The end of the transition period is in sight. What particular challenges does the PRIIPs Regulation pose for real estate fund managers?

According to the current legal situation, the transitional period under Art. 32 of Regulation (EU) 1286/2014 (PRIIPs Regulation) will expire on 31 December 2021. The European Commission has proposed to grant a final deferral of another six months until 30 June 2022. But it is already clear that real estate AIFs will soon fall under the full scope of the PRIIPs Regulation. The implementation of the new regulations poses special challenges for real estate fund managers, which the industry should familiarise itself with in good time.

The PRIIPs Regulation requires manufacturers of so-called "packaged investment products" to provide standardised key information documents ("PRIIPs-KIDs") to prospective product customers if the investment products are to be distributed to retail investors. The PRIIPs-KIDs are intended to serve the goal of increased product transparency and better comparability of different investment products. The packaged investment products that fall within the scope of the PRIIPs Regulation also include alternative investment funds (AIFs) within the meaning of the AIFM Directive, regardless of whether they are open-ended or closed-ended AIFs. Marketing to retail investors takes place if the funds are not exclusively marketed to professional clients within the meaning of MiFID II. For example, semi-professional investors within the meaning of the German Investment Code (KAGB) must also receive PRIIPs KIDs in the future if they are solicited for participation in a special AIF. It is intended that the PRIIPs KIDs will replace the key investor information that previously had to be prepared in accordance with the requirements of the UCITS Directive.

PRIIPs KIDs should contain core information on the respective investment product on a maximum of three A4 pages: ·       

• the so-called overall risk indicator on a scale from 1 (lowest risk class) to 7 (high-risk product); 
• the return outlook in the form of performance scenarios;    
• the cost structure.

It should be noted that the PRIIPs Regulation is also relevant for the fulfilment of MiFID II requirements. This is because, according to the guidelines published by the European Securities and Markets Authority (ESMA) on MiFID II product governance requirements, the overall risk indicator to be shown in the PRIIPs KIDs must be used within the scope of the target market determination in the category of risk tolerance and compatibility of the risk/reward profile of the product with the target market.

The PRIIPs Regulation has been in force since 2018, but AIFs are exempt until 31 December 2021, provided that the respective national provisions for the AIFs require the preparation of key investor information in analogous application of the UCITS Directive. The European Commission is currently planning to extend the transitional period one last time until 30 June 2022. With the expiry of the transitional period, however, all fund managers are obliged to use the PRIIPs KIDs when marketing their AIFs - regardless of whether they are newly launched or already marketed funds.

The reason for the transitional arrangement is that the European legislator wanted to adapt the regulatory technical standards ("RTS"), i.e. the detailed rules for the preparation of PRIIPs KIDS, which are regulated in an implementing regulation, with regard to the special features of investment funds. The European Securities and Markets Authority (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA) were mandated to develop a joint proposal for the RTS amendment. After many months of disagreement between the three authorities (in particular the presentation of the performance scenarios in the PRIIPs KIDs was in dispute), they submitted their draft RTS amendment to the European Commission in February 2021.   

Within PRIIPS, not all types of risks have been dealt with, but three types have been included, namely market risks, credit risks as well as liquidity risks, whereby the latter are not to be quantified. Market risks are positive or negative changes in prices observable in the market. High price fluctuations are thus considered high risks and versa vice. Credit risks are the possibility of a loan and/or a counterparty defaulting. While market risks can be modelled directly using prices, credit risks require additional data (certified ratings). In the case of liquidity risks, it is sufficient to describe whether the product cannot be bought/sold due to insufficient market liquidity. This risk plays a major role, especially in the event of a stock market crash, so as not to be "stuck" with the instruments.

