1.102 Application of Article 16 (liquidity management), Article 19 (valuation), and Article 61 (transitional provisions) of the AIFMD differs depending on whether the AIFM’s AIFs are open-ended or closed-ended.
1.103 Open-ended collective investment funds do not normally have a fixed term, and permit investors to make contributions and request redemptions at certain times during the life of the fund. The number of units or shares issued to an investor in return for contributions to the fund and the amount payable to the investor by the fund upon cancellation of units of shares following a redemption request are based on the price of the unit or share on the day of the contribution or redemption (known as the ‘dealing day’). The price is calculated by dividing the net asset value of the fund—ie the assets minus the liabilities as determined based on prevailing market prices and in accordance with the rules applicable to the fund under its constitutive documents and the law of its place of organization—by the number of outstanding units or shares on the dealing day. The contribution, or the redemption amount, as the case may be, is payable upon the contribution or redemption becoming binding on the investor and the fund.
1.104 Closed-ended collective investment funds have a fixed term and do not permit additional contributions of privately offered closed-ended funds after the fund has closed following the capital-raising cycle. During the capital-raising period, each investor agrees on the amount of (p. 23) capital it will commit to the fund. Once the aggregate of the investors’ capital commitments reaches a certain threshold determined by the manager of the fund, the capital-raising cycle ends and the fund is said to be ‘closed’. The next phase is the investment phase, in which the manager will seek out investment opportunities. The investment will, apart from bank borrowing, be funded by ‘drawing down’ capital commitments, or, later in the life of the fund, by the proceeds from the sale of earlier investments. This will continue until the manager has invested the entire committed capital. In the final phase, the manager will sell the investments of the fund one by one and return capital, plus or minus the return on the particular investment, to the investors.
1.105 Accordingly, open-ended and (privately offered) closed-ended funds have fundamentally different modi operandi. Open-ended funds accept contributions and will permit investors to take their capital out on a continuous, all be it not always high frequency, basis. The share of the investor in the pool is valued based on prevailing market prices that will be obtained from public sources. Closed-ended funds are not open for continuous contributions and redemptions and are perhaps best described as a series of collective investments in individual assets that are funded by the investor and lenders at the time of purchase. Capital is only returned once the investment is sold. Thus, the values of the capital contributions to, and the redemptions from, open-ended funds are determined based on estimated prices, notwithstanding the fact that the manager will normally have to sell fund assets to meet the redemption request. The values of the capital draw-downs and return from closed-ended funds, on the other hand, are based on actual prices.
1.106 Different operational processes have different implications for the liquidity profile and valuation of the fund. The manager of an open-ended fund is concerned with meeting redemption requests out of the portfolio and ensuring that the valuation of the redeemed units is accurate and fair to the remaining investors; the redeeming investor should not be over- nor underpaid. The manager of the closed-ended fund, on the other hand, returns the proceeds of the actual divestment to all investors once the asset has been successfully sold. Liquidity does not play a role in that process and the valuation is a mere calculus event based on the actually achieved price, not an estimation based on a collection of prevailing market values.
1.107 Naturally, the ability to operate an open-ended fund depends on the availability of reliable market prices, as well as relatively liquid markets for the assets in which the fund invests so that the manager may sell assets to meet the redemption requests. If the assets are less liquid, the manager must limit the frequency of the dealing days. Some funds that invest in illiquid hedge fund strategies operate with annual or even less frequent dealing days. At some point, it is tempting to conclude that the fund cannot be said to be open-ended.
1.108 Indeed, this is what ESMA, after consultation, wrote into its initial draft ‘regulatory technical standards’ (RTS) relating to ‘types of AIFM’.82 Recital (3) of ESMA’s initial draft RTS observes that the distinction between open-ended and closed-ended funds should be determined based on ‘an appropriate threshold for the frequency of redemption opportunities offered to AIF investors given the particular relevance thereof to the rules on liquidity management and valuation procedures’ and that given ‘current market practice, it is appropriate to consider as open-ended those AIFs which offer redemption frequencies of at least yearly’.
(p. 24) 1.109 As demonstrated, however, exactly because of the fundamental difference between valuation of investor interests in open-ended and closed-ended funds, the redemption opportunity, no matter how infrequent, would appear to be the wrong determinant. Rather, what matters is whether contributions and redemptions are driven by the manager’s investment opportunity and consequently by funding needs or liquidation proceeds of actual investment transactions.
1.110 The Commission concurs. In a letter dated 4 July 2013, the Commission wrote to ESMA that it has ‘serious doubts’ whether the frequency of the ability to redeem is a criterion that can be used to distinguish between open-ended and closed-ended funds. The Commission observed that Articles 16(1) and 19(3) of the AIFMD, in conjunction, denote a closed-ended fund as a fund which carries out valuations ‘in case of an increase or decrease of the capital by the relevant AIF’, and concludes that in case of a closed-ended fund, the ‘valuation and calculation frequency is therefore linked solely to increases or decreases of its capital’.
1.111 ESMA disagreed with the Commission’s response to its initial draft RTS for several reasons, mostly based on the practical implications of the liquidity and valuation rules for funds that have a low dealing frequency, ie less than once a year.83 Notwithstanding, ESMA submitted re-drafted RTS to the Commission ‘in order to ensure a timely implementation of the AIFMD provisions and move the process forward’.84
1.112 Article 1(2) of the re-drafted RTS provides that an open-ended AIF is an ‘AIF the shares or units of which are, at the request of any of its shareholders or unit holders, repurchased or redeemed prior to the commencement of its liquidation phase or wind-down’. Under Article 1(3) of the re-drafted RTS, a closed-ended AIF is an AIF that is not an open-ended AIF within the meaning of Article 1(1).
1.113 This approach—to base the distinction on whether the fund returns capital to investors after a sale of investment rather than at the request of the investor—is in line with what the market will in practice deem to be the difference between open-ended and closed-ended funds.85