Liquidity and disclosure in the funds industry: an open ended question?
16 / 07 / 2019
The recent suspension of Neil Woodford’s Equity Income Fund to redemptions has put a spotlight on the asset management industry. With billions of pounds of investors’ money now trapped, many are questioning how this could happen.
The role of the regulator is key, but there are other considerations. We consider two of the threads coming out of this fraying tapestry: the suitability of asset classes for the fund type and the role of governance at fund and institutional investor level.
Open or closed ended?
Traditionally, open ended funds such as unit trusts and open-ended investment companies have been used by hedge funds to hold liquid assets (publicly traded stocks, swaps and other financial instruments that have a short life cycle to cashing out). Unlike traditional closed-ended investment funds, an open-ended structure has no termination date and capital can be raised and repaid on an ongoing basis. Valuing the portfolio is one of the most important aspects of open-ended funds: the NAV serves as a determination of performance and fairly prices the units for current investors to exit, or for new investors to enter.
On the other hand, the closed ended model, which has a termination date and does not allow direct withdrawals on demand by investors, has been used by private equity funds for less liquid holdings (such as in unquoted companies and private equity and real estate investments). This makes perfect sense and reflects the investment strategy and nature of the respective asset classes. Investors in a closed-ended fund should understand that they are committing to the scheme for the life cycle of the investment over a number of years and that they would need to find a buyer on the secondary market for their interest if they want to exit early. The exit value might not reflect the net asset value of the proportionate holding of underlying assets in the fund. Liquidity in the secondary market for retail investors has, of course, been facilitated by the rise of listed investment trusts, but the principle remains the same: shares may trade at a discount to the NAV.
Open-ended funds are subject to greater regulatory oversight and administrative obligations than closed-ended funds (including quarterly NAV reporting). Therefore, a manager will be tempted to set up a new fund as open-ended if it cannot attract the same investors on a closed-ended, locked in basis. And that is of course the key issue. Open ended funds are typically more attractive to many retail and institutional investors. Not all investors would buy into a vehicle from which a withdrawal at will is not possible, and would not want to risk needing to exit a closed-ended fund early and potentially realise less than the NAV. With managers being rewarded based on the size of the fund, many may choose the open-ended model to attract more retail investor cash. This is fine, so long as the funds have or can generate the cash needed to meet withdrawal requests.
Despite the problems that can arise in trying to sell illiquid fund holdings at short notice, the managers of many retail funds hold them in highly unsuitable open-ended fund structures. This inevitably causes problems for investors during a market downturn or if there is a “run” on the fund: it is not as if this has not happened before. In the wake of the EU referendum in the summer of 2016, investors rushed to take money out of real estate funds due to fears of a widely predicted economic slowdown. Such mass redemptions create a big problem: the cash needed to meet redemption requests takes time to generate because real estate cannot be sold immediately in the way that, say, listed shares or bonds can. Many funds were forced to suspend redemptions, or apply value adjustments, while they raised money from sales. This typically has a distorting effect on the market and the value of the assets as “fire sales” drive down prices. Investment trusts, which are closed-ended and which do not allow direct withdrawals by investors, did not face the same problem, although their share prices may have been temporarily discounted and the value of their underlying assets reduced. The affected funds reopened in the months which followed, and since then most have learned a lesson and significantly increased the amount of cash held, in an attempt to prevent a recurrence of the problem. Even then, this does not eliminate the issue and can even artificially encourage a rush to redeem if the market “wobbles”, in an attempt to get redemption requests in early before the cash set aside for redemptions runs out, leaving the remaining majority of investors locked in.
Of course, even when an open-ended investment vehicle holds assets that are almost exclusively liquid, fund documents permit the funds to be “gated” and closed for redemptions during exceptional market conditions, and that ability was used during the financial crisis. Suspension clauses tend to be drafted very widely, but, up to now at least, market expectation has been that these clauses are intended for use in rare circumstances and principally when the securities market (or a particular segment of the market), rather than the fund itself, is not functioning as it should. Investors pay the manager to manage the fund well, but the manager is also compensated for poor performance. Gating is not supposed to be a remedy for filling the fund’s portfolio with assets that were never liquid in the first place. That is not the fault of the market: it is the fault of the fund’s investment strategy.
