ASIC Review’s Managed Funds’ Valuation of Illiquid Assets During COVID-19

Are you a responsible entity of a fund that is concerned about liquidity during the COVID-19 pandemic? Are you concerned that you are in breach of the financial requirements of your Australian financial services license? Do you need to update your disclosures to reflect the current market environment? Do you have a query about the requirements of the Corporations Act or ASIC regulation?

Background

ASIC recently released its findings from the review it undertook of managed funds’ illiquid asset valuation practices during the early stages of the COVID-19 pandemic.¹ At that time, investor reactions to the pandemic drove significant downturns in global and domestic markets across many asset classes.

ASIC gathered data between 1 March and early November 2020 and undertook the review to assess whether the current regulatory settings for the valuation of illiquid assets are adequate to protect members’ interests in times of heightened market volatility. ASIC examined how well the responsible entities (REs) in the review managed the challenges of illiquid asset valuation whilst meeting their regulatory obligations during this volatile period.

 ASIC reviewed 10 fund managers (REs with around $165 billion in assets under management, including $21 billion in illiquid assets). The review included listed and unlisted registered schemes targeted at retail and wholesale investors. In terms of asset classes, it encompassed direct real property, mortgage, infrastructure, private equity, private debt and hedge funds.

Key findings

ASIC found that the REs were responsive to the increased valuation risks during the review period. They continued to provide timely valuations of their illiquid assets (including by increasing the frequency of valuations, expanding the sources of information to benchmark valuations and assumptions). The REs also continued to be able to obtain and rely on external valuations.

The REs had adequate arrangements to manage conflicts of interest associated with valuations and appropriately revalued illiquid assets downwards and upwards as appropriate.

The review identified some better valuation practices by the REs, including:

• Close board supervision of valuation processes and involvement in the adoption of the external valuations.
• Segregation of roles, involvement of independent committees and the use of multi-level review processes for internal and external valuations to ensure the accuracy of valuations and to support a robust conflicts-of-interest framework.
• Recognition of conflicts in valuation processes as a standing organisational conflict and addressing these in compliance frameworks to ensure robustness and independence in the valuation process.
• Clearly defined valuation frequencies and trigger points (such as percentage variation of internal valuation compared to the last external valuation) for external valuations to take place.

In ASIC’s view, poor practice in valuation was limited to minor inconsistencies between internal policy and compliance plans.

Outcome

ASIC strongly encourages all REs to review their valuation practices against these better practices and adopt them where applicable. REs should also ensure that the valuation practices in their policies are consistently reflected in their compliance plans and the policies reviewed regularly to ensure they remain adequate.

General principles for liquidity management

ASIC’s findings are a timely reminder for REs to revisit their liquidity management practices, particularly in light of the ongoing volatility attributable to the COVID-19 pandemic. Hamilton Locke previously published an article in 2020 on these matters, the key principles of which we have reproduced below.

Funds that have invested in assets that are not easily traded on a financial market, such as property or mortgage schemes, may experience challenges around liquidity. For some landlords, income streams are under threat as occupiers fail to generate sufficient revenue to make rental payments and, in extreme cases, sustain their businesses.

The effect of the COVID-19 pandemic on the economic environment increases the risk that REs will not have adequate financial resources to meet their financial obligations and needs, including redemptions, distributions and expenses.

The management of liquidity should be considered at both the RE level and the scheme level.

RE level

At the RE level, there should be liquidity risk management processes in place to continually assess compliance with the financial requirements under their Australian financial service license. The financial requirements that are relevant to liquidity include, but are not limited to:

• standard solvency and positive net assets;
• cash needs;
• audit requirements;
• net tangible assets, including requirements for holding at least 50% of the NTA requirement in liquid assets; and
• specific requirements for financial products and services offered.²

REs should forecast their income and continually monitor their ability to meet their financial requirements. If their financial requirements are no longer met, it is likely that a RE will be required to lodge a breach report with ASIC and possibly cease dealing in their funds.

Scheme level

At the scheme level, acting in the best interests of members, the RE is required to manage the objectives of both the scheme and members’ expectations for redemptions. REs need to closely monitor the amount of redemptions and the applications that are being made by members.

ASIC has identified a number of tools that can be used to manage liquidity at the scheme level, including but not limited to:

• redemption fees;
• suspension of withdrawal requests;
• placing a limit on the amount of redemptions;
• in specie transfer;
• swing pricing;
• minimum or maximum limits on withdrawals; or
• satisfying withdrawals on a partial or staggered basis.³

Liquidity and illiquidity

REs should be assessing whether their funds remain liquid or become illiquid. If a fund becomes illiquid, the RE must determine whether there should be a suspension of member related cashflows to protect members.

If the RE intends to suspend redemptions, the constitution must give it the power to do so. ASIC has provided guidance on what type of restrictions should be stated in the constitution. Any decision to restrict dealing with withdrawal requests must be exercised in a manner consistent with the RE’s duties.⁴

Unit pricing

When faced with significant market volatility, REs may be unable to value the scheme assets or calculate the unit price with any certainty. If the responsible entity cannot accurately value the fund’s assets, it may be permitted to suspend unit pricing and therefore a suspension of withdrawal requests.

If the RE intend to suspend unit pricing, the constitution and unit pricing policy must give it the power to do so. This power should also be disclosed in the fund disclosure documents.

Transaction costs

A volatile environment may require some funds to incur more costs than typically arise, including those from liquidating assets to make redemption payments. In such circumstances, in order to act in members best interests of members, the RE may determine that transaction costs (ie. the buy/sell spread) should be increased.

If the RE intends to increase the transaction costs, it should ensure that its terms are consistent with the PDS, the constitution and the unit pricing policy.

Disclosures

It is important that REs ensure fund product disclosure statements (PDS) are up to date. As a result of the market turbulence caused by the COVID-19 pandemic, a number of REs have reviewed fund PDSs and updated their disclosures. Particular focus has been placed on disclosure regarding risk, unit pricing and redemptions.

REs of simple managed investment schemes that have shorter PDSs need to be monitor scheme assets for the strict requirement to have at least 80% of their investments able to be sold within 10 days at market value.⁵ If the threshold is breached, then the scheme is no longer a simple managed investment scheme and the RE is required to cease dealing in the fund until a full PDS is issued.

Notifying ASIC

If a RE determines that a scheme is to be suspended or deems it illiquid, then it should notify ASIC immediately.

How we can assist

We can assist fund managers that are seeking advice on licensing requirements or breaches, liquidity risk management, updating their PDSs, applications for relief, considering trustee duties or other Corporations Act requirements.

²ASIC Regulatory Guide 166 Licensing: Financial requirements

³Regulatory Guide 259: Risk management systems of responsible entities

⁴Regulatory Guide 134: Funds management: Constitutions

⁵Information Sheet 133: Shorter PDS regime -Superannuation managed investment schemes and margin lending