In its recent Discussion Paper “Patient Capital and Authorised Funds”, the FCA has outlined its thinking on how the economic need for “patient capital” can be serviced within the investment regime for authorised funds.
Patient Capital is defined for the purposes of the Discussion Paper as a broad range of alternative investment assets intended to deliver long term returns. Examples cited include infrastructure, real estate, private equity/debt and venture capital. The common factor is that the assets are typically illiquid and often require investors who are “patiently” willing to tie up capital for a prolonged period and as the corollary of that, forego the ability to realise the investment at any time.
The publication of the Discussion Paper has been made at the same time as the FCA is consulting on tightening up the protections available to investors who currently subscribe for units/shares in authorised funds investing in illiquid assets, largely property funds (Consultation Paper on illiquid assets and open-ended funds (CP18/27). There is therefore a difficult balancing act to manage in the proposals, opening up investment in illiquid assets whilst tightening up some of the ways in which authorised funds utilising illiquid assets are currently managed and presented to retail investors.
The FCA notes that the key features of the current authorised fund regime are that:
- Investors will be treated fairly;
- Investment risks are managed in a professional and appropriate manner;
- Investors can redeem their investments on demand.
It is the last of these key features which is perhaps most at odds with the fundamentals of patient capital making it challenging for such funds to obtain exposure to illiquid asset classes.
The current rules for UCITS funds are largely designed to ensure managers maintain exposure to largely liquid investments to achieve that purpose.(Although the FCA notes that this is sometimes achieved by holding liquid investments which give access to illiquid assets such as REITs or index based derivatives). The FCA highlights the significant limitations placed on UCITS funds holding illiquid assets. Clearly any change for UCITS would need to come at European level, subject to all the caveats that apply to Brexit.
The principal benefit of the NURS regime (Non- UCITS authorised funds), by contrast was to create a vehicle which would qualify as a retail friendly authorised fund but at the same time offer exposure to more illiquid assets. As such, they can have substantial exposure to illiquid assets but with many of the protections retail investors expect. The current Consultation Paper covering illiquid assets and open –ended funds highlights some difficulties that come with illiquid investments and the NURS regime, but the proposals do not propose material changes to the investment proposition. Rather the proposals are intended to ensure that the investors better understand the implications of the investment and experience greater fairness in valuation.
The FCA is interested to understand whether there is a demand for investors to use the authorised fund regime to invest directly into patient capital assets and if so, what safeguards would need to be provided. It poses a number of questions.
Clearly investments in infrastructure assets, private equity and real estate are all available to retail investors through the REIT, VCT and investment trust vehicles- so do authorised funds offer something different?
The benefit of the Investment trust/REIT and VCT vehicles is that there is generally a ready market for shares to trade, albeit shares can trade at a premium or discount to net asset value depending on market views. The fact that the investment manager does not need to fund redemptions means that managers can take a more long term approach to investment generally. Investment limitations may not be fixed as with authorised funds but if they are clearly disclosed to investors in offering documents, is that a significant drawback for investors?
One of the issues highlighted by the FCA with reference to the existing NURS regime is that investments in illiquid investments are restricted to freehold or leasehold property in England (heritable in Scotland) and the equivalent abroad. Financing of infrastructure projects may mean that funds have less clearly defined interests in the projects. Should therefore more latitude be given as to what will be permitted as a legitimate investment interest?
The FCA also highlights the options available to the more sophisticated investment community. Qualified Investment schemes (“QIS”). QIS are authorised funds but have a much more permissive regime for investing as befits funds which are open only to professional clients and sophisticated retail investors. QISs may invest in the same type of investments as UCITS and NURS but have no limits or restriction by way of category limits or diversification rules although the Manager must seek to ensure there is a spread of risk. The FCA is asking whether the current regime is sufficient to allow investment in patient capital, or should changes be made?
One other issue that the FCA highlights is the need to ensure fairness for investors buying into and leaving a fund, that they do so at the right value. If the fund is not priced correctly, some investors will suffer. Those leaving at a more beneficial price prejudice existing investors. If those redeeming receive too low a valuation, they clearly suffer to the benefit of exiting investors.
To the extent investment in more categories of illiquid investments is permitted, work would need to be done in ensuring an appropriate valuation methodology is applied to investments whatever they are, as there is unlikely to be a ready market valuation, such as with listed securities. The FCA are proposing that if a valuation methodology breaks down due to material uncertainty, there should be provision for a dealing suspension so that dealing only takes place when there is certainty on price- much as the FCA have proposed in their Consultation Paper on illiquid assets.
The FCA notes the experience with European Long Term Investment Funds. Two key features of these are the fact that these must exist for a fixed period to reflect the illiquid nature of the assets that they apply to and that there are only very restricted rights to redeem holdings. The FCA also notes the limitations that apply to those investing in ELTIFs. The FCA concludes by stating to date it has received no applications to launch an ELTIF- perhaps not surprising in view of some of the restrictions that apply to investment parameters, marketing of units and redemption.
The case for authorised funds investing in patient capital may be a difficult one to make. Existing quoted and traded vehicles seem to be tailored to the needs of patient investment capital, giving management the space to invest for the long term without constant pressures on liquidity. The difficulty with introducing the compromises needed to allow such investment for authorised funds is whether the hybrid structure that results, will be of sufficient appeal to both managers and investors. The closing date for responses is 28 February 2019, and there is a response form available here.
On January 29, 2019