ESMA Consults on Liquidity Management Tools for Open-Ended Funds

On 8 July 2024, the European Securities and Markets Authority ("ESMA") published draft regulatory technical standards [1]("RTS") and draft guidelines [2]("Guidelines") addressing liquidity management tools ("LMTs") for open-ended funds.

The RTS and Guidelines are addressed at all open-ended funds, both retail mutual fund UCITS funds and private AIF funds, though in this note we will focus on the implications for AIFs. The application of the RTS and Guidelines to non-EU funds marketed into the EU remains unclear at this point.

The RTS include details on the characteristics of LMTs and define the constituting elements of each LMT, such as calculation methodologies and activation mechanisms.

The Guidelines provide guidance on how managers should select and calibrate LMTs, in light of their investment strategy, their liquidity profile and the redemption policy of the fund.

The RTS and Guidelines are designed to promote convergent application for both UCITS and open-ended AIFs and to make EU fund managers better equipped to manage the liquidity of their funds, in preparation for market stress situations. Additionally, they intend to clarify the functioning of specific LMTs.

ESMA will be consulting on the RTS and Guidelines until 8 October and expects to publish a final report by 16 April 2025.

We have set out a summary below of the provisions of the RTS and Guidelines and some analysis as to the real-world implications given current practices in the semi-liquid private fund space.

RTS

Pursuant to Directive (EU) 2024/927[3], which recently amended the AIFM (and UCITS) Directives, ESMA is required to develop RTS specifying the characteristics of LMTs, from which AIFMs of open-ended AIFs will be required to select at least two appropriate LMTs (or, in the case of money market funds, one appropriate LMT). Those LMTs are as follows:

• Suspension of subscriptions, repurchases and redemptions
• Side pockets
• Redemption gates
• Extension of notice periods
• Redemption fees
• Swing pricing
• Dual pricing
• Anti-dilution levies
• Redemptions in kind

The expectation is that AIFMs of open-ended AIFs should always have the option of temporarily suspending subscriptions, repurchases and redemptions or activating side pockets where this is in the interests of investors, whereas other identified LMTs will only be available to the extent included in the relevant fund's documentation.

The RTS sets out a description of the characteristics of the specified LMTs, summarised below.

Suspension of subscriptions, repurchases and redemptions

As noted above, suspension is not intended to be one of the LMTs that a manager selects but is rather available to all managers in exceptional circumstances.

The characteristics identified by ESMA are as follows:

• A triggering event shall consist of exceptional circumstances and the decision made in the interests of all investors.
• Once triggered, the manager shall not process any request for subscription, repurchase and redemption. The fund cannot be open for subscriptions and closed for redemptions and repurchases (or vice versa).
• Subscription, repurchase and redemption orders placed but not executed before suspension shall not be executed until the suspension is lifted.
• Any decision to suspend must be accompanied by a plan for the future of the fund (e.g. reopening after a specified period, side-pocketing, liquidation).
• The fund must be reopened simultaneously for subscriptions, repurchases and redemptions.

It is worth noting that, in our view, the suspension as conceived in the RTS and Guidelines is not entirely consistent with current market practice - existing funds often allow for suspension of redemption without suspension of subscriptions, save in circumstances where NAV cannot be determined.

Side pockets

As noted above, side pockets are not intended to be one of the LMTs that a manager selects but are rather available to all managers of open-ended AIFs in exceptional circumstances, having regard to the interests of investors.

Side pocketing refers to separation of certain assets with distinctive economic or legal features from the other assets of the fund. Separation can be done through physical transfer or accounting segregation.

The characteristics identified by ESMA are as follows:

• Side pockets shall be closed-ended.
• Investors will receive interests in the side pocket pro rata to their holdings in the original fund.
• The AIFM will manage the side pockets with the sole objective of liquidation.
• Cash from the sale of side-pocketed assets shall be paid to investors (and cannot be reinvested).
• A proportion of liquid assets shall be allocated to the side pocket to meet possible liabilities.
• The remainder of the fund shall be managed in accordance with the investment policy.
• New subscriptions and redemptions shall be executed on the basis of the fund - excluding the assets of the side pocket.

It is worth noting that, in our view, the prohibition of reinvestment of cash from the sale of side-pocketed assets may be problematic in the semi-liquid private assets space, where there may be revolving credit facilities or other assets in respect of which the fund may be contractually required to provide further capital in certain circumstances.

