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Latest ESMA Alternatives Survey Highlights Ongoing Liquidity Risks

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The European Securities and Markets Authority (ESMA) has once again highlighted the potential liquidity issues within EU alternative funds, as it published its third annual statistical report on the Alternative Investment Fund (AIF) sector yesterday.

Despite steady asset growth between 2018 and 2019 for AIFs, particularly amongst private equity funds, the European regulator warned that there remains a ‘mismatch between the potential liquidity of the assets, and the redemption time frame offered to investors.’ 

That mismatch was particularly evident in real estate vehicles and fund of funds, while leverage remained the major worry for hedge funds, the Pan-European watchdog said.

The report found many fund of funds, which account for some 15% of the NAV of EU AIFs, or around €1 trillion in assets, would have trouble meeting heavy redemptions. While investors can generally redeem 39% of the NAV in one day, only 29% of the underlying assets could be liquidated during the same time. ‘If large redemptions were to occur,’ ESMA said, ‘AIFs would face challenges due to this liquidity mismatch.’

Property funds also remain a concern. ‘Real estate funds are exposed mostly to illiquid physical assets which take time to sell, so liquidity risk in real estate funds remains a concern,’ ESMA cautioned. While the bulk of real estate funds gated in recent years have been in the UK, particularly commercial real estate following Brexit and Covid-19, the high percentage of retail investors (21%) in European real estate funds is notable. 

For hedge funds, meanwhile, leverage is more worrying for regulators, given their strict redemption restrictions make liquidity mismatches rare. The European hedge fund sector may have just €354 billion in assets, or some 5% of all AIF assets, but that quickly balloons to some 62% of assets when gross exposures are included. ‘Leverage is very high at more than 900% after adjustments,’ ESMA said. 

The widespread use of derivatives, and the ability of a handful of funds to wreak havoc, was illustrated in spectacular fashion with the recent Archegos blow-up. And although Archegos was a family office, and thus operating largely outside the eye of regulators, the episode sent shockwaves throughout the market and highlighted the threat of leverage in general. 

Still, ESMA has been aware of these risks for some time. Last year, for instance, it announced that it was working on a common criteria to promote convergence in the way that National Competent Authorities (NCAs) assess leverage used. It is in the process of designing, and implementing, specific leverage limits. 

Clearly, then, fund liquidity and leverage are likely to remain key focus areas for regulators. Although there have been major improvements in these areas, including the successful implementation of ESMA’s Liquidity Stress Guidelines in September last year, managers can expect more changes and regulations in the future.

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