Patient capital and authorised funds – the FCA publishes its feedback

FS20/2, Patient Capital and Authorised Funds

On 28 February 2020, the FCA published FS20/2, Patient Capital and Authorised Funds (FS 20/2).

FS20/2 provides the FCA’s feedback to responses received to its discussion paper DP18/10. In DP18/10, the FCA invited views as to whether there were any barriers that might impede investment in long-term assets through authorised fund vehicles.

The most substantial response received was that of the Investment Association (IA), which set out its proposal for a new type of authorised fund, the Long-Term Asset Fund (LTAF). Although not dismissing the option outright, the FCA did note that the IA would need to do more work on its proposal before the regulator would consider putting it out for consultation.

As the FCA’s overall view, in light of responses received, is that there are no inappropriate barriers to investing in long-term assets within its authorised funds regime, it seems unlikely that any proposals for rule changes will emerge as a result of DP18/10.

This is, though, only one of a number of workstreams in which the FCA is currently engaged (see the section, The FCA’s work on liquidity, below) which looks at the general issue of fund liquidity and redemption rights. Hanging over all of this, of course, is the shadow of the LF Woodford Equity Income Fund (Woodford), an authorised UCITS scheme (and so accessible to retail investors) which suspended dealing on 3 June 2019 and which was subsequently liquidated, causing loss to its investors.

The FCA notes in FS20/2 that it will ‘also be considering’ any rules changes that may be recommended later this year following its work with the Financial Policy Committee (FPC) (see below).

Key outcomes from FS20/2

The UK’s authorised funds regime generally

• The FCA found that there were no inappropriate barriers to investing in long-term assets within its authorised funds regime.

• Respondents regarded the current regime as broadly fit for purpose for long-term investment by both professional and sophisticated retail investors.

• For broad retail distribution funds, though, the FCA’s view was that barriers do exist that limit the range of available investment options.

• However, the FCA accepts that it is not clear that such barriers are inappropriate nor how they could be relaxed without introducing a degree of risk that would be unsuitable for retail investors. At thesame time, retail investors already have alternative ways of accessing long-term investments through other investment products, such as investment trusts.

UCITS and non-UCITS retail schemes (NURS)

• Respondents agreed that investment restrictions intended to offer enhanced investor protection mean that UCITS and NURS provide only limited options when it comes to investing in long-term assets.

• The FCA notes that, while respondents felt it was desirable for retail investors to have greater access to investment in infrastructure funds through NURS, they did not identify any infrastructure assets in which authorised retail funds cannot currently invest.

Qualified investor schemes (QIS)

• QISs, on the other hand, were generally considered to be suitable for long-term investment.

Diversification rules in authorised funds

• It was felt overall that these rules can be problematic for fund managers wishing to invest in long-term assets and could be made more flexible.

• The FCA’s work with the FPC (see below) is exploring what other tools might be introduced to help funds manage their liquidity to avoid systemic risk or investor detriment. These tools might include notice periods and pricing adjustments.

ELTIFs, EuVECAs and EuSEFs

• Because of the perceived complex operational requirements and suitability requirements surrounding them there is little interest in, and limited use made of, these vehicles.

• To date, the FCA has received ‘only a handful’ of applications for registration of EuSEFs and EuVECAs and no applications for authorisation of ELTIFs.

Other regulatory barriers

• A key barrier to investment in long-term assets was felt to be a reluctance on the part of platforms to accommodate funds that do not deal daily, with the result that funds dealing, say, weekly or fortnightly, have far more limited opportunity to access investors.

• The FCA expects that its future work with the FPC (see below) around notice periods for open-ended funds which invest in illiquid assets will include discussions with distributors. If, as a result of this work, the FCA decides to make proposals for change, it will consult on these in the usual way.

The Investment Association’s proposal for a Long-Term Asset Fund

• The most substantive response to DP18/10 was from the IA, which put forward proposals to introduce a new type of authorised fund, able to invest in long-term assets, the LTAF.

• An LTAF would require the adaptation of the existing NURS structure and would have the following features:

  • It would be an authorised retail fund, the target market for which would most likely be DC pension schemes, professional investors and private wealth/discretionary portfolio managers

    The IA expects there would be limited interest from retail investors wishing to invest direct or on an execution-only basis but feels that it is important for an LTAF to be capable of being marketed to retail investors, where the fund manager assesses this to be appropriate.

  • The investment and borrowing powers of a NURS would need to be amended to allow the LTAF to invest in long-term assets. Such changes would include:

    • up to 100% of the fund’s net asset value (NAV) may be invested in unauthorised collective investment schemes;

    • direct investment permitted in limited partnerships;

    • up to 100% of NAV may be held in unlisted securities; and

    • a wider range of derivatives to be held for hedging purposes.

  • An LTAF would have flexible dealing frequencies with dealing from daily up to two years.

  • An LTAF would have a range of liquidity management tools including the ability to use notice periods for redemptions so fund managers have sufficient time to sell underlying assets, as well as permitting deferred and limited redemptions.