Redemption gates

A redemption gate means a temporary and partial restriction on the right of unit holders to redeem so that investors can only redeem a portion of their interest.

The characteristics identified by ESMA are as follows:

• An activation threshold that triggers the redemption gate, determined, for any given dealing day, as the net redemption orders as a percentage of NAV (other than for ELTIFs which are subject to different treatment).
• Investors have a temporary and partial restriction on their ability to redeem.
• The redemption gate corresponds to the actual proportion of redemption orders executed for a given dealing date and shall not be below the activation threshold.
• Once activated, the same redemption gate level shall apply to all redeeming investors on a pro rata basis, across all share classes.
• When the activation threshold is exceeded, the gate may be activated either automatically or by a decision of the AIFM.
• Unexecuted redemption orders shall be carried forward to the next dealing date or cancelled by the investor.
• The AIFM shall specify in advance whether or not unexecuted redemption orders carried forward will have priority over new redemption orders submitted at the next dealing date.
• The fund may remain open for subscriptions.

ESMA is of the view that determining the activation threshold by reference to individual redemption orders should not be permitted, as this allows differential treatment of investors (investors placing orders below the threshold will have their redemption request met in full, whereas other investors will not).

It is worth noting that, in our view, the specified method of calculating activation thresholds is not entirely consistent with current market practice, which uses a variety of methods, often involving calculation as an average over a period rather than a snapshot. At present, certain funds also apply different redemption gates to different share classes, which may be difficult to reconcile with the requirement that redemption gates be applied pro rata across all share classes.

Extension of notice period

This refers to extending the minimum notice period that investors must give, beyond any existing minimum period, when redeeming interests.

The characteristics identified by ESMA are as follows:

• The extension of the notice period shall be the period of time that is added to the minimum notice period that investors are required to give when placing redemption orders.
• The AIFM may decide to apply the extension for a determined period of time.
• The extension notice will apply to all redeeming investors across all share classes.

Redemption fees

This refers to a fee, within a predetermined range, that takes account of the cost of liquidity paid to the fund by redeeming investors in order to ensure that remaining investors are not unfairly disadvantaged.

The characteristics identified by ESMA are as follows:

• Redemption fees are predetermined fees charged to redeeming investors (i.e. transaction-based fees) which are fixed or have low variation, and are deducted from money received by redeeming investors.
• Paid to the fund to the benefit of remaining investors.
• Intended to impose on redeeming investors the estimated cost of portfolio transactions caused by redemptions, including any estimated significant market impact of asset sales required to meet redemptions.
• May apply to all redemption orders or only redemption orders exceeding a certain threshold, expressed as a percentage of NAV or the number of interests redeemed, or both.
• Investors placing redemption orders that correspond to a certain redemption fee shall all be charged the same fee.

It seems, in our view, unlikely that redemption fees will be well suited to the semi-liquid private fund space given that the nature of the underlying investments means transaction fees are variable and do not reflect the explicit and implicit costs involved.

In the semi-liquid private funds space, it is not uncommon for investors to be subject to a "soft-lock" (whereby investors are only permitted to redeem prior to a specified date, subject to paying an early redemption fee). It is unclear whether this would constitute a "redemption fee" for these purposes.

Swing pricing

This refers to a pre-determined mechanism by which the NAV or the interest in a fund is adjusted by the application of a "swing factor" that reflects the cost of liquidity.

The characteristics identified by ESMA are as follows:

• The swing threshold: the application to every dealing date (full swing) or only when net redemptions or subscriptions are greater than a predetermined swing threshold (partial swing).
• The swing factor - the estimated cost of liquidity used to adjust the NAV (the swung NAV).
• The swing factor will impose the costs (explicit and implicit) of transaction costs - including any significant market impact - of portfolio transactions caused by subscription or redemption.
• On any given dealing date, if there are net subscriptions then the swing factor is added to NAV, and if there are net redemptions then the swing factor is deducted from NAV.
• All transacting investors will transact on the basis of swung NAV, across all share classes.

It seems, in our view, unlikely that swing pricing will be well suited to the semi-liquid private fund space given the nature of the underlying investments.

Dual pricing

This refers to a pre-determined mechanism whereby the subscription, repurchase and redemption prices are set by adjusting NAV per unit to reflect the cost of liquidity.

