Final reports on ESMA’s guidelines and RTS: what are the upcoming liquidity management requirements under the new UCITS/AIFMD Framework?

IFMs should also consider whether to activate LMTs individually or in combination with additional LMTs or other liquidity measures.

How to select LMTs? 

IFMs should consider the following factors when assessing the suitability of an LMT: 

• The fund’s legal structure and any specific features associated with the manner in which it is structured 
• The fund’s investment strategy and investment policy
• The dealing terms of the fund⁴  
• The liquidity profile of the fund and its underlying assets
• The results of liquidity stress testing
•  The characteristics of the fund’s investor base
• The fund’s distribution policy
• Any other relevant operational barriers and complexities that may impact on the feasibility of implementing certain LMTs  

Which LMTs are only allowed in exceptional circumstances? 

Suspension of subscriptions, repurchases and redemptions, as well as side pockets are only allowed in exceptional circumstances and where justified having regard to the investors’ interests. Pursuant the Guidelines, exceptional circumstances mean (non-exhaustive list):

Suspension of subscriptions, repurchases and redemptions specificities

This LMT should apply for the same period of time to all investors, and should be activated only on a temporary basis. In the case of a fund with multiple share classes, the suspension should apply to all shares/units. 

It is worth noting that where the valuation is uncertain and it is not possible to compute the NAV, the activation of such LMT may include the suspension of the NAV calculation as well.  

Use of side pockets 

The RTS foresees two types  of side pockets:

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

What can be requested by the competent authority on an ad-hoc basis? 

At the request of the competent authority, IFMs are expected to be able to:

• Demonstrate that the activation and calibration(s) of the selected LMTs are in the best interest of all investors and are appropriate and effective in light of market conditions and the relevant characteristics of the fund  
• Justify on an ex-post basis the swing factor applied 

Notification procedure 

Under the new Directive, IFMs will have to implement detailed policies and procedures for the (de)activation of LMTs and notify, without delay, the competent authorities of its home Member State: 

• When an IFM (de)activates the suspension of redemptions and subscriptions 
• When (de)activating side pockets, in a reasonable timeframe prior to the (de)activation of them 
• When (de)activating any other LMT in a manner that is not in the ordinary course of business as envisaged in the fund rules or the instruments of incorporation of the AIF

Differences between the new AIFM RTS and the ELTIF Framework  

Pursuant the Delegated Regulation (EU) 2024/2759 (ELTIF II RTS), ELTIFs subject to ELTIF II must comply with specific liquidity management requirements when allowing redemptions before the end of their life cycle. The first difference we may mention is that IFMs must justify to the competent authority of the ELTIF the appropriateness of the redemption frequency and its compatibility with the individual features of the ELTIF where redemptions take place more frequently than on a quarterly basis.  

ELTIF managers are also subject to stricter rules regarding the calibration of the percentage allowed for redemption¹² which should consider either :

• The redemption frequency and the notice period of the ELTIF, including the extension of the notice, if any, depending on which of one of the three options referred to in Annex I of ELTIF II RTS is selected by the ELTIF manager or
• The redemption frequency and the minimum percentage of liquid assets as specified in Annex II of ELTIF II RTS

Where the second option is used and the amount of liquid assets falls below the thresholds set out in Annex II of the ELTIF II RTS, the ELTIF manager must, within a period of time that is appropriate for that ELTIF, take the necessary measures to reconstitute the minimum percentage of the liquid assets, while maintaining the ability of investors to redeem their units or shares, taking due account of the interests of the investors in the ELTIF. 

Furthermore, to determine the maximum size of redemption at a given redemption date, the ELTIF manager must apply the percentage allowed for redemption as specified in Annex I or Annex II of ELTIF II RTS to the sum of the liquid assets at that redemption date and the expected cash flow (forecasted on a prudent basis over 12 months). 

Regarding the notice period, where it is less than 3 months, the ELTIF manager must inform the ELTIF’s competent authority and explain how that shorter notice period is consistent with the individual features of the ELTIF. 

With regards to anti-dilution tools, such as in the new AIFM RTS, the IFM is not required, but should consider selecting and implementing at least one ADT. However, ELTIF II RTS provides a shorter list: anti-dilution levies, swing pricing and redemption fees, only.

ELTIF managers may also select and implement other LMTs. In this case, upon request by the competent authority of the ELTIF, IFMs must provide it with information on why the ADTs aforementioned are not adequate for that specific ELTIF or why another set of LMTs would be more appropriate, taking into account the interests of the ELTIF and of its investors. 

How can EY help 

Advice on design and validation of key features of your open-ended funds which includes: 

• Liquidity Management Tools (LMT): Gating, lock-ups, payment terms of redemptions, etc. 
• Asset liquidity ladders under normal and stressed conditions  
• Setting appropriate NAV frequencies and valuation mechanisms 
• Anti-dilution pricing mechanisms: dual pricing, Cap&AM, etc. 
• Subscription payment design: Commitment versus one-shot payment 
• Review and comparison of alternative investment strategies 

We develop integrated financial models suitable for open-ended structures, which are able to dynamically recalculate and simulate your fund’s liquidity situation, taking into due consideration all relevant input parameters. 

We advise on the establishment of policies and procedures for fund managers related to the activation of liquidity management tools.