At a stressful time for investment funds, Nicholas Pratt finds more tolerance for liquidity management tools in the ‘plain vanilla’ world and among alternative investors.
The difficult relationship between investment funds offering daily redemptions despite holding illiquid assets was in the spotlight long before the Woodford Investment Management saga and the more recent run on property funds that saw, once again, the use of fund gating and fund suspensions.
After investors could not get their money out, a debate ensued about whether some funds were suitable for less-informed retail investors. It seems patently obvious that there is a problem with offering daily liquidity for illiquid assets such as real estate, which can take months to sell.
Almost drowned out by the noise around Covid-19 is the renewed debate around liquidity management tools and techniques, including the blunt act of suspending redemptions and the more subtle practice of ‘swing pricing’.
In September 2019, the European Securities and Markets Authority produced guidelines on liquidity stress-testing to apply to regulated funds from September 2020. In essence, the guidelines will ask firms that provide Ucits funds or alternative investment funds to produce more details about liquidity management practices.
Some European markets have been quicker to act than others. In Germany, where real estate funds are highly significant in portfolios, changes to the redemption periods of open-ended funds were instigated after the 2008 financial crisis. Since 2013, investors must give 12 months’ notice to redeem.
According to the BVI, Germany’s fund association, the changes have restored investor confidence in the sector, resulting in more robust funds at the onset of the pandemic. “Open-ended real estate funds have continued to attract inflows from both retail and professional investors,” says BVI spokesperson Patrizia Ribaudo.
Given that changes to redemption periods were made seven years ago, awareness of liquidity management methods distributed in Germany is already very high. “Fund managers operate with high proficiency when it comes to liquidity management. In contrast to the UK, by and large, investors of German funds were able to sell their shares without any problems.”
German funds could still see outflows as the pandemic evolved, but even then, open-ended investment funds may find some help from an amendment by German legislators before the coronavirus crisis emerged.
“The objective is to allow these funds to improve their liquidity management with a range of tools such as redemption gates, notice periods and swing pricing, and to prevent funds from having to close down,” says Ribaudo.
However confident Germany’s funds market is about liquidity management, though, there are some complexities. In Ireland, industry association Irish Funds and its working group on investment risk produced a paper in June on liquidity challenges. This notes the impact of investor behaviour on fund flows and highlights the fact that it is difficult to profile investors and their redemption preferences.
Assumptions about investor behaviour are inherently difficult to validate, the paper says, and should not be relied upon exclusively in the absence of industry-wide adoption.
The study also notes that “access to investor data is an ongoing challenge” and calls for more help from regulators in ensuring the “standardisation of investor data which will help firms deliver enhanced liquidity protection and analysis to investors”.
Moreover, it weighs in on the “critical importance that a fund’s offering terms continue to match the investor profile and asset/liability side liquidity profile”.
A number of steps for fund manufacturers are recommended, including verification of the fund’s dealing frequency, detailed liquidity analysis of assets and liabilities, and clear documentation around additional redemption terms, such as anti-dilution levies, gating and in-kind redemptions.
All processes should be documented and tested, says Irish Funds. There should be explanations of how decisions are made and it should be clear who is responsible for approval.
No more naming and shaming
The Luxembourg funds industry association, Alfi, places a good deal of emphasis on documentation too. “The trade-off between extended redemption periods and illiquid assets is a question of transparency and disclosure, making sure that the product is suitable to the investor – as per MiFID II – and that the fund characteristics are clearly set out in the offering documents,” says Marc-André Bechet, Alfi’s director of legal and tax.
Investors may well accept longer redemption periods, but what about more blunt instruments, like dealing suspensions when funds come under stress? Bechet thinks they are more accepting of these, too. “Suspending used to be a name-and-shame affair but that is less the case today,” he says.
This is partly down to improved communications from fund providers, reminding investors that measures such as gating (partial or short-term restrictions) are there to protect them.
Funds based in Luxembourg have been using swing pricing increasingly, according to Bechet. This is where calculation of the net asset value can ‘swing’ from using the mid-price to the bid or offer price, presenting a clearer cost of producing or disposing of extra units at a time when a fund is stressed by subscriptions or redemptions.
“The purpose of swing pricing is to provide reasonable protection to existing shareholders in a fund against the negative dilution impact occurring when a fund invests/disinvests in securities as a result of shareholder activity,” he says. “This is achieved by transferring the estimated impact arising to those shareholders transacting.”
He adds: “These tools have been in place for some time. But you cannot expect investors to accept them blindly. You need their approval in some circumstances. What matters is to remind ourselves that all liquidity management tools are being used with a view of protecting investors and striving to treat them equally.”
Specialist fund administrators
Fund manager clients of specialist fund administrators often offer closed-ended funds investing in the likes of private equity and real estate. Liquidity in these funds is extremely limited due to lengthy ‘lock-up’ periods.
Since the start of the pandemic, fund managers have realised that a primary concern was to identify whether their investment portfolios’ were vulnerable to liquidity issues in the short or medium term, says Marie Fitzpatrick, senior director at JTC – adding that in the private capital markets, a variety of liquidity management tools have been considered and deployed.
“Managers whose funds were fully [invested] have looked to recall capital distributed within the last 12 months. Others have simply requested to renegotiate terms and provisions in their ‘limited partnership agreement’ to enable them to recycle capital if the situation arises.
“Fund managers with a more pressing need for liquidity have explored credit lines, NAV facilities or preferential equity as a tool to manage liquidity of their portfolio investments.”
Furthermore, some fund managers were in conversations with debt specialists to explore “co-investment optionality”, according to Fitzpatrick.
Liquidity has always been an issue for investors contemplating private assets, says Claude-Joseph Pech, head of business development and client relationships at Pictet Asset Services. He says liquidity is now part of the “standard asset allocation gridline” for institutional investors and high-net-worth individuals who are more relaxed about lock-up clauses, reduced redemption frequency and gating.
“Low or negative interest rates on cash and fixed income probably favoured private-asset allocations for cash-rich investors. As a long-term and diversification approach applies, investors have indeed accepted that these funds operate differently from plain vanilla.”
‘Subscription line financing’ is another more widely used tool, says Justin Partington, group head of funds at IQ-EQ. “Many managers and portfolio companies have fully drawn down available credit facilities in anticipation of a potential liquidity crunch. A number of managers have created a pool of liquidity at the fund level that could be lent to the underlying portfolio companies on a case-by-case basis.”
Michael Johnson, group head of fund services at Crestbridge, says private market investors’ use of cashflow-forecasting tools has definitely grown. “These allow general partners to measure their cashflows for the short term in a much faster and more precise way than doing so manually, thereby alleviating their administrative burdens.”
Enterprise resource planning systems were increasingly used prior to the pandemic, but adoption has grown even more in recent weeks and months, Johnson adds.
“Staying on top of cashflow is integral to the successful management of private market portfolios,” he says.
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