Category: Member Update

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Member Update

The Retailisation of Illiquid Assets

Illiquid assets are not for retail

While asset managers have largely navigated COVID-19 – both in terms of investment performance and operational resiliency – a number of longer-term risks are starting to emerge. Ultra-low interest rates are unlikely to disappear anytime soon, nor will the widespread equity market volatility, both of which are going to negatively impact investment returns. In response, there are now growing calls by some in the industry for retail investors to be given easier access to illiquid asset classes such as private equity. NCI believe this is a mistake, and risks doing major harm to the industry’s reputation.

Leave illiquids for the institutions

In theory, there is a robust case for greater investment into illiquid assets. The collective performance of private capital managers – namely private equity and private debt – has been impressive recently, and both asset classes are attracting record inflows from institutional investors. In fact, distressed debt is one of the very few asset management strategies to have benefited from COVID-19. But that does not mean illiquid asset classes are suitable investment products for retail.

Firstly, the appetite among retail investors for illiquid assets is not there. Retail investors – young and old – want liquidity on a daily or weekly basis. Unlike institutions with long-term investment horizons, retail investors will simply not accept the 10-year plus lock up periods accompanying private capital strategies. This is one of the principle reasons why the ELTIF (European Long-term Investment Fund) – an EU fund structure designed to give retail investors and smaller institutions access to illiquid assets like infrastructure, loans and real estate totally failed to generate interest.

Going against the prevailing tide

Although a number of asset managers have repeatedly expressed frustration about some of the (many) flaws around investor reporting, templates such as the UCITS KIID (Key Investor Information Document) do serve a useful purpose insofar as they provide a digestible summary of what a fund’s core objective is. Unlike conventional equities and bonds, illiquid assets are complex instruments, as are the funds that invest in them. While explaining the operating model of a vanilla UCITS vehicle to retail clients is a fairly simple exercise, it is naïve for people to assume the same will be true for private capital, which use intricate distribution waterfall methods to allocate capital gains to clients.

Making illiquid assets available to retail investors also goes against the prevailing regulatory tide. The Financial Conduct Authority (FCA) in the UK is currently examining the liquidity risk management practices at asset managers following the Neil Woodford Equity Income Fund gating incident back in 2019 and the trading suspensions by a number of daily dealing property funds during the height of the pandemic. Any attempt by asset managers running illiquid strategies to broaden their distribution reach into the retail world would risk regulatory scrutiny given these recent events.

Is it worth the risk?

As enticing as it may be for managers to offer retail investors access to illiquid assets, it is not a sensible policy to pursue. The reputational damage, which the funds industry would face should something go spectacularly wrong – is too great. At a time when investment firms are gradually rebuilding trust with retail investors, shifting into illiquids would be a terrible and ill-advised move.

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Member Update

Beware the threat to delegation

Having had more than four years to prepare for Brexit, the majority of UK investment firms appear to be in a reasonably robust position to withstand any challenges that may arise. In July 2020, the European Securities and Markets Authority (ESMA) and national EU regulators reiterated that the memoranda of understandings (MOUs) it agreed with the UK Financial Conduct Authority (FCA) on cooperation and information exchange in the event of a no-deal Brexit were still valid. According to ESMA, the MOUs will help facilitate continuity for financial institutions if no UK-EU deal is obtained.

Although fund managers are confident that existing distribution channels will not be disrupted when Brexit takes effect on January 1, there are some more longer-term concerns about the ease in which investment firms will be able to sell into the EU. This trepidation stems in part from a letter penned by ESMA in August 2020. While the bulk of the letter’s contents were not especially controversial or substantive in nature (i.e. calling for greater harmonisation between UCITS and the AIFMD [Alternative Investment Fund Managers Directive]), its comments on delegation elicited criticism.

Delegation is the process whereby an EU entity – known as a ManCo (management company) – outsources investment and risk management activities to a third country manager – enabling them to seamlessly passport or distribute their funds into the EU. For non-EU managers, this allows them to maximise their distribution footprint. It is also one of the reasons why UCITS and AIFMD structures are so universally popular, especially among SME (small to medium sized) asset managers who otherwise would be unable to afford the costs of building up a physical presence inside the EU.

While the ESMA letter did not say it would ban delegation outright, it did acknowledge there were flaws in the model. ESMA accepted that delegation arrangements did generate efficiencies for investment firms but added it “may also increase operational and supervisory risks and raise questions as to whether those AIFs and UCITS can still be effectively managed by the licensed AIFM or UCITS management companies.” ESMA continued there needed to be legal clarification on the maximum extent of delegation that is permitted so as to ensure supervisory convergence and that authorised AIFMs and UCITS management companies maintain sufficient substance within the EU.

Any attempt to impose additional barriers around delegation is likely to frustrate third country asset managers – including those located in the UK post-Brexit, as it could force them to increase their operations and headcount inside the EU at significant cost. In the past, there have been attempts by some member states to restrict delegation but these efforts came to nothing, owing to effective lobbying by industry groups and representatives from onshore fund domiciles such as Ireland and Luxembourg. However, fund managers are under no illusion that future bids to roll back on delegation by European policymakers could potentially gather more momentum over the next 18 to 24 months. As a result, this is an issue, which UK fund managers should be paying close attention to.

