Luxembourg regulator probes loan investments by Ucits

Lawyers say CSSF has already told a number of funds to prepare to sell their holdings

Luxembourg is the biggest European hub for Ucits

Loan investments by popular European retail funds have been put under the microscope by Luxembourg’s financial regulator, the CSSF, with some funds said to have been advised privately by the watchdog that they should prepare to sell their holdings.

Liquidity risk is one of the reasons for the regulator’s concern. Many undertakings for collective investment in transferable securities, or Ucits, allow daily redemptions, while selling loans in the secondary market typically takes a lot longer. Although Ucits are only allowed to hold loans worth up to 10% of their net assets – the so-called trash bucket – liquidity mismatches have shot up the regulatory agenda after investors were locked into UK investment manager Neil Woodford’s flagship fund last year.

“We have done a study on loans in Ucits funds. We are in exchange with the industry on related results and also the potential consequences of that,” says Alain Hoscheid, a CSSF official who works on prudential supervision and risk management of collective investment schemes. “Once we have finalised this, this will also be communicated to the wider market.”

According to two lawyers, the CSSF has gone further in private.

“They have contacted a number of asset managers to ask them not to make any further investments in this type of loans and also over time to disinvest from these positions within a reasonable timeframe, taking into account the best interests of investors. So, basically, you don’t need to sell immediately but should sell over time,” says Jacques Elvinger, a partner at Luxembourg law firm Elvinger Hoss Prussen.  

“The CSSF’s position is that going forward this type of loans should no longer be eligible investments,” adds Elvinger, whose clients are among those contacted by the regulator, starting two months ago.

Hoscheid at the CSSF declines to comment on whether the regulator has told some Ucits to stop adding to their loan positions and to divest.

“We have done this study, we are having an exchange with the industry and we are discussing the results, so that’s the state of play,” he says, adding that the discussions are “mainly bilateral” for the moment.

Post-Woodford nerves

The secondary market for loans is substantial, with trading volumes totalling $19.94 billion in Europe, the Middle East and Africa for the fourth quarter of 2019, according to the latest data from Refinitiv. Funds can invest via so-called loan assignments and loan participations. The first approach involves the transfer of an existing loan to a new lender of record; the second involves buying a part of a loan that has been originated by another firm.

Ucits funds’ exposure to loans, including leveraged loans, amounted to €7.4 billion ($8.1 billion) at the end of 2018, according to a report by the European Securities and Markets Authority (Esma) published in September. Most of the exposure was concentrated in a few Ucits, with the top 20 accounting for 80% of the exposure.  

Ucits exposures to loans

Those Ucits that invest in loans run the risk of being stuck with the positions for longer than planned.

“The loan markets are not as liquid as equity markets, so direct investors are not guaranteed to find a buyer,” says a third lawyer, Will Sykes, a partner at Macfarlanes. “And also, if you are buying a €20 million slice of a €100 million loan, you are reading the underlying loan, you are doing due diligence, you are working out the terms, so loans tend to settle in 10 days, 20 days, a month – some of them take ages to settle. It’s a pretty illiquid instrument to be trading in.”

Even instruments such as collateralised loan obligations (CLOs), credit default swaps and repackaged notes that provide indirect access to the loan markets are generally less liquid than equities, foreign exchange and government bonds – the other instruments Ucits invest in, he notes.

“Given Woodford, I can see why the Luxembourg regulator is nervous about loans.”

The same connection is made by another lawyer, Marc Seimetz, a Luxembourg-based partner at law firm Dechert. “Liquidity of assets is an important feature of Ucits. And events such as Woodford put an additional emphasis on what’s already an important point.”

Elvinger at Elvinger Hoss Prussen says the relative illiquidity of loans is one of two key reasons for the CSSF’s concerns.

Ucits are primarily required to invest in securities that can be easily bought and sold, and in money market instruments, but some funds have justified their loan investments by pointing to Article 50.2(a) of the Ucits directive, which permits up to 10% of a fund to be invested in less liquid transferable securities and money market instruments. In Luxembourg, funds have successfully argued that loans should be permitted within this ratio if they share certain characteristics with money market instruments, says Elvinger.

“Over the last four to six months, the CSSF has started to revisit its position,” he says. “Generally these loans – and this is the reason why certain managers are so interested in them – have higher rates than traditional money market instruments.” This goes against a regulatory requirement that for a money market-like instrument to be eligible for investment by Ucits, its rate should be reset on a periodic basis “in line with money market conditions”. 

Secondly, “in many cases the terms of these loans provide for settlement periods that are of such length that it is difficult to justify that they meet the liquidity requirements that apply in relation to eligible money market instruments”, Elvinger says.

The CSSF’s Hoscheid says the watchdog is “looking at loans from a wider perspective” but concedes that “part of it is, of course, also liquidity”.

Ireland to follow?

Luxembourg is, by far, the biggest European hub for Ucits, and the runner-up, Ireland, is expected to mirror its position on loan investments. The two countries account for 57% of European Ucits’ net assets, according to data for the third quarter of 2019 from the European Fund and Asset Management Association.   

“One can reasonably assume that the CSSF is speaking to the Central Bank of Ireland on this and I would be astonished if they were not aligned – if not now, then in the very near future,” says Elvinger.

Seimetz at Dechert echoes that comment: “If Luxembourg is the first one to take a restrictive approach on certain loan investments by Ucits, I can’t imagine other jurisdictions will not follow. It’s probably partly based on discussions at the Esma level.”

If Luxembourg is the first one to take a restrictive approach on certain loan investments by Ucits, I can’t imagine other jurisdictions will not follow
Marc Seimetz, Dechert

Hoscheid at the CSSF declines to comment on whether the regulator is in contact with the Central Bank of Ireland. The bank itself says: “The central bank does not comment on bilateral engagements with other regulatory authorities.”

What the Irish regulator is more open about is its recent focus on other investments by Ucits.

On January 29, it updated its Q&A on Ucits, inserting a section on contracts for difference (CFDs), CLOs, contingent convertible securities (CoCos) and binary options.

“Where a Ucits proposes to invest in CFDs, CLOs, CoCos or binary options, that Ucits may be subject to enhanced scrutiny at the authorisation phase with a view to ensuring that the proposal is appropriate taking into account the overall portfolio of assets proposed,” the document warns.

If Ucits are banned from investing in loans directly, through the trash bucket, and in all products referencing or tracking loans, including CLOs, the resulting greater protection for investors will come at the cost of eroded returns, predicts Sykes.

Whether that is overall a good or a bad thing “depends on your view of what an investment manager is”, he says.

“You may think the manager should be free to choose what to invest in and when the investments are not very good, you pull your money out and go somewhere else. It depends on your general world view: individualism versus nanny state.”

Elvinger thinks the CSSF will announce its new position on loans either via a note in its annual report, which comes out in April, or an update to its own Ucits Q&A.

Update, February 12, 2020: The story has been updated with details of Ucits funds’ exposure to loans.

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