Liquidity – Independent Investment Management Initiative

Liquidity risk management – expect new rules

Liquidity risk management was an area of concern for the UK’s Financial Conduct Authority (FCA) long before COVID-19 struck. The preceding summer had seen Neil Woodford’s Equity Income Fund forced to suspend redemptions after investing into difficult-to-dispose of assets. The FCA and Bank of England are currently reviewing liquidity risk management practices at managers with one possibility being that redemption notice periods be lengthened to reduce the risk of panic selling, particularly at daily dealing funds whose portfolios contain difficult to sell assets. In 2020, the FCA sent a survey to asset managers asking them about their financial resilience during COVID-19, the findings of which are likely to feed into any future policies concerning liquidity risk management.

COVID-19 did cause a handful of short-term liquidity issues, especially for entities exposed to real estate assets and corporate debt. The European Securities and Markets Authority (ESMA) subsequently issued a report in November 2020 urging AIFMs and UCITS to implement changes to ensure they are better prepared for future shocks, including improved liquidity profile reporting and ongoing supervision checking there is alignment between the fund’s investment strategy, liquidity profile and redemption policy.

Operational resiliency will continue to be a priority

While the FCA has applauded the asset management industry’s response to COVID-19, it is likely to continue focusing forensically on the sector’s operational resilience. Rather fortuitously, the FCA published a guide to operational resiliency in 2019 just ahead of COVID-19. Among some of its main requirements are that financial institutions consider how disruption to their business services can have an impact beyond their own commercial interests; that firms set a tolerance for disruption for each important business service and ensure they can continue to deliver these critical services during serious crises; and a requirement for financial institutions to map out and test important business services so as to identify vulnerabilities in their operational resilience.

ESG and a new era of regulation

The absence of regulation and a litany of different standards has meant that investing into ESG (environment, social, governance) assets can be a complicated activity. The EU – conscious of the challenges facing investors when allocating into ESG funds – has sought to make the process more straightforward through the passage of the Sustainable Finance Disclosure Regulation (SFDR), which will oblige fund managers to disclose on their websites how they incorporate sustainability risks into their investment decision-making and remuneration policies. A template specific to sustainability funds will need to be produced from next year, while it is expected the taxonomy will also be published in 2021. Although the UK has yet to introduce its own equivalent ESG rules, few expect the country will deviate too much from the EU. Furthermore, many existing non-EU AIFMs leveraging the national private placement regimes will still need to comply with SFRD and the taxonomy rules.

Charles Gubert

Charles is the Head of Regulation at the Independent Investment Management Initiative.

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.