The Alternative Investment Fund Managers Directive (AIFMD II) was published in November 2023 and one area of evolution is an increased emphasis on open-ended alternative investment funds' liquidity management. Policymakers have stressed the importance of proper liquidity risk management to mitigate against the adverse consequences liquidity mismatches can cause for investors and the wider financial markets. The solution has been the introduction of the mandatory application of liquidity management tools (LMTs) in a somewhat prescribed manner, and all that underpins them.
What are the new liquidity management requirements?
AIFMD II applies to alternative investment fund managers (AIFMs) from the European Economic Area. While it does not apply to AIFMs from the UK, it will affect UK managers that, for example, use the services of host AIFMs in Luxembourg and Ireland.
AIFMD II introduces a specific list of LMTs from which AIFMs must select at least two "appropriate" tools "for possible use" to ensure that each fund complies with its underlying obligations. The ability to utilise redemption suspensions or side-pockets does not count towards these two tools.
What does this mean for AIFMs?
Managers must assess the suitability of each of the tools in light of the fund's pursued investment strategy, liquidity profile and redemption policy. Detailed policies and procedures must be put in place for their operation by 16 April 2026. The LMTs must also be included in each fund's private placement memorandum (PPM).
The policies and procedures need to explain the operational and administrational arrangements for the use of each tool and for their activation and deactivation. This must be provided to the AIFM's national competent authority (NCA) and application of an LMT may trigger a notification to the NCA.
Types of LTMs
Redemption gate
A redemption gate means a temporary and partial restriction of the right of unit-holders or shareholders to redeem their units or shares, so that investors can only redeem a certain portion of their units or shares.
Extension of notice periods
The extension of notice periods means extending the period of notice that unitholders or shareholders must give to fund managers, beyond a minimum period which is appropriate to the fund, when redeeming their units or shares.
Redemption fee
Redemption fee means a fee, within a predetermined range that takes account of the cost of liquidity, that is paid to the fund by unitholders or shareholders when redeeming units or shares and that ensures that unit-holders or shareholders who remain in the fund are not unfairly disadvantaged.
Swing pricing
Swing pricing means a predetermined mechanism by which the net asset value of the units or shares of an investment fund is adjusted by the application of a factor – a "swing factor" – that reflects the cost of liquidity.
Dual pricing
Dual pricing means a predetermined mechanism by which the subscription, repurchase and redemption prices of the units or shares of an investment fund are set by adjusting the net asset value per unit or share by a factor that reflects the cost of liquidity.
Anti-dilution levies
Anti-dilution levies are a fee that is paid to the fund by a unitholder or shareholder at the time of a subscription, repurchase or redemption of units or shares that compensates the fund for the cost of liquidity incurred because of the size of that transaction and that ensures that other unitholders or shareholders are not unfairly disadvantaged.
Redemption in kind
Redemption in kind means transferring assets held by the fund, instead of cash, to meet redemption requests of unitholders or shareholders. Redemptions in kind can only be utilised to meet redemptions requested by professional investors and, as a main rule, only if the redemption in kind corresponds to a pro rata share of the assets held by an AIF.
Activating any of these LMTs for a fund in a manner that is not in the ordinary course of the fund's business under their rules or instruments of incorporation triggers a notification to the AIFM's NCA.
In addition, fund managers may use:
Suspension of subscriptions, repurchases and redemptions
Suspension of subscriptions, repurchases and redemptions means temporarily disallowing the subscription, repurchase and redemption of the fund's units or shares. An option to suspend the fund does not count towards the required two LMTs managers must put in place for each fund.
Side pockets
Side pockets means separating assets, whose economic or legal features have changed significantly or become uncertain due to exceptional circumstances, from the other assets of the fund. An option to utilise side pockets does not count towards the required two LMTs managers must put in place for each fund.
LTMs in conjunction
Use of suspensions and side pockets is only permitted in exceptional cases where justified in the interests of the fund's investors. And doing so always triggers a prompt notification the manager's NCA. However, unlike the redemption gate and redemption in kind, AIFMD II does not require these tools to be included in the funds rules or instruments of incorporation, as a condition precedent for their use.
Managers should also note that choosing swing pricing and dual
pricing as a fund's only two LMTs is insufficient (even where
side pockets or suspension are an option).
Also, for authorised money market funds, only one LTM is
required.
What next?
EU Member States must transpose AIFMD II into national law before 16 April 2026. Further guidance on LMTs will be provided by the European Securities and Markets Authority (ESMA) in the form of "level 2" measures. By 16 April 2025, ESMA will develop draft regulatory technical standards to specify the characteristics of LMTs to assist managers in their selections. ESMA will also develop guidelines on the selection and calibration of LMTs by managers which will focus on liquidity risk management and mitigating financial stability risks.
Osborne Clarke comment
It's a policy call whether investors are best served by fund managers following mechanical rules or being provided with broader discretionary powers as to how to act under given circumstances. To what degree discretion is revoked by mechanical rules will partially depend on ESMA; but more often than not their rules are prescriptive, both in terms of applicable conditions and procedures. We think these measures could be counterproductive to the problems they are seeking to address.
The new rules may provide a feel of predictability for investors. But this comes as the price of limiting fund managers ability to act in an agile manner under unknown turbulent future market conditions. Similar funds are likely to choose the same LMTs, herding fund managers in the same direction when markets go awry, potentially aggravating a crisis.
The lack of flexibility is partially offset by the wording that the LMT's are for "possible use", meaning managers can include LMTs and not use them (providing the conditions under which they are not used are clearly described). However, if most fund managers do so, this will water down the intended impact of the rules.
Managers are, among other duties, required to act with due skill, care and diligence and there may be little incentive for managers not to act in the best interests of investors under a crisis. Almost invariably, managers already reserve the right to use appropriate LMTs, with less formality and prescription around how to do so compared with the potential rules. This begs the question whether these rules are actually helpful.
The notification requirements will enable and perhaps create an expectation that NCAs can take a live hands-on approach as liquidity challenge arise. However, regulators do not know the ins and outs of each of the thousands of available funds distributed across the EU. Nor are they equipped with the required skill sets to act as fund managers. We are sceptical as to whether regulators will be able to proactively intervene in a timely fashion. In worst-case scenarios, this could lead to multiple "behind the curve" interventions; again, potentially aggravating a crisis. Decisions on how best to address liquidity risks will, in practice, remain with managers.
We think it's worthwhile for managers to take a considered approach in assessing their current selection and implementation of each LMTs and review each of their (sub)funds accordingly. They should also consider documenting the required suitability assessment for each fund.
It is no longer feasible to include LMTs in fund PPMs "just in case" they might be needed, or to reserve them for potential use in the future, without having comprehensive policies, procedures and operational readiness to implement in line with the rules that ESMA will publish.
For example, where managers are dependent on third parties to implement the tools, such as suspending funds distributed via platforms, it is likely they will need to have coordinated and contractually agreed the implementation of the suspension of redemptions across their distribution lines.
AIFMs should consider the impact of the LTM requirements to ensure that their liquidity risk management strategies, policies, procedures, disclosures, administration and operational set-up all line up for each fund. They should also ensure they retain a sufficient degree of discretion to navigate each fund through unpredictable events. This could, for example, mean removing tools altogether from fund documentation, where full compliance isn't possible to mitigate against investor claims of capital losses. Claims could be brought if tools were not deployed and investors believed they should have been deployed in line with ESMA's rules or deployed subject to operational issues later arising.
This Insight was written with the assistance of Yazmin Adrissi, Trainee Solicitor at Osborne Clarke.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.