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Amid Volatile Markets, History Rhymes
The second installment of this article series discusses lessons from the Global Financial Crisis and their impact on operational due diligence approaches today.
As the adage goes, history doesn’t repeat but often rhymes. The phrase holds true now, as many recent financial news headlines are reminiscent of the Global Financial Crisis (GFC), when liquidity was deteriorating and funds enacted gates to restrict redemptions.
In consideration of current market volatility amid the COVID-19 pandemic, concerns have arisen with respect to liquidity and valuation risk among investment funds. While investors in need of cash look to redeem their investments, investment managers lacking sufficient portfolio liquidity may enact gates or side pocket arrangements. A spike in such activity can result from issues related to obtaining valuations.
These issues once again have the potential to impact investors across many asset classes. Mutual funds, ETFs, REITS, and hedge funds may experience liquidity and valuation concerns, and private market funds may experience inconsistencies with valuation methods. As the COVID-19 pandemic continues to strain financial markets, fund investors across all asset classes may experience these familiar trends. When they do, a thorough operational due diligence (ODD) analysis can support investors’ understanding of fund liquidity terms and confidence in how their assets are valued.
2007 to 2020: Reemerging Trends
Many investors will need liquidity in this volatile environment, and investment managers should evaluate their ability to meet investor redemption expectations. During the GFC, some asset owners were forced to liquidate a portion of their holdings due to increased volatility, including pensions that were unable to own junk-rated debt when credit ratings decreased. Conversely, other investors who believed they understood their investment liquidity profiles were caught off guard when investment managers were forced to enact redemption suspensions, causing investors to face uncertain liabilities.
As the risk of similar outcomes has arisen in 2020, regulatory bodies across the globe have begun to respond. The United Kingdom’s Financial Conduct Authority, sensing coronavirus-fueled economic fallout, called on asset managers to issue a clear warning to investors if a fund experienced liquidity issues.1 The Reserve Bank of India set up a $6.6 billion fund to stave off a liquidity crisis.2 Germany’s fund industry is collaborating with regulators and custodians to implement new fund liquidity management tools.3 In the United States, the Federal Reserve stepped in to provide liquidity first as a back-stop for money market funds, and more recently enacted support for businesses by buying corporate bond ETFs.4
In the event that investment managers are unable to fulfill their redemption commitments, they are often required to refer to their fund boards. These boards might consider discretionary liquidity provisions, such as redemption gates or side pockets (via the creation of illiquid vehicles). When this happens, what are the options for investors?
- Waiting Out Gates – Investors can wait for gates to lift and hope to recover most or all of the anticipated value of an investment holding. However, waiting out a gate requires time and patience, and can lead to portfolio liquidity and cash management issues for investors. Those in need of cash due to portfolio requirements or other liabilities, for example, may be forced to liquidate assets managed by different investment firms, or funds they would have otherwise held but which provide a more immediate source of liquidity.
- Turning to Secondary Markets – As a reaction to their own need for liquidity and cash, especially in the case of private investments, investors may look to sell their interest via a secondary market, generally operated by specialty banks or brokers. However, significant discounting on secondary markets may give investors pause when planning to sell their interest, and they should ensure they receive a fair valuation for their private market assets if they pursue this option. In 2008, a major secondary market platform noted a large spike in activity with discounts up to 50%5, and some 2020 secondary market activity resulting from COVID-19 volatility has already been reported. For example, one fund-of-funds firm saw its flagship fund lose nearly 24% of its value amid the downturn and sold $100 million worth of holdings on the secondary market to generate liquidity and buy into more favorable holdings.6
- Accepting In-Kind Distributions – Not all investment managers will be able to meet redemption flows after gates are lifted, and not all investors may elect to sell their interests via a secondary market. If a manager is unable to sell an asset, they can turn to a redemption method known as a payment in-kind. However, the investor then potentially faces the burden of finding a market to sell such holdings. Specifically, some investors who invest only in investment funds may be forced to open brokerage accounts they otherwise may not have needed in order to sell certain assets, such as publicly traded securities.
While these are examples of some actions for investors to consider during a period of volatility, it’s also helpful to examine how investment managers reacted in the past to determine the way forward.
In looking at the history of investment managers’ reactions during and after the GFC, some managers chose to restructure their funds’ redemption terms by creating more attractive share classes and fee structures, with longer lock-up periods to make recommitting capital appealing. Some investment firms enacted stricter liquidity risk management into their investment process by creating Chief Risk Officer roles, utilizing enhanced portfolio management software and improving compliance policies to monitor position liquidity. Other managers determined to create side pockets or special purpose vehicles with holdings of such illiquidity that they remain in portfolios nearly 13 years after the start of the GFC.
In the midst of the GFC, one fund manager put it plainly: "If you have an illiquid portfolio with distressed securities, you should not be expected to be able to get your money back in a month."7
How Can ODD Add Value During Volatile Investment Periods?
Over the coming months, investment firms and investors alike will be forced to navigate the effects of the post-pandemic economic downturn, seeking the best way forward for their investments. For some, the chosen path will include deep analysis of liquidity options and asset valuations that aren’t typically employed during periods of low volatility. Under such conditions, ODD can be a value-added resource for investors, particularly when carried out by third-party ODD providers, as they have the immediate resources to quickly ramp up and perform a thorough analysis on specific areas of risk, which could include the following practices:
- Liquidity Terms – For fund structures, an ODD professional can complete an analysis of fund offering documents to ensure the liquidity, or redemption terms, match those of the underlying assets. This can help prevent an asset/liability mismatch, which is often the reason managers enact redemption gates.
- Valuations – A thorough ODD analysis of investment manager valuations would include a review of a manager’s valuation policy to ensure it is in line with industry standards and valuation principles. In addition, an ODD specialist may seek to ensure there is consistency in valuation methodologies of assets from valuation period to valuation period, requesting sample documents such as valuation memoranda, and ensuring finalization of valuations are approved through a governance structure such as a valuation committee.
- Risk Management – Although an ODD analysis may confirm a sound valuation process and determine that fund liquidity terms are fair, all of this can ultimately be undermined if the investment manager lacks a developed portfolio risk management process. An ODD process should review and scrutinize portfolio risk parameters to understand the process by which a portfolio manager is alerted to investment risks, what technology (if any) is used in the risk process, and how any deviations from such processes are approved and recorded.
Current financial markets may force investors to make difficult decisions. These conditions could cause investors to believe they must assume greater risk, and accept otherwise extraordinary actions or terms that are outside of their control. However, a third-party ODD service allows investors to assess their investment options and risk criteria quickly, while also leveraging the experience and expertise of professional due diligence resources to assist in making informed investment decisions.
1 Ignites Europe, FCA calls for early warning on funds at risk of being gated, March 13 2020
2 Ignites Asia, India sets up US$6.6B emergency fund to stave off liquidity crisis, April 28 2020
3 Ignites Europe, BVI working on implementation of new fund liquidity management tools, May 19 2020
4 Federal Reserve Board, Federal Reserve announces extensive new measures to support the economy, March 23 2020
5 Wall Street Journal, Selling Hedge-Fund Stakes, October 23 2008
6 Bloomberg, Scaramucci’s SkyBridge Looks to Dalio, Marks to Boost Returns, May 11 2020
7 Wall Street Journal, Hedge Funds Slam 'Gates' on Their Edgy Investors, October 27 2008