Author: David McClean & Andrew Burton
With its publication of PS22/8 ‘Protecting investors in authorised funds following the Russian invasion of Ukraine’, the FCA gave the go-ahead to funds holding assets impacted by the Russian invasion of Ukraine to transfer these assets to a ‘side-pocket’. This allowed new investors once more to buy into impacted funds without taking on the illiquidity and price risks of affected assets as well as existing investors to have the liquidity of their fund holdings restored. However, as the FCA’s consultation paper and policy statement make clear, fund boards and fund managers face a number of ethical decisions with regards to the establishment, operation and eventual winding-down of these side-pockets. Many of these decisions do not have universal ‘right’ or ‘wrong’ answers with the right answer depending heavily on the individual circumstances of the fund concerned. So, the FCA left these decisions for fund boards to make on their own, providing only a discussion of the various issues to consider. This discussion came partly in the form of feedback they had received in responses to the consultation and included a number of points that CFA UK had made in its response. Below we provide a summary of the more interesting discussion points:
- It took four months from the time of Russia’s invasion of Ukraine to the publication of PS22/8 and affected funds then have a period of possibly several months from then onwards to set up any side-pocket. In this period, the liquidity of the most exposed funds has been heavily impacted. This has given rise to the suggestion from us at CFA UK and others that side-pockets should be a feature of funds envisaged in their documentation that can be immediately invoked by the FCA given repeat circumstances. The FCA has said they will review the effectiveness of this exercise first before considering a broader application of side pockets to deal with future liquidity impacting events. CFA UK were evidently not alone in proposing side-pockets become a permanently enabled feature of authorised funds; though some responses appear to have gone further than us in suggesting that side-pockets be available at all times and not just in circumstances requiring FCA direction which was our more limited recommendation. IOSCO is also considering this possibility and it is apparent that the FCA will want to be aligned with international practice.
- Perhaps the central question for fund boards to consider in relation to whether to set up the side-pocket, or not, was whether it was in the overall interests of existing unitholders. Did the key benefit of restoring liquidity to the fund by removing impacted assets justify the additional expense and complexity of setting up the side-pocket? This is a judgement call that can only be taken by each fund board, weighing up its fund’s own set of circumstances.
- One thorny question (see 3.26) left to fund managers to determine was how they were going to ensure the side pocket had sufficient liquidity to meet the fees and costs of running the side pocket. One way was to transfer cash to the side-pocket along with the impacted assets but the problem of relying on this approach is that the length of time before the side pocket could be wound up, and therefore the amount of costs and fees that need to be provided for, is indeterminate. We recommended that cash balances in the side-pocket be kept to a minimum, and that instead fees and charges be met by the investment firm with an accrual position building in the side-pocket that, of course, may or may not be cash settled depending on the eventual performance of the side-pocket assets.
- Another issue (see 3.55) relates to the way which fund boards might elect to announce the establishment of the side-pocket. Should all communications be left until the moment when the side-pocket has been legally created and is able to take transfer of the impacted securities, thus minimising the length of any suspension period; or, should the fund make an early announcement confirming its intention and approximate range of dates when the fund might be suspended whilst the transfers were being put into effect? We favoured the latter approach, though much depends here on the make-up of the assets in the fund and the proportion of that are impacted. Another factor is how the units are held and the abilities of various platforms to accommodate the restructuring in a prompt fashion.
- A key issue (see 3.55 also) relates to the price at which the assets are transferred to the side-pocket. This is of course in most cases almost impossible to reliably establish as the assets themselves have not been traded or allowed to trade since the invasion wreaked considerable economic damage in the region. Should the assets be transferred at ‘a best guess’ or imputed valuation or at zero value? CFA UK favoured the zero valuation as it meant that any exiting or entering investor in the main fund could more easily see whether there had been any loss of NAV as a result of the restructuring. Since the impacted assets were not for sale, and for the most part a small proportion of the total fund, then no existing holder stood to lose out if the write-down to zero were subsequently proven to have been unnecessary. A zero value also meant the side-pocket fee issue became an irrelevance.
- Another difficult question (see 3.38) was about the structure of any fee on the side-pocket. CFA UK’s central position was that investors should not be left any worse off than they would otherwise have been. However, what about performance fees? The FCA disagreed with us on this, but we had concerns around managers finding it easier to sell side-pocket assets at the signs of the first bid rather than hang on longer for best price. In distressed assets, written down perhaps to zero, we saw that a performance fee (with a cap) could serve to sharpen a fund manager’s focus even on a legacy position and prevent distressed sales. However, the FCA were not persuaded by our arguments.
- One challenging question (see 5.30) for funds setting up side-pockets is how to return value to their unitholders once assets became liquid again. It is distinctly unlikely that liquidity will return to all impacted assets at the same time. Faced with this scenario, should the side-pocket sell assets off individually and return the proceeds to unitholders in dribs and drabs or accumulate cash and make periodic dividends? At what point should any accrued fees be applied? Or should they allow side pocket investors to sell their units back against cash received on a first-come, first-served basis as is their right on the main holding. CFA UK’s take on this was not to permit partial redemption, so avoiding the risk that slower unitholders are left holding the rump of the most distressed assets.
- In our letter we raised the issue of recording past performance and involved the GIPS team. In their reply (see 5.41) the FCA included our response under ‘other issues raised’. As soon as they establish the side-pocket funds have ‘double-vision’. Existing investors view historic fund performance still including the performance of the side pockets whilst new investors will view it without those assets! The only fair way of dealing with this is to have two records.
- Since publishing PS22/8, the FCA have provided retail investors with the following guidance on how side-pockets work and what retail investors can expect to happen if a fund they are invested in adopts one.