AIFMD 2.0 Impact on Open-ended Funds: Liquidity Management Tools

In summary:

• Suspensions and side pockets should always be available to the AIFMs to use in exceptional circumstances,⁴ where justified, having regard to the interests of the AIF’s investors. 
• AIFMs are required to provide in the fund documentation for two of the LMTs listed under 2 to 8 above to be used in relation to their open-ended AIFs (provided that the two cannot be swing pricing and dual pricing). Money market funds only need to pick one LMT.
• “Redemption in kind” can only be activated to meet redemptions by professional investors and must correspond to a pro rata share of the AIF’s assets.⁵

The AIFMs must develop detailed policies and procedures for the activation and deactivation of any selected LMTs and communicate those policies and procedures to the national competent authority (NCA) of the AIFM (the LMT Policy).

In addition, the AIFM is required to notify its NCA without delay, where the AIFM activates or deactivates the suspension of subscriptions, repurchases and redemptions and where the AIFM activates or deactivates any of the LMTs referred to in Annex V, points 2 to 8, in a manner that is not in the ordinary course of business as envisaged in the AIF rules or instruments of incorporation. Finally, the AIFM is also required to notify its NCA within a reasonable timeframe before it activates or deactivates side pockets. Finally, in exceptional circumstances where it is in the interest of investors and after consulting the AIFM in cases where there are risks to investor protection or financial stability, regulators may require the activation or deactivation of the suspension of subscriptions, repurchases and redemptions. This authority applies not only to EEA AIFMs of EEA AIFs and non-EEA AIFs, but also to non-EEA AIFMs marketing their funds into the EEA.⁶

Draft Regulatory Technical Standards (RTS) and Guidelines

Further detail regarding the application of the LMT requirements will be provided in regulatory technical standards (RTS) and a set of guidelines (the Guidelines) for which consultation papers were published by ESMA on 8 July 2024 (together, the Consultation Papers).⁷  The Consultation Papers describe rules relating to the characteristics and the use of the LMTs in great detail. It is apparent that the rules have been drafted with liquid portfolios in mind, but with less sensitivity to the complexities of running semi-liquid or semi-open-ended funds.

Given the volume of detail contained in the Consultation Papers it is not possible to provide an exhaustive summary of the proposed rules, but below are some of the main issues that are being discussed in the industry.

• Mandatory inclusion of LMTs - The Guidelines propose that when making the selection of the two minimum mandatory LMTs, AIFMs should consider, where appropriate, at least one quantitative-based LMT (being redemption fees, swing pricing, dual pricing and anti-dilution levy) and at least one anti-dilution tool (ADT) (being suspension of subscriptions, repurchases and redemptions, redemption gates and extension of notice period), taking into consideration the investment strategy, redemption policy and liquidity profile of the fund and the market conditions under which the LMT could be activated. In practice, there will be funds where not all LMTs will be practically available, and it may not be possible or appropriate to choose one quantitative-based LMT and one ADT. The Level 1 text does not impose such restrictions and, instead, merely recognises that the primary responsibility for liquidity risk management remains with the AIFM. Investment managers who currently do not provide for any liquidity management tools in their fund documentation will need to consider what is most appropriate and least likely to raise objection from investors.
  
• Interaction of existing liquidity management tools with mandated LMTs  - First, it is unclear how the existing funds should approach the liquidity features already included in the fund documentation. This is particularly the case for AIFs that are semi-liquid and already have some liquidity tools hardwired into their terms as part of the design of the fund (e.g. limitation of redemptions in ordinary course of business expressed as a percentage of the NAV per quarter), as opposed to the introduction of the LMTs within the meaning of AIFMD 2.0 (e.g., activation of redemption gates in exceptional circumstances). The understanding in the industry is that such hardwired terms should not be affected by AIFMD 2.0 and are, generally, of different nature to the LMTs being introduced to cope with exceptional circumstances. In any case, AIFMs will have to review critically the liquidity profile of their products and either re-format the AIF’s existing liquidity features to fit within the characteristics of the Guidelines and RTS or provide for additional LMTs. This may require finding language or terminology to distinguish, e.g., a standard liquidity gate included to manage the fund’s liquidity on a non-emergency basis from an emergency LMT type of gate.
  
• The meaning and use of side pockets –
  
  • Similarly, the definition of side pockets in AIFMD 2.0 refers to these as pools of assets separated from the rest of the portfolio given that their ‘economic or legal features have changed significantly or become uncertain due to exceptional circumstances’. The industry is keen to obtain confirmation that the new side pocket definition included in AIFMD 2.0 does not cover classes tracking a specific asset that are part of the ordinary fund strategy of many semi-liquid funds and are hardwired into the strategy of such funds from the outset (also referred to as “side pockets” on the market) or “side pockets” that are used to ring fence an assets subject to an event for the duration of, e.g. a work-out process, but where such an event is an expected part of the strategy and not “exceptional circumstances”.
    
