ESMA liquidity stress tests, redemption gate, anti-dilution levy, side pocket and redemption fee
Investing in funds gives investors access to a wide range of asset classes with different liquidity profiles. However, in times of crisis, the liquidity of fund assets and redemption flows can take on a particular dynamic, forcing asset management companies to activate protection mechanisms. These liquidity management tools (LMTs), designed to preserve the stability of the fund, can have a significant impact on investors wishing to sell their holdings.
In-depth due diligence on a fund’s liquidity is based on 2 lines of analysis:
- An assessment of the liquidity stress tests performed by the management company: Liquidity stress tests are mandatory for managers of open-ended UCITS and FIAs under ESMA guidelines.
- A review of the LMTs that the management company can use to adjust the exit conditions for investors.
1. Liquidity stress tests: the liquidity of a fund as analysed by the asset management company
The ESMA guidelines (1) aim to standardise liquidity management practices and strengthen the resilience of funds in the event of deteriorating market conditions. These recommendations require management companies to
– Develop stress scenarios tailored to the specific risk profiles of funds, their assets and liabilities.
– Analyse the impact of stressed markets on asset liquidity and the fund’s ability to respond to redemptions.
– Adopt an approach that integrates market data and theoretical assumptions.
ESMA also emphasises the frequency of testing, the granularity of analysis and rigorous documentation of methodologies and results. These requirements place a direct responsibility on management companies.
Effective due diligence will focus on analysing these practices and verifying that the management company complies with these guidelines and correctly assesses the stress scenarios applied to assets and liabilities and compares them to relevant external scenarios.
2. Liquidity management tools (LMTs) : instruments and challenges
In the event of a liquidity crisis, the management company can adjust the exit conditions for investors. Possible restrictions include
– Redemption Gate, which limit redemptions to a certain percentage of the fund.
– Anti-Dilution Levy Mechanisms, which adjust the net asset value to reflect additional transaction costs.
– Side-pockets to isolate illiquid assets.
– Redemption fee, which allow the redemption terms to be changed according to circumstances.
– Total or partial suspension of the fund’s liquidity.
During due diligence, the liquidity management mechanisms in the fund documentation are analysed. In exceptional circumstances, asset management companies may activate LMTs not explicitly provided for in the initial documentation. These LMTs must also be identified during the due diligence, as their activation may have a significant impact on the liquidity perceived by investors.
For French fund managers, the AMF provides a framework for the presentation of these tools in its document 2017-05 (2). On 16 April 2025, ESMA will publish new guidelines (3) on the use of Liquidity Management Tools, further strengthening the European regulatory framework.
Conclusion
Liquidity risk management is an essential part of fund analysis for both fund managers and institutional investors. In-depth due diligence provides a better understanding of the tools and scenarios put in place to deal with stress situations, and offers a clearer view of the associated risks and their potential impact on investors.