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:
so-called overall risk indicator on a scale from 1 (lowest risk class) to 7
return outlook in the form of performance scenarios;
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%.
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
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.)
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
Special thanks to Boris Wälchli and Dietrich Wagner of Evershed Sutherland for their contributions
 Source: UBS, Does
taking more risk equal more return? 30 October 2019, 11:24PM UTC Chief