The IOSCO Final Report on Anti-Dilution Liquidity Management Tools (the "IOSCO Guidance")[4], with which ESMA agrees, indicates that dual pricing can be calculated either by calculating an "ask" NAV for subscribing investors and a "bid" NAV for redeeming investors or by setting an adjustable spread around the fund's NAV under which assets are priced on a mid-market basis, with a bid price at which the fund redeems and an offer price at which the fund subscribes.

The characteristics identified by ESMA are as follows:

• Either
  • There will be two NAVs with subscribing investors taking the ask NAV and redeeming investors taking the bid NAV, or
  • The NAV will be adjusted by a factor that reflects the cost of liquidity with subscribing investors taking the NAV with the adjustment factor added and redeeming investors taking the NAV with the adjustment factor deducted.
• The same methods must be applied to all investors across all share classes.

It seems, in our view, unlikely that dual pricing will be well suited to the semi-liquid private fund space as the nature of the underlying investments means investors have little portfolio visibility or basis to determine NAV.

Anti-dilution levy

This refers to a fee paid by investors at the time of subscription, repurchase or redemption to compensate the fund for the cost of liquidity and to ensure other investors are not disadvantaged.

Anti-dilution levies are different from redemption fees in the sense that they are variable and calibrated according to the fund's net flows. Redemption fees on the contrary are pre-determined fixed fee (regardless of the net flow of the fund), which can be increased under, for example, stressed market conditions (i.e. expressed as range).

The characteristics identified by ESMA are as follows:

• The levy is expressed as a percentage of the subscription or redemption order.
• It can apply on all dealing dates or be subject to a pre-determined threshold.
• On any given dealing date, if there are net subscriptions, then the levy will be charged to subscribers. If there are net redemptions, then it will be charged to redeeming investors.
• Once activated, the levy must be charged to all investors. The amount must be the same for all investors or be tailored to the exact transaction costs of a particular investor if the AIFM can quantify.

Redemption in kind

This refers to transferring assets held by the fund to redeeming investors.

ESMA proposes that redemption in kind should only be used for redemptions by professional investors.

The characteristics identified by ESMA are as follows:

• Redemption in kind allows funds to avoid the sale of large amounts of securities to meet redemption requests, avoiding transaction costs and market impact and protecting remaining investors.
• Only for use to meet redemption requests from existing investors.
• For professional-only, funds the AIFM is not required to transfer assets to redeeming investors on a pro rata basis.

Redemption in kind is, in our view, likely to be of limited utility in the semi-liquid private fund space given the nature of the underlying investments and the expectation of professional investors investing in this asset class.

Guidelines

The scope of the Guidelines is stated as being calibration and minimum expectations on activation and deactivation for suspension and side pockets, and selection, calibration and minimum expectations on activation and deactivation for other specified LMTs.

In selecting LMTs, the Guidelines provide that managers should assess their suitability in relation to:

1. a fund's investment strategy and investment policy;
2. the fund structure, in particular notice period, lock up period, settlement period and dealing frequency;
3. the liquidity profile of the fund and underlying assets, and other liquidity demands and liquidity sources;
4. the fund's redemption policy and investor base; and
5. the fund's distribution policy.

ESMA has, in line with the IOSCA Guidance, determined that LMTs can be broadly divided into Anti-Dilution Tools ("ADTs", or price-based tools) and quantitative LMTs.

The Guidance adopts the following distinction between types of LMT:

• ADTs: Redemption fees, swing pricing, dual pricing, anti-dilution levy;
• Quantitative LMTs: Suspension, redemption gates, extension of notice;
• Other LMTs: Redemptions in kind, side pockets.

The Guidelines stress that LMTs are not the AIFM's only method of managing liquidity risk and should be seen as part of the wider responsibilities of the AIFM.

The Guidelines go on to suggest that, when selecting the two minimum mandatory LMTs, managers should consider, where appropriate, selecting at least one ADT and at least one quantitative LMT.

Managers should be able to demonstrate at the request of the relevant competent authority that the activation and calibration of the selected LMTs are in the best interests of all investors and are appropriate and effective for the prevailing market conditions, whether normal or stressed.

