Sharing insights elevates their impact (2024)

BLOG Jul 10, 2019

Over recent months, fund classification of UCITS has been calledinto question due to liquidity issues, redemption gates andconcerns that there are incentives for fund managers to act outsidethe spirit of the directive. A particular area of interest has beenvaluation uncertainty and the liquidity properties of asset thatconstitute what's sometimes called the 10% "trash bucket",referring to the portion of a fund's assets that can, under UCITS,be invested in illiquid instruments. Given recent spotlight, assetmanagers need to review their 10% allocations quickly, before theirinvestors or regulators come knocking.

The Undertakings for Collective Investment in TransferableSecurities refers to a series of European Union directives thatestablished a uniform regulatory regime for the creation,management and marketing of collective investment vehicles in thecountries of the EU. UCITS is a mutual fund wrapper that emerged inthe 1980s and which is readily available to retail investorsglobally.

Seen as an international gold standard of fund regulation, theUCITS sector consists of roughly €9.5tn of assets spanning morethan 33,000 funds. UCITS is an example of successful Europeanfinancial integration but in some quarters questions are beingraised about this political and economic accord. Some €352bn inassets are held in so-called "Alternative UCITs" funds in Europewhich are designed to replicate hedge fund strategies in aninstant-access mutual fund format.

UCITS typically invest in securities listed on public stockexchanges and regulated markets. Due to the retail investoraudience, UCITS products are generally considered vanilla innature, operating with embedded investment restrictions and subjectto robust regulatory oversight and scrutiny. The UCITS directiveshave brought European investors a wide offering of funds along withprovisions for investor protection. Investors can invest in anyUCITS fund that has been registered for sale in their country.Before the first UCITS directive, most investors were largelylimited to funds offered by fund companies based in their countryof residence. The UCITS directives have thus greatly broadened thechoice of funds available to investors in the EU.

Since UCITS funds are designed to be suitable for retailinvestors, their rules incorporate certain levels ofdiversification with the aim of reducing their vulnerability to theperformance of a small number of assets. In general, the morediverse the assets in a fund, the less likely it is that investorscould lose a substantial portion of their investment if oneparticular asset falls in value. Furthermore, redemption liquidityis one of the most important characteristics of UCITS.

The most commonly known restriction is the so-called "5/10/40rule". In summary, this says that a maximum of 10 per cent of aUCITS fund's net assets may be invested in securities from a singleissuer, and that investments of more than 5 per cent with a singleissuer may not make up more than 40 per cent of the wholeportfolio.

There are some exceptions to this rule. For example, where thefund is replicating a stock market or other index, the maximumlimit per issuer is 20 per cent of net assets (or 35 per cent inexceptional circ*mstances).

An individual investment in another UCITS fund must not exceed20 per cent of assets, while no more than 30 per cent of the UCITSfund's portfolio can be invested in non-UCITS funds. In addition,UCITS funds may not make an investment in another UCITS fund thatamounts to more than 25 per cent of the other fund's totalassets.

In accordance with the principle of risk-spreading, theregulator of a UCITS may authorise it to invest up to 100 per centof its assets in securities and money-market instruments issued orguaranteed by EU member states or local authorities (intended toencourage investment in slower-growth EU member states).

But has the hunt for yield over the last decade resulted in someUCITS principles being compromised in sprit?

Of the five iterations of the UCITS directive, the passage ofUCITS III in 2003 was perhaps the most instrumental in giving riseto some of the liquidity concerns that have been expressed byregulators and commentators recently. UCITS III expanded the typeof instruments which funds could hold to include investments in OTC(over the counter) derivative instruments and ETD (exchange tradedderivatives) for purposes beyond just risk mitigation andhedging.

In the hunt for yield, in a world of ultra-low interest rates,this has pushed some UCITS funds to invest in riskier and lessliquid assets (such as unlisted equities and private credit) thatcomply with the letter of the UCITS directives but may prove toughto sell in a downturn or in an underperforming sector. This createsa risk that the fund will not be able to sell sufficient assets tomeet redemption requests from investors.

Article 50(2)(a) of the UCITS Directive provides the legalunderpinning for the 10% illiquid assets ("trash") ratio.Effectively, this 10% can be used for a range of investmentsincluding open-ended unregulated hedge funds and Level 3 (illiquid)investments, provided the investment made under Article 50(2)(a):

1. Does not compromise the liquidity requirements of UCITS and afund's ability to comply with its redemption requirements;
2. Does not present a risk that the potential loss which the UCITSfund may incur, with respect to holding these instruments, willexceed the amount paid for them;
3. Is consistent with the UCITS fund's investment objectives orinvestment policy;
4. Has appropriate information available in the form of regularand accurate information on the security or, where relevant, on theportfolio of the security;
5. Has its risks adequately captured by the risk managementprocess of the UCITS fund; and
6. Makes reliable valuations available on a periodic basis whichare derived from information provided by the issuer of the securityor a competent advisory.

