How EU regulation could force a fire sale of 50% of LGPS assets

Local government pension funds have had a far from easy ride this year with a raft of new regulation and demands from the chancellor to reduce costs by pooling investments.

As if this were not enough, things are about to get more complicated thanks to a European regulation that could force a fire sale of assets, increase costs and restrict what the scheme can invest in.

Under the revised Markets in Financial Instruments Directive (MiFID II), LGPS funds will be treated as retail clients by default from January 2017. This will have major implications as funds currently have professional client status under MiFID I, through which they have been able to invest in complex sectors such as private equity, hedge funds and infrastructure. Under MiFID II asset managers are not allowed to sell these investments to retail clients because of their complex nature.

Legal structure
The problem for the LGPS stems from the lack of legal separation between local authorities and their pension schemes, unlike in the private sector where trust-based schemes are separate legal entities from sponsoring companies and therefore escape MiFID II.

The worst case scenario is that up to 50% of the £230bn LGPS assets will be affected, according to Local Government Association (LGA) head of pensions Jeff Houston.

Funds will be able to go through an election process to be upgraded to professional clients but it will take time and will be onerous as they will have to prove to each asset manager that they meet the strict qualitative and quantitative criteria. These include showing the requisite experience, expertise and knowledge so the funds are capable of making their own investment decisions.

Although managers carry the regulatory risk, it is the funds that will have to collate the information to prove they are professional clients, says Nabarro head of pensions North John Hanratty.

Short timescale
The biggest issue for the LGPS is the short timescale. When the rules come into force in January 2017 if funds hold assets in products outside of the retail scope and have not been upgraded to professional status in time, they may find the manager ejects them from the products, resulting in a fire sale of assets.

Hanratty urges funds to act now: "They need to pool together information to show they are professional investors, and speak to their in-house investment people or external consultants. If they are entering tenders now for investment mandates, they should start applying MiFID II now."

The LGA is lobbying the Financial Conduct Authority (FCA) to give funds a transition period. Houston says the impact on local authorities could be lessened if the regulator were to allow funds to keep products bought as professional investors for a period of time.

The FCA tells PP it is "considering the issue" and will publish a consultation paper on the implementation of MiFID in the first half of 2016.

Even if funds can be elected to professional status, the ongoing requirements should not be underestimated.

Hanratty says it is not just at the outset of the sales process that investors have to be eligible to buy complex products. "They have to have an ongoing system to prove they are large professional investors," he says. "If they ever have a check through the FCA they have to be able to show that not only do they have this status but [can prove they] qualify for it as well."

Impact on pooling
MiFID II could have major consequences for the government's wish for LGPS funds to invest more in infrastructure - an asset class which will be restricted to professional investors.

Although, this problem could be mitigated through asset pooling, as this would result in structural changes to the management of LGPS assets. Investment Association retail markets specialist Mike Gould says this would reduce the impact of MiFID II as there would be a smaller number of much larger funds.

Hanratty argues it could even meet the government's agenda of driving down the number of funds. "It may drive the merging of funds - where smaller funds with tens of millions in assets may see it as too costly and team up with other funds to get critical mass so they can be a professional investor."

This is because the practical challenge of satisfying the tests will be particularly challenging for smaller funds. "The financial tests are easy - but it's the part about having the right people in the organisation that is the troublesome bit," according to Squire Patton Boggs head of pension fund investment group Clifford Sims.

"This won't be a problem for big funds such as West Midlands or Strathclyde as they have in-house investment management. It's the smaller authorities that might struggle to find they have right people in their own organisations," he adds.

The London Pension Fund Authority could be treated slightly differently as its structure is different to the rest of the LGPS; a spokesperson says it is speaking to the government about this.

The London collective investment vehicle, set up earlier this year as an authorised contractual scheme and in the final throes of receiving FCA authorisation, will definitely be eligible as a professional investor, Sims says. Not all pooling models will be, however.

Hanratty points out that although pooling will mitigate the effects of MiFID II, the extra compliance requirements on managers may come as an additional cost to the LGPS.

"Every time an asset manager goes for a mandate, it will have to satisfy itself that the fund to whom it's pitching is a professional. There will be additional due diligence required by managers which I suspect will be passed down as costs to the funds. So the cost savings from amalgamating the funds will be offset somewhat by the additional cost of compliance."