The LMTs, methodology for calibration and conditions for activation should all be contained in a written LMT policy which, according to the Guidelines, should include at least:

1. clear and objective criteria for the selection of LMTs;
2. clear and objective criteria for the activation/deactivation of selected and available LMTs, including an "LMT playbook" highlighting the potential sequencing and interdependencies of selected and available LMTs;
3. the methodology for the activation and, where appropriate, deactivation of LMTs, as well as the calibration of selected and available LMTs;
4. the governance framework around the selection, activation, deactivation and calibration of selected and available LMTs;
5. the governance framework around the frequency of monitoring and reviewing the calibration of an activated LMT to ensure ongoing correctness and effectiveness;
6. a detailed description of senior management's role in the process, including the governing body and the staff involved in the decision making;
7. the role and oversight of internal control functions (e.g. risk management, compliance and internal audit);
8. the management of conflicts of interests, and where such conflicts cannot be avoided, how their impact is managed and mitigated in the best interest of investors, including to avoid that the use of LMTs is aimed at artificially increasing/reducing the NAV and that the knowledge of subscription/redemption flows, or of other information related to the calibration of LMTs (e.g. ADTs' thresholds) is used by some investors to benefit from more advantageous subscription or redemption conditions;
9. procedures to ensure the operational readiness and effectiveness of the manager and relevant stakeholders (e.g. depositary, accounting, distributors and other services providers) in the event of the activation of LMTs;
10. reporting and escalation procedures;
11. assumptions related to the availability of data for activating and calibrating LMTs, their justification and the frequency of their review;
12. routine checks, including back testing, on the activation of LMTs;
13. procedures to ensure record keeping and record retention on: i) the activation, deactivation and calibration of LMTs and the reasons for their activation, deactivation and calibration; and ii) the relevant data concerning the funds, investors, historical flows, results of LMTs and market data;
14. procedures for effective and efficient communication to investors and other stakeholders (e.g. swing pricing factors and thresholds, and, if appropriate, the explanation of how they mitigate the risk of first mover advantage, bearing in mind that it should be avoided that the disclosed information is used by some investors to benefit from more advantageous subscription or redemption conditions, as explained under point h) above), as well as the notification process to the NCA, where relevant.

Managers should provide appropriate disclosure on selection, calibration and conditions for activation and deactivation of LMTs to investors in order for investors to understand the implications of LMTs in terms of liquidity costs and access to capital.

The Guidelines also include guidance in relation to specific LMTs, summarized below.

Suspension

Activation should only be considered in exceptional circumstances, defined as unforeseen events and/or operational or regulatory environments that materially impact the fund's ability to carry out normal business functions.

Can be activated with or separate from suspension of NAV calculation, and should be activated on a temporary basis in conjunction with a detailed LMT plan setting out, amongst other things, the exceptional circumstances leading to activation, expected duration, assessment of impact on investors and an exit plan.

Side pockets

Activation should be considered only in exceptional circumstances. Before activation the manager should formulate a detailed plan including, amongst other things, governance considerations, consideration of impact on investors, communication plan, estimated timeline and an exit plan.

Redemption gates

Activation should be considered especially by managers of funds with a strongly concentrated investor base or funds whose assets might become less liquid during stressed conditions.

For funds marketed to retail investors, redemption gates should not be used to manage day-to-day liquidity but should be activated only in specific circumstances, for instance, to address severe liquidity stresses or stressed market conditions.

Extension of notice period

Activation is recommended for funds where the liquidity can deteriorate quickly during times of stress and for AIFs invested in less liquid assets such as real estate and private equity funds.

Redemption in kind

Application is restricted to professional investors, so managers of funds marketed to both retail and professionals should consider carefully whether to select this as one of the minimum LMTs.

Where redemption in kind is activated, an independent third party (e.g. depositary, auditor) should value the relevant assets.

Redemption fee

Activation is considered most appropriate for funds that have fixed foreseeable transaction costs or low-variation transaction costs (e.g. fixed taxes and levies on real estate transactions) or less liquid assets where other ADTs may be challenging.

Swing pricing

Activation is considered most appropriate for funds whose underlying assets are actively traded and where bid/ask prices are available and up to date.

May be less appropriate in cases of valuation uncertainty (or valuation infrequency).

Not, in our view, expected to be suitable for the semi-liquid private fund space where assets are generally valued quarterly.

Dual pricing

Activation is considered most appropriate for funds the underlying assets of which are actively traded and where bid/ask prices are available and up to date.

May be less appropriate in cases of valuation uncertainty.

Not, in our view, expected to be suitable for the semi-liquid private fund space where assets are generally valued quarterly.

Anti-Dilution Levy

Activation is considered most appropriate for funds whose the underlying assets are actively traded and where bid/ask prices are available and up to date.

May be less appropriate in cases of valuation uncertainty.

Not, in our view, expected to be suitable for the semi-liquid private fund space where assets are generally valued quarterly.

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