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Member Update

Well-intentioned but light on substance: The ESMA review of AIFMD

In August 2020, the European Securities and Markets Authority (ESMA) published a letter to the European Commission (EC) outlining its recommendations on future potential amendments to the Alternative Investment Fund Managers Directive (AIFMD). The letter’s contents have yielded a mixed response from the asset management industry. The NCI takes a look at some of ESMA’s proposals.

Greater harmonisation

The lack of harmonisation between UCITS and AIFMD has been a source of frustration at asset managers for a long time. Accordingly, ESMA has asked the EC to align AIFMD and UCITS where possible. ESMA also said there needed to be greater consistency between AIFMD/UCITS and MiFID (Markets in Financial Instruments Directive) to ensure that entities providing similar services are subject to comparable regulatory standards. Again, this is a welcome development for the funds’ industry. Having made improvements to AIFMD’s Annex IV reporting, ESMA also said it was vital that UCITS reporting should now become more harmonised and less duplicative. The lack of reporting standardisation in member states has been a significant barrier for asset managers undertaking cross-border distribution. The implementation of a more homogenised regulatory and reporting regime for UCITS would help provide a much-needed boost to cross-border distribution and sales.

ESMA added there needs to be greater EU-wide consistency on liquidity risk management, an issue which has become more crucial following the Covid-19 crisis. “In ESMA’s view, the EC should take the opportunity to  review the availability of all liquidity management tools outlined in the European Systemic Risk Board’s (ESRB) recommendation A. In addition, the availability of tools should also be included in the UCITS directive.” Among the ESRB’s suggestions were that additional provisions be inserted into AIFMD and UCITS clarifying the roles of regulators when using their powers to suspend redemptions in situations where there are cross-border financial stability implications. For instance, there is still uncertainty as to which regulator is responsible for supervising redemptions and subscriptions– when the fund and its management company are located in different member states.

Delegation in the spotlight

Delegation arrangements at asset managers have been subject to intense scrutiny ever since Brexit. While ESMA accepts delegation promotes efficiency, it warns the practice can increase operational and supervisory risk, especially if more strategic activities take place outside of the EU. In response, ESMA said “further legal clarifications on the maximum extent of delegation would be helpful to ensure supervisory convergence and ensure authorised AIFMs and UCITS management companies maintain sufficient substance in the EU.” Although previous attempts by some member states to limit delegation were rebuffed, it continues to be an ongoing risk for non-EU investment managers.

A damp squib

While advocating for further harmonisation of UCITS and AIFMD is not a bad thing, the ESMA letter is deliberately vague. The section on reverse solicitation simply calls for greater clarity owing to the fact different member states are adopting their own interpretations. This is a sensible recommendation but ESMA provides little detail on how this should be achieved. Similarly, ESMA takes a fairly ambiguous position on the establishment of a pan-EU depositary passport – a topic which has been under discussion since the early 1990s – by  kicking the issue into the long grass. Even though ESMA’s message is generally positive, the letter is extraordinarily light on substance.  

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Member Update

Not the time for deviation on ESG standards

Although interest in ESG (environment, social, governance) investing has been gathering momentum for several years now, Covid-19 has accelerated this trend exponentially. Data released by Morgan Stanley shows issuance of social and sustainable bonds topped $32 billion in April 2020, a monthly total surpassing that of green bonds for the first time ever. The market share grab by social bond issuers has been extraordinary, but it is reflective of a wider shift into ESG by investment managers.

The rise of ESG has been organic, fuelled by institutional clients becoming more aware about societal and environmental issues, and who in turn are demanding asset managers plough more resources into ESG investing. It has also been regulatory-led. The EU’s Sustainable Finance Action Plan is widely seen as being a trailblazer on ESG. Assuming deadlines are met, the European Commission has said it wants financial institutions – including fund managers – to be compliant with the new rules by 2021. 

The Brexit effect

Although the UK has said repeatedly that it does not intend to deviate from EU regulations following the Brexit transition, the government has yet to publish comprehensive legislation on sustainable finance, something which could result in ESG requirements coming into force later in the UK than in the EU. A senior official from the Department for Work and Pensions (DWP) also said the extent of the UK’s application of EU directives and regulations – such as the adoption of sustainable finance disclosure rules – would be conditional on the ease of market access following the Brexit transition.

A handful of industry associations are beginning to sound the alarm. The UK Sustainable Investment and Finance Association (UKSIF), a body that represents financial institutions with assets totalling more than £7 trillion, implored the Treasury to outline its regulatory approach on sustainable investing. This comes amid fears the UK is at risk of undermining its reputation as an ESG leader in financial services. Moreover, asset managers with cross border operations have warned they could face added costs if the UK develops ESG regulation that does not correspond with the EU’s rules. 

Standards correspond with success

The Treasury’s plans are not yet known , but it has said that more information about its ESG disclosure regime will be released in due course. The issue of the UK arbitraging with the EU is worrying, particularly on ESG standards. Right now, ESG standards are a mess, mainly because so many bodies and associations (albeit good-intentioned) have developed their own, customised standards. In addition, different regulators are pursuing their own ESG regimes, further complicating the process.  All of these conflicting rules are going to prove incredibly confusing for global investors. 

A failure to develop harmonised, sensible and easy to understand standards will undermine regulatory efforts to stamp out green-washing and ESG mis-selling, an issue which is likely to become more prevalent moving forward. It is vital that regulators and industry bodies communicate with each to create common standards to preserve the integrity of the rapidly-growing ESG market.