The City regulator – the Financial Conduct Authority – has suggested new rules to help protect those investing in commercial property funds. These would also apply to other open-ended funds trading in illiquid assets, such as infrastructure.
This consultation papers comes after many commercial funds suspended trading after the Brexit vote. At the time there were fears this could spark a downturn in prices, and that fund managers would be unable to sell assets quickly enough to pay investors looking to exit these funds.
Many funds stopped withdrawals completely, or imposed hefty penalties of up to 15%. Similar restrictions were put in place following the 2008/09 financial crisis.
However, the FCA stopped short though of proposing a ban on open-ended funds trading in these illiquid assets. It said it did not think such action would be “appropriate” or commensurate with the risks faced by investors.
Should Property Funds Hold More Cash?
Instead it has proposed a number of “solutions” to improve the way these liquidity risks are managed.
These include imposing a cap on these illiquid assets help within a fund, which in effect would mean many of these commercial property funds holding a far larger cash stake. This though could dent longer-term returns, as this buffer is likely to act as a drag on performance, particularly during periods where prices are on an upward curve.
Many commercial property funds already do hold reasonable cash buffers. Laith Khalaf, a senior analyst at Hargreaves Lansdown adds: “It’s worthy of note that commercial property funds held high levels of cash in the run up to the EU referendum, yet this did not stop trading suspensions when the UK electorate pressed the Brexit button.”
Whatever a minimum cash buffer is set at, there is always the danger that the number of investors looking to exit the fund could exceed this.
Alternative Ways To Manage Liquidity Risks
Alternatively, the FCA suggested: splitting the investments of institutional and retail investors, placing restriction on multi-asset or multi-manager funds investing in these funds, diversifying the investor base of these funds, and improving disclosure to investors – so they are more aware of these risks.
In addition, the FCA also suggested developing a secondary market in units of open-ended funds. If done successfully this would enable investors to effectively “cash in” their holding, without the fund manager selling assets. However, in periods when property prices fall, and there is a rise in investors selling this is likely to mean units are sold at significant discounts.
These proposals are now open to consultation.
Making Investors More Aware Of Liquidity Risks
Khalaf added: “The FCA has ruled out banning open-ended funds from holding illiquid assets – such as commercial property or infrastructure. This is entirely sensible, as that would have been an over-reaction to the problems in the commercial property sector which surfaced last summer.
“However, the regulator has set out a list of possible measure it could take to mitigate any future issues arising from funds which hold illiquid assets. Any effective solution will probably have to strike a compromise between the demand from investors for regular dealing and the illiquid nature of the assets held in these funds. Even then there are no guarantees such measure will prevent the same problems resurfacing in future.”
He added: “We remain of the view that commercial property investments is more suited to closed-ended funds, buy where investor are advised to buy open-ended funds, the illiquidity risk must be clearly explained upfront so that are going in with their eyes open. Fostering a long-term approach to investing also helps investors to see past periods of market turmoil, like the one we witnessed in the commercial property sector last summer.”
