17/1 – Consultation Paper 18/27”. The consultation closes on January 25th, 2019.
• We agree with the general philosophy outlined by the FCA on how Liquidity should be managed in direct property funds:
a. In times of significant withdrawals, funds should not wait too long with suspending redemptions to avoid those who redeeming early having an advantage (Treating Customers Fairly)
b. Funds should hold some cash to manage redemptions for normal market circumstances, but not excessive cash to avoid gating, as this defeats the fund objective. Investors chose property fund as they want to predominantly benefit from the risk/return characteristics of property investing.
• We agree with the proposals for enhanced disclosures and a specific identifier for such funds indicating the challenges of offering daily liquidity when the underlying asset class is less liquid. As a residential property fund manager, our aim is to work with investors who see residential property as a long term, strategic investor. We, as well as our current investors, have no interest in flows from tactical asset allocators with a short investment horizon.
• Some of the new rules proposed seem somewhat arbitrary and might not always work when nuanced decisions need to be made at pace. In particular, the proposal for mandatory suspension where the Standard Independent Valuer has expressed material uncertainty about immovables that account for the value 20% of the scheme properties. As with any simplistic rule and deterministic rule, it is unlikely to work well when decisions need to be made in a complex and fast-moving environment. How does the valuer assess whether 18 or 21% of a portfolio are difficult to value? When does normal uncertainty become “material”? How can this be implemented consistently across the industry?
• Extending some of the rules to Fund of funds investing in illiquid funds on one hand seems logical, but on the other hand will exacerbate the problem as Fund of fund investors might be forced sellers at a time when such investors could and might want to provide stability in the market
• We would like the regulator to consider one change to current rules. When redemptions in fund units are suspended, there is at the same time a suspension to issue new units. We would like the FCA to consider the option of suspending redemptions, whilst at the same time NOT suspending the issue of new units. Many investors and advisers hold FIIAs as a strategic and long term holding, often a relatively small part of their / their client’s portfolios. They would want to ensure that they can invest into the fund on an ongoing basis and might often be in disagreement of some of the actions / redemptions taken by other unit holders. During times of heightened market volatility, they might specifically want to invest, and not be precluded from investing, to take advantage from good price entry points. As long as a fund can be priced correctly, such allowances would be in the best interest of investors and ensure a more efficient and competitive market. This could be administered via signing of a specific form with clear disclosures indicating that redemptions in such an FIIA are currently suspended. At times where more and more of investors’ wealth is manged by automated algorithms, whether passive or smart beta, it is important for the industry and all investors to continue to be able to invest in real assets, directly. Overall, the FCA is demonstrating pragmatism and a focus on customers’ needs in their consultation to illiquid investments to ensure UK savers and investors continue to have a diverse suite of options available for their accumulation and decumulation portfolios.