In the first quarter of 2021 and of relevance to Irish regulated property funds, the following were published by the Central Bank:

1. February 2021: results of the Central Bank’s deep dive survey of property funds which identified liquidity mismatch and excessive leverage as potential financial stability risks; 
2. March 2021: correspondence requiring fund management companies to consider how fund liquidity risk management frameworks and fund structures need to be adapted to take account of the findings from the ESMA review of liquidity risk, including in property funds; 
3. April 2021: regulatory guidance, in the form of new AIFMD Q&As, clarifying (i) that Irish regulatory rules do not envisage or specifically permit regulated alternative investment funds (AIFs) to raise capital from investors by way of shareholder loans and (ii) key points for consideration by AIFMs in advance of AIFs entering into investor transactions.  

Property Fund Deep Dive Survey Results

In December 2019, the Central Bank announced its intention to undertake a deep dive review of Irish regulated AIFs invested in Irish property assets (the Deep Dive Survey).  The purpose of the Deep Dive Survey was to review and assess the financial stability risks of Irish regulated AIFs investing in Irish commercial real estate with “a view to considering whether an ex ante macroprudential policy response to any identified risks was required”. In the course of 2020, the Central Bank reviewed 171 regulated AIFs invested in Irish property assets and, in February this year, published the results of its review which focussed on key metrics of liquidity mismatch and leverage to assess financial stability risk.

Liquidity Mismatch

The Central Bank considers liquidity mismatch in funds (i.e. where a fund’s dealing frequency does not match the liquidity of the underlying assets) a potential source of financial vulnerability as it can force funds, in receipt of large redemption requests which may not be met out of liquid assets, to sell assets in a short period of time thus leading to dislocated prices and knock-on real economy effects.  

Liquidity timeframes (i.e. time from redemption request deadline to redemption settlement date) of funds surveyed ranged from 7 to over 1200 days, with 58% of funds (accounting for €13.6bn approx. of property assets) having timeframes of less than 200 days.  Fund managers responding to the survey estimated an average of 180-210 days to sell a property in normal economic times and 420 days in stressed economic times.  The Central Bank is concerned, therefore, as to the “significant liquidity mismatches in the majority of the funds surveyed” estimating that, on the basis of the survey results, only 17% of property assets are held in funds which would avoid liquidity mismatches during stressed market conditions by having a liquidity timeframe of 400 days of more. 

The Central Bank notes that liquidity mismatch risk in property funds can be mitigated by factors such as the level of liquid asset holdings (generally 5% of assets), infrequent dealing (most are closed-ended or limited liquidity funds) and a limited investor base (65% of property assets are held in single-investor funds). However, it remains concerned as to the surveyed funds’ ability to deal with large redemption requests as the results highlight that the majority of property funds operate liquidity timeframes of less than 200 days. And while single-investor funds may not, due to the absence of first-mover advantage dynamics, be as susceptible to liquidity mismatch risks, the Central Bank is concerned as to the possibility of indirect liquidity mismatch risk given approximately one-fifth of such funds are financial institutions with multiple underlying investors.

Leverage

The Central Bank considers higher levels of leverage in property funds to be problematic as it can have an amplifying effect on decreasing equity returns in downward markets and, in its Deep Dive Survey results, points to several sources concluding that overall leverage has a negative impact on property fund returns.

The Deep Dive Survey found that a significant portion of funds (67% of single-investor and 41% of multi-investor) have leverage levels of more than 50%. While such levels are higher than the European average, the Central Bank acknowledges this is, in part, due to the significant presence of shareholder and affiliated lending in Irish property funds. However, even when affiliated loans are excluded from the leverage metrics, Irish property funds hold higher leverage than their European counterparts. And while most of the funds surveyed have a single investor, the Central Bank does not view this as necessarily affecting the increased vulnerability of being highly leveraged as a single investor may still look to sell fund assets, whether as result of being leveraged in its own right or otherwise, during stressed market conditions and thereby triggering downward price pressures. 

Mandated Review of Liquidity Risk Management Frameworks 

As per previous briefings (here), in March this year, the Central Bank wrote to fund management companies following the publication by ESMA of its findings from the supervisory review of liquidity risk in real estate and corporate bond UCITS and AIFs (Liquidity Risk Review).  Fund management companies not in receipt of the Central Bank’s March correspondence should note that the Central Bank considers “the findings from the more broadly are important and should be noted by all firms.” 

The adverse findings from the Liquidity Risk Review and the follow-up recommendations for fund management companies are summarised in our briefing, ESMA Recommends Liquidity Action Items for Funds, and include a requirement for managers to review fund liquidity risk management processes to ensure all liquidity risks are assessed and liquidity stress testing is in place in line with the ESMA Guidelines on Liquidity Stress Testing.

In addition to the findings from the Liquidity Risk Review, property fund managers would be well advised to build in consideration of the Deep Dive Survey results, in particular those relating to liquidity mismatch, in their review of fund liquidity risk management frameworks.

Future Regulatory Action

As previously reported (see here), regulators have for some time been building towards implementation of a macroprudential framework for funds which may provide for both ex-ante leverage limits and liquidity management from a system-wide perspective. As recently as last month, the Central Bank noted that “The absence of such a macroprudential framework for investment funds remains, in our view, a key omission in the European regulatory toolkit. Considering the events last year, the scale of the sector in Ireland, and the continued uncertainty we face, developing a comprehensive macroprudential framework for the non-bank sector remains an important priority for the Central Bank.”  The Central Bank also noted in its Deep Dive Survey results that its analysis of property funds “will form part of the development of a comprehensive macroprudential framework for market-based finance”. The Central Bank’s Macroprudential Measures Committee were presented with the results analysis of the Deep Dive Survey in February of this year, along with a follow up action plan and further developments can, as such, be expected.

Contributed by Daniel O’Toole