  • The manager of an LTAF would need to make use of a valuation model which considered a range of economic information which relates to both the asset and the wider market.

  • If redemption opportunities are to be less frequent for an LTAF than are currently allowed for authorised funds, it may be necessary to require investors to receive advice and/or limit the amount of an individual’s assets he/she is able to invest in an LTAF.

• While the FCA does not dismiss the idea of an LTAF being introduced in the future, its response to the IA’s proposal is, perhaps, best described as lukewarm (no doubt informed to some extent by the intervening context of Woodford) and its conclusion is that ‘more work is required before we consider consulting on changes to our rules'.

The FCA’s work on liquidity

The FCA’s discussion on patient capital is just one part of a series of different workstreams all of which touch upon the liquidity (or illiquidity) of assets. Over all of these, to a greater or lesser extent, hangs the shadow of Woodford and so, FS20/2 should be seen in the overall context of the FCA’s other work, which includes:

• HM Treasury’s Patient Capital Review

As highlighted above, FS20/2 sets out feedback to the FCA’s December 2018 discussion paper, DP18/10.

DP18/10 was, in turn, part of the FCA’s response to HM Treasury’s Patient Capital Review, introduced as a way of considering how investment in long-term assets (‘patient capital’) could be increased - in particular, the supply of long-term finance to innovative UK companies.

As the FCA’s overall view, in light of responses received, is that there are no inappropriate barriers to investing in long-term assets within its authorised funds regime, it seems unlikely that any proposals for rule changes will emerge as a result of DP18/10.

• FCA’s CP18/40 on permitted links

While DP18/10 looked at whether the UK authorised funds regime faced barriers to investing in long-term – and, typically, illiquid – assets, CP18/40 (which was published at the same time) put forward FCA’s proposals to change its permitted links rules to facilitate investments in long-term assets through unit-linked funds.

The FCA published PS20/4 on 4 March 2020, setting out its final rules and feedback on comments received to CP 18/40.

• Financial Policy Committee (FPC) review of fund liquidity and redemption terms

The FCA has been working since July 2019 with the Bank of England’s FPC on a review of how an open-ended fund’s redemption terms can best be aligned with the liquidity of its assets, with the FPC warning that the mismatch between the two has the potential to become a systemic risk.

A statement issued jointly by the FCA and Bank of England in December 2019 noted that, if greater consistency is to be achieved between the liquidity of a fund’s assets and its redemption terms, the following principles should apply:

• The liquidity of fund assets should be assessed either (a) by reference to the discount in price that would be needed for a quick sale of a representative sample of those assets or (b) the time frame needed to achieve a sale which avoided a material price discount

• To ensure an outcome that is fair for both redeeming and remaining investors, those investors who want to redeem their units should receive a price that reflects the discount which would be needed to sell the required portion of the fund’s assets in the specified redemption notice period.

• Redemption notice periods should reflect the time that would be needed to sell the required portion of a fund’s assets without a discount beyond that captured in the price which redeeming investors would receive.

The review will now go on to consider how these principles might be implemented in a way that is both proportionate and effective. The FCA will use the conclusions of the review (which will be published in 2020) in the development of its rules for open-ended funds.

• FCA’s PS 19/24 (Illiquid assets and open-ended funds)

In October 2019, the FCA announced in PS19/24 that it was bringing in a number of changes to its rules for NURSs which invest in illiquid assets.

The rule changes come into effect on 30 September 2020.

• FCA’s letter to Chairs of Authorised Fund Managers

In November 2019, the FCA wrote to all Chairs of Authorised Fund Managers (AFMs) to remind them that ensuring effective liquidity management in the funds they manage is one of their central responsibilities, even when investment management has been delegated to another person.

The FCA’s letter notes its expectation that AFMs would review their practices as soon as practicable to ensure that they and their fellow AFM board members are comfortable they are appropriate. It also refers AFMs to the FCA’s 2016 paper Liquidity management for investment firms: good practice, which outlines good practice for disclosing, overseeing and implementing liquidity tools and against which AFMs should review their own arrangements.

International work

It is not just the FCA, though, that has the issue of fund illiquidity in its sights. Other international initiatives include:

• ESMAs Final Report, Guidelines on liquidity stress testing in UCITS and AIFs.

On 02 September 2019, ESMA published its Final Report, Guidelines on liquidity stress testing in UCITS and AIFs, setting out 16 guidelines addressed to UCITS ManCos and AIFMs, one to depositaries and one to national competent authorities (NCAs). The guidelines will apply from 30 September 2020 – see our summary [here][12].

• IOSCO’s Recommendations for Liquidity Risk Management for Collective Investment Schemes.

IOSCO’s Recommendations for Liquidity Risk Management for Collective Investment Schemes, published in February 2018, contain 17 recommendations for those responsible for managing fund liquidity aimed at ensuring that investors’ interests are protected and that liquidity is managed appropriately even in stressed market conditions.