It is not unreasonable to suggest that ultimately the purpose of disclosure is precisely to allow investors to identify these risks – namely, full disclosure of the investment strategy in the fund documents. Institutional and professional investors are responsible for making informed decisions about the risks involved (something we have touched on in relation to governance, below). For investors in open-ended VC funds for example, the promise of liquidity may be a moot point (startups do not generally pay dividends and secondary fund markets can be patchy). The trouble is that so many investment policies are written in such broad terms, with so many disclaimers, in the offering memorandum that it is not always easy to identify specific risks until after asset selection has taken place. Although, ironically, the Woodford Equity Income Fund appears to have offered a certain degree of transparency as to the assets held for those willing to carry out due diligence, many open-ended funds do not and only disclose the largest holdings. The rise of execution-only platforms for retail investors make disclosure a more difficult proposition. How many ordinary people investing in a fund through an online supermarket actually read the fund documentation, rather than just checking the box without actually doing so? This perhaps demonstrates a case for increased regulatory oversight of open-ended retail funds, and those who promote them, to ensure managers are complying with the investment mandate, the appropriate levels of liquidity are maintained to satisfy redemptions and retail investors understand the nature of the investment. Liquidity in securities needs to be true liquidity, where there is a steady supply of buyers and sellers, not a cosmetic listing of illiquid assets on a platform without active market trading.
So-called evergreen funds are an alternative model worth considering for funds that invest in illiquid assets such as property and untraded equities. A hybrid of a traditional closed-ended private equity fund and an open-ended fund, they are permitted to recycle capital after an exit, keeping powder dry for follow-on and opportunistic investments. This is in contrast to traditional funds, which distribute it to investors. Redemptions are typically allowed only every few years. The core advantage of such funds are that they have more flexibility. Without an end date and with the ability to raise more capital, and without needing to be ready to satisfy redemption requests at short notice, they can focus on long-term capital appreciation for investors. There are relatively few disclosed examples of such funds and the majority are US and UK VCs investing in software and life sciences. The true numbers cannot be known, and are likely to be far higher, because this manner of investing is widespread amongst angels, family offices, and corporate venture units who do not publish their investment activity. The retail funds sector might take note.
It is worth noting that the open-ended model can work perfectly well for private funds set up to hold family office assets – often illiquid ones. It is not unusual for such funds to be “wired” as open ended hedge funds to allow redemptions for maximum flexibility, but to contain a variety of long-only liquid and illiquid assets, with acquisitions and disposals and any trading being driven by internal events rather than the market. Periodic redemptions are permitted, such as annually on a set valuation day each year, with board discretion required for more frequent redemptions. What is important in this much less visible segment of the funds industry, is that there are no investor expectations of being able to “cash out” at will. These funds are run according to the needs of their investors, who have full visibility – and, often, input – into holdings and investment decisions.
The importance of good corporate governance arises at two levels: at the level of the fund, and at investor level.
There is a common practice at fund level for many ACD platforms, in their standard form OEIC documents, to shift responsibility for governance back to the manager. This is despite governance being a cornerstone of the responsibilities of a director and the ACD specifically being put in place as a guardian of good governance within the boardroom. It seems likely that this practice will come under increasing scrutiny. It is not a stretch to conclude that the current ACD/UCITS regulatory model gives false comfort to investors and should be refined.
And at investor level, it is difficult to see how so many institutional investors got this so wrong. Investment policies appear to have suffered from insufficient diversification and a failure to carry out appropriate due diligence at the time of initial investment, or to monitor investments on an ongoing basis. Investors seem to have ignored the warning – often used but, it seems, never heeded enough: past performance is no guarantee of future performance.
All of this dovetails into the role of the FCA and the effectiveness of its oversight. It remains to be seen whether the FCA will respond to the crisis of the Woodford funds with changes to the regulatory landscape (or changes to its approach to enforcement).
It is appropriate to step back and consider why some fund managers fail to do what they say they will. Markets constantly evolve. How can one deliver the needed flexibility in investment strategy without giving a very broad discretion to the manager? It is cumbersome for managers to go back to investors for consent to change their mandate, and retail investors in funds are notoriously poor at stewardship and voting. So, it gets left to disengaged capitalism. Should there be a stronger relationship between manager and investor, or enhanced regulation, or both?
In the meantime, if recent events are anything to go by, one will see more capital flowing into index linked funds. Increasing numbers of investors are happy to track the relevant market, rather than trying to pick a manager who will beat it (and take the risk of the reverse happening). That in turn can cause its own problems: with higher levels of passive capital following a relatively smaller pool of actively managed capital, this can distort the market and leave it more vulnerable to disruption, should anything go wrong with the managed portion of the industry.
Claire’s practice covers corporate, funds and financial services matters, with particular emphasis on cross border, offshore and alternative investments. She advises a number of fund managers and also acts for investors on the buy side.
Edward is a corporate and capital markets lawyer with a particular specialism in corporate governance, being the author of the Corporate Governance Code issued by The Quoted Companies Alliance in both 2013 and 2018 (now applied by almost 90% of companies on AIM).