  • In addition, the RTS clearly expect that a fund manager should manage the side pockets with the sole objective of liquidating the assets in the side pocket and distributing cash. However, there could be circumstances where reintegration of side-pocketed assets may be in the fund’s best interests. For example, a distressed asset may become temporarily illiquid while it goes through a work-out process, following which it becomes liquid again and may then form part of the main portfolio. Further, it should be clear that, to the extent the investment is realised in full or in part, the proceeds of such realisation may be reinvested into the main portfolio as continuing investors may prefer to continue to be exposed to the assets of the fund rather than receive a cash payment.
    
  • Finally, it is proposed that a side pocket should be closed to repurchase. This may be problematic since side pockets assets are often realised over time and repurchase would be the method to make partial returns to investors – without this capability, investor cash will remain locked up in a side pocket longer than necessary.
• Suspension – The suspension LMT (which covers suspension of the NAV calculation, suspension of subscriptions, redemptions and repurchases) is mandatory for all funds and the draft RTS ties the three together, e.g., once one is suspended they are all suspended. However, there may be circumstances where subscriptions are suspended (for example, the strategy is capacity constrained), but redemptions and repurchases should be allowed to continue. There may also be circumstances where subscriptions and redemptions are suspended, but repurchases should not be; for example, in order to manage a controlled wind down of a fund by repurchasing fund interests in one or more tranches at such times as the investment manager determines there is sufficient liquidity, but not making redemptions at investor request. In addition, there may be circumstances when the suspension of NAV calculation does not necessarily mean that redemptions or repurchases need to be suspended. For example, if redemptions are effected pro rata in specie, the NAV of the assets does not matter because the investors are receiving their pro rata share of the relevant assets.
  
• Operation of redemption gates – The Consultation Papers provide that the activation threshold of redemption gates should not be expressed at the level of the single redemption order but rather at the fund level on the basis that this prohibition should ensure that investors are treated fairly. However, given the diversity of open-ended products and various legal structures available on the market (including e.g., AIFs with tracking share classes where each class/investor tracks a different pool of assets), the industry requires flexibility as to the introduction and activation of different types of redemption gates (which may include on investor per investor basis or on a per class basis) to ensure that this LMT can be tailored to each fund and ensure that investors are treated fairly given the specific context of their investment and the redemption scenarios.
  
• Redemptions in kind – With regards to the activation of “redemption in kind,” the Guidelines contemplate that an independent third party (e.g., the fund auditor or depositary) should perform an additional valuation of the relevant asset(s). This could prove costly and time consuming in respect of some types of assets. Ideally, some flexibility would exist here, especially if the fund is only sold to the professional investors. Further, if all investors are participating pro rata in specie redemption, the value of the assets is unlikely to matter.
  
• General guidance regarding disclosure of LMTs – The proposed Guidelines also recommend that AIFMs should provide appropriate disclosure on the selection, calibration and conditions for activation, deactivation of the selected and available LMTs in the fund documentation, rules or instruments of incorporation, prospectus and/or periodic reports (e.g., a periodic report would provide an ex-post overview of activation whereas fund rules and prospectuses would state the conditions for activating an LMT), including the reasons for their activation, their objectives, the implications of the various mechanisms and governance structures around the process. This, together with mandatory selection of additional LMTs, means that the fund documentation updates will likely be necessary for a large number of funds. However, the Guidelines and RTS do not give any consideration to whether such updates to fund documentation would require investor consent.
  
  Open-ended loan originating funds and LMTs
  
  As discussed in our earlier publications,⁸ AIFMD 2.0 sees EU legislators introduce specific rules to regulate AIFs that originate loans. AIFs that originate loans as their main strategy, or if they invest 50% or more of their NAV into loans that they originate, (so-called loan originating AIFs), will be subject to additional requirements.
  
  One of the requirements is that loan originating AIFs must be closed-ended unless the AIFM that manages the loan originating AIF is able to demonstrate to its home NCA that the AIF’s liquidity risk management system is compatible with the investment strategy and redemption policy, in which case the AIF may be open-ended.
  
  Open-ended loan originating AIFs will need to comply with the abovementioned rules on LMTs alongside all other open-ended AIFs and they will be subject to additional requirements as ESMA is mandated to develop further draft RTS establishing the requirements with which loan originating AIFs are to comply in order to operate in an open-ended structure. ESMA published the draft RTS⁹ on 12 December 2024. For more details see our OnPoint, available here.
  
  Conclusion
  
  While the final form of the rules regarding the use of LMTs are still to be finalised, the Consultation Papers provide a fairly clear picture of ESMA’s general direction of travel, including a relatively restrictive set of required LMTs whose applicability lacks sensitivity to the variety of alternative investment funds in the market and limited distinction between professional investor AIFs and UCITS. Hopefully industry response to the Consultation Papers will encourage greater flexibility in ESMA’s approach to the RTS and Guidance recognising that ultimately it is the AIFM that is responsible for liquidity risk management and best placed to evaluate the appropriate tools for this purpose. The final RTS and Guidelines should be published by April 2025 and apply from April 2026.