One implication of the 10% ratio is that it increases the riskto investors that a fund might restrict redemptions if it is unableto or unwilling to sell illiquid assets in times of market stress.Europe is not alone in permitting such action. In the US, reformsto Rule 2a-7 under the Investment Company Act of 1940 liberalisedthe use of gates.

From the fund manager's perspective, imposing a "gate" isreserved for extreme conditions, because in benign market andredemption conditions:

• The illiquid part of the portfolio is a small percentage andthey can meet redemptions by disposing of the liquid parts of theportfolio;
• Imposing a gate could damage the Sharpe ratio of the fund (dueto the premiums the illiquid assets should exhibit);
• They may have long-standing and loyal cornerstone investors whohave stuck with them even during underperformance, so they may feelthere is little risk of an increase in redemptions affecting thestrategy.

For the investor, the challenge is that these can all be true ata point in time, but all are subject to change at short notice.

When a fund faces higher than usual redemptions, illiquidpositions are, typically, not sold down pro-rata and will thereforeform a higher relative portion of the portfolio, increasingliquidity risk for remaining investors. There are two reasons fornot selling the illiquid holdings:

1. Should you sell a sizable holding in an un-listed or thinlytraded asset then it will move the market price down and lock in aloss as you're facing a market in which (as your time to unwindshortens) it would be difficult to achieve what could be consideredfair-value.
2. The rest of your holdings may be marked down too. This leads tofurther poor performance, causing more investors to worry andrequest redemptions.

The sale or purchase price for a UCITS fund is determined by theNet Asset Value per share or NAV. NAV is equal to the net assets ofthe fund divided by the number of shares or units held by investorsso pricing and valuation of the assets are clearly important.

For investors to have confidence in a UCITS fund, they must beable to trust the valuations it uses for individual assets and forthe NAV. Investors buy shares or units in a UCITS without knowingthe exact price, which is only established after the deal has beenplaced. As a rule, the latest official market closing prices mustbe used to value publicly-traded securities, otherwise a 'fairmarket value' must be provided. This is designed to offerprotection against late trading, market timing and other practicesthat can affect the value of a fund.

When a fund contains illiquid assets, it makes the valuationprocess more complicated and introduces greater subjectivity intothe NAV calculation. The fund manager may appoint an outside firmto carry out such valuations. If the manager carries out valuationsin-house, the process must be independent of the portfoliomanagement to avoid conflicts of interest.

It's critical to understand that there are benefits from the 10%illiquid ratio in UCITS funds, especially when these investmentssupport long-term and socially beneficial assets such asinfrastructure projects and relatively early stage companies.However, as seen on numerous occasions, capturing risk andappropriately valuing assets in such investments may be a challengefor the manager. This matter was recognised by the InternationalPrivate Equity and Venture Capital Valuation Guidelines Board andin October 2018 a draft revised guidance note was issued byIPEV.The revised IPEV guidance is not prescriptive but does providethe framework which should be considered in assessing the fairvalue of a company.

The material enhancements to the guidance were to:

1. Remove Price of a Recent Investment as a Valuation Technique toreinforce the premise that Fair Value must be estimated at eachMeasurement Date. This removes the possibility that funds orvaluation advisors rely on historical funding data for too long;and
2. Expand Valuation considerations for early-stageinvestments.

Accordingly, valuation and risk policies become extremelyimportant for Level 3 assets. This could be an area which is notgiven due consideration by UCITS managers (particularly those whodon't benefit from independent third party valuations), because the10% illiquid bucket requires additional levels of controls andverification.

When valuing an early stage innovative company, a number offactors should be considered, including:

1. The change in market and sector pricing conditions;
2. The complexity of the capital structure of the company;
3. The recent developments in the underlying technology andinnovation of the business and the industry; and
4. The timeline and exit plan for the investor.

Due to the difficulty of gauging the probability and financialimpact of the success or failure of development activities of earlystage companies, one should consider that the traditional valuationtechniques cannot be used in all cases.

In their latest draft valuation guidelines, the IPEV and theAICPA recommend the use of more complex valuation methodologies,when necessary. These complex valuation techniques may include:

1. Scenario-Based Model (or PWERM);
2. Option Pricing Model; or
3. Milestone-Based Model (or adjusted price or recentinvestment).

*For more detail on the IPEV guidelines please see Appendix1.

It's important to note that the key difference when dealing withLevel 3 assets (and particularly early-stage unlisted equityassets) is the heavily analyst-driven approach to valuation.Valuations analysts in such investments must have the aptitude tounderstand and analyse the legal documentation of the deal,corporate finance theory, financial performance and the relevanceof milestones and disclosures, as well as the modelling skills toensure these are appropriately captured at inception and throughoutthe life of the deal.

Due to the heterogeneous nature of investments, this requiressignificant access to the correct market data, research, modelinfrastructure, people and control oversights. Are the events ofthe last few months just the start of the debate on the suitabilityof illiquid investments in mainstream and retail investment funds?Directional change on the fundamental pillars of the investmentlandscape takes years but scrutiny by investors of the 10% "trashbucket" has already changed materially in just a few weeks due tothe perceived change in risk.

