Side pockets must be closed-ended and no subscription must be accepted. Investors must receive shares/units of the side pocket on a pro rata basis in relation to their holdings in the fund.
Furthermore, IFMs should consider:
- Determining the circumstances for activating a side pocket and defining when such conditions no longer exist
- Setting criteria for assessing and monitoring the conditions that prompted the use of the side pocket
- Consider the merit of placing some cash to manage the potential liabilities of the side pockets
- The criteria for reviewing and potentially revising the side pocket decision and the changing circumstances that would warrant this
Redemption gates and extension of notice period: activation threshold and practical scenarios
ESMA clarifies that redemption gates should be considered especially for funds:
- With a concentrated investor base, where a redemption of a significant size could cause liquidity issues to the fund and affect investors
- Whose assets might be less liquid, inherently illiquid, or might become illiquid during stressed market conditions and/or assets that might take longer time to sell
Redemption gates are, however, not recommended to funds facing valuation issues.
Activation threshold
When using redemption gates, an activation threshold must be in place. Such threshold must be based on the total net or gross redemption orders received for a given dealing date and must be expressed in proportion of the fund’s NAV. AIFs have, nevertheless, the option to express the threshold as either:
- A proportion of the NAV or in a monetary value or as a combination of both; or
- A percentage of liquid assets
Moreover, when calibrating the threshold, IFMs should take into account the NAV calculation frequency, the investment objective, the liquidity of the underlying assets, the current market conditions and the expected cash flows.
How to apply the redemption gate: practical scenarios
The redemption gate must be applied in one of the following ways:
- Execute the redemption orders from all share-/unitholders for that dealing date in accordance with the redemption arrangements of the fund for an amount that corresponds at least to the level of the activation threshold in proportion to the total amount of those redemption orders, or
- Set a predefined redemption amount of individual redemption orders below or equal to which redemption orders from all unit-/shareholders for that dealing date will be executed in full, with the redemption gate being applied only to the portion of the redemption order that exceeds that predefined redemption amount
Note that, as long as the activation of the gate remains temporary in nature, IFMs should not restrict the use of redemption gates in terms of the maximum period over which they can be used or the maximum number of times that redemption gates can be activated.
The extension of notice periods
For funds whose liquidity is particularly susceptible to deterioration in times of market stress, and for AIFs invested in less liquid assets (particularly, for real estate and private equity funds), the extension of notice period could be considered as an LMT. When selected, IFMs should carefully calibrate the length of the extension of notice periods, considering the time necessary for the orderly liquidation of the underlying instruments in the best interests of the investors. The RTS highlights that the extension of notice periods must not have any impact on the redemption frequency of the fund.
Should redemptions of ETF shares be considered as a redemption in kind?
Redemptions in kind should be used to prevent the sale of sizable blocks of securities, which would create significant transaction costs and market price impacts to share-/unitholders. In this context with respect to the selection of redemptions in kind, IFMs should consider the structure of the fund, the investor concentration, the asset types, and the applicable restrictions that apply to the use of such LMT to professional investors only.5
It is worth noting that the delivery in whole or in part of underlying securities held by, or on behalf of, an ETF to authorized participants or market-makers to satisfy regular dealing requests (in the normal course of dealing activities) should not be considered an activation of redemptions in kind.
When to use other anti-dilution tools (ADTs)?
IFMs should assess the different levels for the activation of ADTs, and set and regularly review appropriate activation thresholds in order to prevent any material dilution impact on investors, in both normal and stressed market conditions.
The ADTs, both under normal and stressed market conditions, should impose the estimated costs of liquidity on subscribing and/or redeeming investors. Such cost should:
- Include both explicit and implicit transaction costs of subscriptions, repurchases or redemptions, including any significant market impact of asset purchases or sales
- Be based, as a starting point, on costs associated with transacting a pro-rata slice of all assets in the portfolio, unless this does not represent a fair estimate of the true liquidity cost6
Overview of the main anti-dilution tools7