For market risks, a special form of the value-at-risk concept is applied and the market price fluctuations are converted into the "VaR equivalent volatility" and then assigned to 7 categories. The lowest risk category has a volatility of < 0.5% (category 1), the highest category (7) is obtained with a volatility of ≥ 80% (Annex II to Delegated Regulation (EU) 2017/653 in Part 1, point 2). In order to calculate market risks, at least monthly (at least 5 years of history), weekly (at least 4 years of history) or daily prices (at least 2 years of history) are required. If these values are not available, the product is automatically assigned to risk category 6, which corresponds to a volatility of 30% - 80%.

Credit risk, which, unlike market risk, is not mandatory to calculate, shall be determined when the probability of default of related entities to the PRIIPs and its impact on the value of the investor return may be affected. The assessment of credit risk shall be based on credit ratings where available. Otherwise, a standard credit assessment shall be performed, adjusted by maturity and mitigations.

In order to assign the quantified risk types to a final risk category, a matrix was specified that gives a slightly higher weighting to the market risks in the aggregation (Matrix Annex II to Delegated Regulation (EU) 2017/653). For example, an instrument can show a 1 in the final risk category even if the credit risk was calculated at level 2.

It is noticeable that illiquid instruments are to be listed in the basic information sheet with risk category 6 (30% - 80% volatility), if the data basis does not meet the minimum regulatory PRIIPs requirements. In this respect, such instruments have an unattractive risk/reward ratio, if one compares this, for example, with the volatilities and returns on the stock market, where 10%-11% returns can be achieved depending on the time period, with a volatility of 15-20%[1].

The regulation allows illiquid instruments to be supplemented with proxies which are priced on a sufficiently regular basis. In this case, the market risks are calculated using similar products or indices in order to know or calculate the risks more precisely. This can lead to a lower VaR-equivalent volatility if the actual underlying risks of the instrument are lower. This can be the case in particular for real estate funds, since a volatility of > 30% per annum is hardly discernible for solid properties, even during a financial crisis.

The manufacturer is required to document the choice of the proxy and to argue it’s suitability.

A typical proxy is a similar product that is sufficiently often traded on the market, meaning at least monthly and daily in the best case. A special form of a proxy is a replicating portfolio, where basically any underlying can be replicated with a portfolio of suitable factors and or instruments. This can be a mix of weighted financial instruments or indexed macroeconomic factors or alternative data as well as a combination of factors and instruments.

Although replicating portfolios are a typical approach in insurance it is also very well performing in banking. (W. Chen and J. Skoglund. Cash flow replication with mismatch constraints. The Journal of Risk, Vol. 14, No. 4:pp. 115/128, 2012, T. Kalberer and Z. Strkalj. Is life really difficult? Milliman Research Reports, 2012. Seemann. Replizierende Portfolios in der deutschen Lebensversicherung. ifa, 2011.)

However, especially useful for the application of replicating portfolios within the framework of the PRIIPs Regulation is the research of Natolski and Werner in 2016 which allows us to expect that a replication with a daily, weekly or monthly pricing frequency of illiquid assets is possible with little deviation from the real prices. (J. Natolski, R. Werner, Mathematical Foundation of the Replicating Portfolio Approach (August 14, 2016). Available at SSRN: 2771254, 2016 ).

This is especially interesting for real estate funds which in many cases do not exhibit a high risk or volatility historically considered, but are all rated as high risk by the PRIIPs framework due to the very low pricing or valuation frequency of the underlying assets.

The advantages of the application of replicating portfolios apply to any fund with illiquid underlyings, as long as sufficient historical data is present to allow the robust modelling of the respective replicating portfolio.

It goes without saying that the robust modeling and documentation of a replicating portfolio is challenging. During the implementation of the approach various additional parameters such as scenarios, the individual portfolio components, the optimization algorithm etc, need to be defined and calibrated by the user. Finally the plausibility and accuracy of the chosen approach needs to be validated by extensive backtesting. (Deutsche Aktuarsvereinigung 2015).

Special thanks to Boris Wälchli and Dietrich Wagner of Evershed Sutherland for their contributions