However, just the musings of policymakers and regulators (fromthe Bank of England to the Financial Conduct Authority to ESMA)openly reflecting of the virtues of bank-style stress testing,capital requirements and liquidity testing is sufficient to causeanxiety in the fund industry. At the same time, one needs torecognize the success of the UCITS program and guard againstoverreaction.

Time will tell, but fund managers have the opportunity now to beproactive in reviewing their valuation methodologies and evaluatingtheir 10% buckets before their investors do!

A further look into the IPEV guidelines:

For unlisted equity there are generally accepted industry bestpractice - the International Private Equity and Venture CapitalValuation Guidelines issues by the IPEV Board, US GAAP and IFRS -incorporating the most widely used methodologies to establish abaseline valuation. The latest text from IPEV Concept of Fair Valuestates:

1.1 Fair Value is the price that would be received to sell anasset in an Orderly Transaction between Market Participants at theMeasurement Date.

1.2 Fair Value measurement assumes that a hypotheticaltransaction to sell an asset takes place in the Principal Market orin its absence, the Most Advantageous Market for the asset.

1.3 For actively traded (quoted) Investments, available marketprices will be the exclusive basis for the measurement of FairValue for identical instruments.

1.4 For Unquoted Investments, the measurement of Fair Valuerequires the Valuer to assume the Investment is realised or sold atthe Measurement Date whether or not the instrument or theUnderlying Business is prepared for sale or whether itsshareholders intend to sell in the near future.

1.5 Some Funds invest in multiple securities or tranches of thesame Investee Company. If a Market Participant would be expected totransact all positions in the same underlying Investee Companysimultaneously, for example separate Investments made in series A,series B, and series C, then Fair Value would be estimated for theaggregate Investment in the Investee Company. If a MarketParticipant would be expected to transact separately, for examplepurchasing series A independent from series B and series C, or ifDebt Investments are purchased independent of equity, then FairValue would be more appropriately determined for each individualfinancial instrument.

1.6 Fair Value should be estimated using consistent ValuationTechniques from Measurement Date to Measurement Date unless thereis a change in market conditions or Investment-specific factors,which would modify how a Market Participant would determine value.The use of consistent Valuation Techniques for Investments withsimilar characteristics, industries, and/or geographies would alsobe expected.

The latest text from IPEV Principles of Fair Valuestates:

2.1 The Fair Value of each Investment should be assessed at eachMeasurement Date.

2.2 In estimating Fair Value for an Investment, the Valuershould apply a technique or techniques that is/are appropriate inlight of the nature, facts, and circ*mstances of the Investment andshould use reasonable current market data and inputs combined withMarket Participant assumptions.

2.3 Fair Value is estimated using the perspective of MarketParticipants and market conditions at the Measurement Dateirrespective of which Valuation Techniques are used.

2.4 Generally, for Private Capital Investments, MarketParticipants determine the price they will pay for individualequity instruments using Enterprise Value estimated from ahypothetical sale of the equity which may be determined byconsidering the sale of the Investee Company, as follows:

• Determine the Enterprise Value of the Investee Company usingthe Valuation Techniques;
• Adjust the Enterprise Value for factors that a MarketParticipant would take into account such as surplus assets orexcess liabilities and other contingencies and relevant factors, toderive an Adjusted Enterprise Value for the Investee Company;
• Deduct from this amount the value, from a Market Participant'sperspective, of any financial instruments ranking ahead of thehighest-ranking instrument of the Fund in a sale of the InvesteeCompany;
• Take into account the effect of any instrument that may dilutethe Fund's Investment to derive the Attributable EnterpriseValue;
• Apportion the Attributable Enterprise Value between theInvestee Company's relevant financial instruments according totheir ranking;
• Allocate the amounts derived according to the Fund's holding ineach financial instrument, representing their Fair Value.

2.5 Because of the uncertainties inherent in estimating FairValue for Private Capital Investments, care should be applied inexercising judgement and making the necessary estimates. However,the Valuer should be wary of applying excessive caution.

2.6 When the price of the initial Investment in an InvesteeCompany or instrument is deemed Fair Value (which is generally thecase if the entry transaction is considered an OrderlyTransaction), then the Valuation Techniques that are expected to beused to estimate Fair Value in the future should be evaluated usingmarket inputs as of the date the Investment was made. This processis known as Calibration. Calibration validates that the ValuationTechniques using contemporaneous market inputs will generate FairValue at inception and therefore that the Valuation Techniquesusing updated market inputs as of each subsequent Measurement Datewill generate Fair Value at each such date.

2.7 Valuers should seek to understand the substantivedifferences that legitimately occur between the exit price and theprevious Fair Value assessment. This concept is known asBacktesting. Backtesting seeks to articulate:

• What information was known or knowable as of the MeasurementDate;
• Assess how such information was considered in coming to themost recent Fair Value estimates; and
• Determine whether known or knowable information was properlyconsidered in determining Fair Value given the actual exit priceresults.

Posted 10 July 2019 by Leon Sinclair, Global Head, Private Equity & Debt Services, S&P Global Market Intelligence

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.