Funds Legal Update | 02 June 2020

In difficult economic conditions, well-informed investment decisions are critical. The latest guidance published by the Standards Board for Alternative Investments (SBAI) provides a powerful toolkit for the alternative investment industry. With a specific focus on valuation, this guidance coincides with efforts at a European level to assess how well prepared the real estate and corporate debt fund industries are to withstand significant redemptions or an increase in valuation uncertainty.

In these times of intensified market volatility, the European markets have also seen an upsurge in the number of retail investors, prompting a reminder from the European Securities and Markets Authority (ESMA) about firms' conduct of business obligations under the second iteration of the Markets in Financial Instruments Directive (MiFID II).

While many funds have experienced net outflows as investors have reacted to international lockdown measures, responsible investment funds bucked the trend in March and recorded a net retail inflow. With sustainable investing remaining firmly on the agenda, are companies sufficiently clued up on how they are being rated on environmental, social and governance metrics?

Finally, we look at the Financial Conduct Authority's (FCA) new initiatives grid and what is coming down the regulatory pipeline.

The Future Fund: further guidance released but questions remain

On 18 May 2020, the British Business Bank (BBB) published final details for the UK government’s hotly anticipated Future Fund, which is intended to provide UK-based innovative companies with sufficient capital to cope with the financial impact of the coronavirus pandemic by advancing funding via convertible loans. The window for applications opened on 20 May 2020 and will stay open until the end of September 2020.

The BBB has reported significant uptake under the scheme, with well in excess of £500 million worth of applications received in the first few days.

The strong recommendation from the BBB is that potentially eligible companies should still apply. To find out what the final guidance means for companies and investors, what still remains to be confirmed and what actions companies should be taking, take a look at our Insight.

New guidance for alternative credit

The Covid-19 crisis has brought issues such as fund structure and valuation into sharper focus. As liquidity is squeezed, now more than ever managers and investors are looking to the protections and flexibility available to preserve value.

The three memos published by the SBAI on alternative credit fund management provide welcome guidance to managers and investors operating in the alternative investment industry. Focusing on fund structuring considerations, valuation and conflicts of interest, the SBAI also provides a framework of questions investors may wish to ask managers when conducting operational due diligence. The memos reaffirm the SBAI Alternative Investment Standards that were established over a decade ago and have been adopted by many of the largest managers in the alternative investment industry.

• Fund Structuring Memo: focuses on key considerations for the two most common fund models employed by alternative credit managers: the closed-ended private equity model and the open-ended hedge fund model.
• Valuation Memo: highlights the key features of a robust valuation framework and illustrates the fair value process for direct loans.
• Conflicts of Interest Memo: identifies the specific conflicts of interest that can arise in funds investing in alternative credit, including in situations where different funds invest in different parts of a company's capital structure and where one fund refinances a loan held by another fund.

There is more in the pipeline as the SBAI Alternative Credit Working Group continues to review other areas of relevance in alternative credit, including investor disclosure and applicability of Responsible Investment considerations. In addition to the SBAI’s work in Alternative Credit, it is also running a number of working groups focusing on governance, responsible investments, insurance linked funds, factor investing and a standard investor profile template.

Corporate debt and real estate funds high on the priority list

On 14 May 2020, the European Systemic Risk Board (ESRB) published a recommendation on liquidity risks in investment funds. Following significant redemptions from certain investment funds and a significant deterioration in financial market liquidity, it has identified two segments of the investment funds sector as particularly high-priority areas for enhanced scrutiny from a financial stability perspective, namely: corporate debt funds and real estate funds.

In this context, the ESRB's recommendation is for ESMA to:

• co-ordinate with the national competent authorities to undertake a focused piece of supervisory work with investment funds that have significant exposures to corporate debt and real estate assets to assess the preparedness of these two segments to potential future adverse shocks, including any potential resumption of significant redemptions or an increase in valuation uncertainty; and
• report to the ESRB on its analysis and on the conclusions reached regarding the preparedness of the relevant investment funds.
  ESMA is required to communicate the actions taken in response to the recommendation to the European Parliament, the Council of the EU, the European Commission and the ESRB by 31 October 2020.

When it comes to liquidity management, asset managers have a wide range of liquidity management tools at their disposal, including anti-dilution levies, redemption fees, swing pricing, redemption gates and the suspension of redemptions. These are designed to ensure that investment funds with multiple investors can continue to operate in the best interests of all investors, both in normal times and in periods of economic stress. In this recent statement, the ESRB emphasises the importance of the timely use of liquidity management as a key element of prudent liquidity risk management by investment funds. However, without adequate legal backing, the availability of these tools remains patchy across the EU. While the ESRB recognises the need to rectify this in light of recent market developments, it remains to be seen how quickly harmonisation can be achieved in practice.

Responsible investment funds remain resilient – but ESG rating is important

Responsible investment funds remained resilient in March, with £113 million in net retail sales, according to the Investment Association's latest figures.

This comes at a time when companies are being told the higher their ESG score, the greater the investor interest they will receive – together with a boost that comes with being included in the increasing number of ESG-focused index funds. However, according to a recent Financial Times article, fund managers are struggling to "compare ESG apples with oranges". The EU Commission recognises the need for precise and validated sustainability ratings, and is currently consulting on how it might improve the oversight of ESG ratings as part of a renewed sustainable finance strategy. The deadline for responses is 15 July 2020.

Treating investors honestly, fairly and professionally

On 6 May 2020, ESMA published a statement reminding firms about their conduct of business obligations under MiFID II in the context of increasing retail investor activity during the COVID-19 pandemic. According to ESMA, firms have even greater duties when providing investment services to investors, especially when they are new or have limited investment knowledge or experience, who decide to invest during these volatile market conditions.

The statement reminds firms of their obligation to act honestly, fairly and professionally in accordance with the best interests of their clients and to comply with all relevant MiFID II conduct of business and related organisational requirements. In particular, ESMA highlights firms' obligations in respect of product governance, information disclosure, suitability and appropriateness. ESMA says that it and local regulators will continue to monitor retail clients' involvement in the financial markets and firms' compliance with their conduct of business obligations and related organisational requirements under MiFID II.

Don't forget – MiFID II is under review. The Alternative Investment Management Association and Managed Funds Association recently submitted a detailed response and cover letter in response to the European Commission's consultation on the review of the MiFID II/MiFIR framework. The Commission will now consider the responses it has received and could come forward with an initial set of legislative proposals as early as June.

FCA provides some clarity in a crisis

This new initiatives grid published by the FCA is a comprehensive guide to what we can expect to come down the regulatory pipeline over the medium term. The grid is organised by sector. It includes a "multisector" chapter that covers initiatives that span more than one sector in addition to sector-specific chapters, including retail investments and investment management.

• Retail investments: This chapter contains six initiatives, most of which are in the form of consultation or implementation of rule changes. All but one (namely, the evaluation of the Retail Distribution Review and the Financial Advice Market Review) have been postponed due to Covid-19, with new dates yet to be confirmed.
• Investment management: There are five initiatives in the investment management chapter, which are of lower impact to the sector. All work streams save for two (namely, the Overseas Funds Regime and the Investment Firms Prudential Regime) have been delayed due to Covid-19.