To state the obvious, the COVID-19 novel coronavirus has rapidly become the most serious global public health crisis since the Spanish Flu epidemic of 1918, more than a century ago. Italy's 60 million people are in quarantine lock down. Markets are reeling. And, of course, it's too late to redeem, for hedge funds at least - quarterly with 45 days means request mid May effective June 30 to be paid July or August. That is an eternity given the speed in which the virus is impacting countries around the globe.
Our first blog on the coronavirus - almost a month ago - touched on four points:
Nearly a month later, with the epidemic now far more widespread and serious, what are actions that investors (and managers) can now take?
1. Inventory Your Asset Managers
An obvious point for investors, but a necessary starting point.
- Bank / custodian
- Prime broker
- ISDA counterparties
- IT service provider
- Compliance consultant
- Valuation agent
- Data vendors
2. Survey Your Asset Managers
There is, unfortunately, rarely a simple answer to a complex question.
Castle Hall does not recommend asking the junior ODD analyst to blast out a simplistic questionnaire to all managers in a portfolio and then recommend redemption from managers 9, 26 and 85 because, for example, they report that they did not complete an annual BCP test over the prior 12 months. Mechanical, checklist ODD will no longer work (not that it ever did).
First, as above, it's too late for redemptions, even if you are invested with a manager with sub par BCP and disaster recovery capabilities. Second, taking this example, no one has tested their BCP for a full scale pandemic. As such, "how often do you test your BCP plan", while a pre-existing and necessary question within institutional quality ODD, is not necessarily a guaranteed indicator of COVID-19 preparedness. These are new and unheralded business challenges for everyone.
However, what is helpful is to have consistent, systematic information across the portfolio, with a view to identifying managers at higher risk. Investors can then engage with those managers to share information and partner to help each business take protective steps wherever possible.
Some of the questions which can be asked, either through questionnaire, phone call, or in combination:
We recommend a hybrid approach to manager outreach, balancing systematic data gathering to obtain a consistent data set across all managers, with a pragmatic calibration of questions. Again, it is not reasonable to expect a 9 person hedge fund start up to have Pimco level BCP preparedness. Equally, the 9 person start up will likely be very responsive to investor suggestions and eager to discuss how they can protect their portfolios and their business.
3. Hope for the Best, But Prepare for the Worst.
There does not appear to be an easy "get out of jail card" for COVID-19. This will be a fluid and rapidly evolving situation, and both investors and managers should expect...the unexpected.
In no particular order, here are some observations from Castle Hall as to potential weaknesses across the asset management industry which will likely; could perhaps; or probably will not (but we don't know) happen.
a) Expect some hedge funds to be gated.
This is the most significant financial drawdown since 2008, and it is quite likely that at least some hedge funds will trigger gates and / or suspend redemptions due to redemption requests. What is different in 2020 is that offering documents are typically "tighter" than pre 2008.
Over the last 10 years, fund lawyers have written in extensive provisions such that a typical fund has full flexibility to suspend redemptions, gate the fund, or withhold payment of redemption proceeds (which can often include use of vehicles such as liquidating trusts - which are just side pockets with a different name).
As an example of typical language:
In the sole discretion of the General Partner, the Partnership may make distributions in cash or in kind (to the extent that the Partnership receives an in-kind distribution from the Master Fund), or in a combination thereof....The General Partner may, in consultation with the Master Fund Board of Directors, choose which underlying assets of the Master Fund to distribute in kind. If a distribution is made in kind, immediately prior to such distribution, the General Partner shall determine the fair value of the assets distributed...In-kind distributions may be comprised of, among other things, interests in Special Purpose Vehicles holding the actual investment or participations in the actual investment or participation notes (or similar derivative instruments), which provide a return with respect to certain securities of the Master Fund.
2) Expect liquidity mismatch issues - especially for retail funds
Woodford has, of course, shown what happens when a retail fund with a portion of illiquid assets is required to suspend redemptions. Last year, Mark Carney, then Governor of the Bank of England, said that "these funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid. And that leads to an expectation of individuals that it’s not that different to having money in a bank."
This obvious failure in structuring funds has not stopped these investment products being very popular, especially in Europe - we shake our heads at the very large open ended real estate fund industry in the UK and Continental Europe. Europe is also exposed to its large UCITS industry where at least some funds have stretched the regulatory rules to the limit as to portfolio composition and fund structuring, relying on the "don't worry, it's a UCITS fund" mantra.
Also interesting is AIFMD, the role of the depositary and the other changes introduced by creation of AIFM and AIF structures. Coronavirus will be the first test to see if the EU rules have any effect to protect investors during a market dislocation.
3) Expect valuation difficulties
What is "fair value"? Castle Hall's answer is that something is worth what someone will pay for it, at the time that the seller wishes to sell - which merely highlights the subjectivity of valuation of Level 2 and Level 3 assets, especially in a period of significant market pressure.
As a particular issue, we highlight that administrators have, since 2008, largely removed themselves from any responsibility around valuation. A typical prospectus often includes language similar to:
In calculating the Net Asset Value of the Company, the Administrator shall, and shall be entitled to, rely on, and will not be responsible for the accuracy of, financial data furnished to it by the Master Fund's prime broker, market makers and/or independent third-party pricing services. The Administrator may also use and rely on industry standard financial models in pricing any of the Master Fund's securities or other assets. If and to the extent that the Investment Adviser is responsible for or otherwise involved in the pricing of any of the Master Fund's securities or other assets, the Administrator may accept, use and rely on such prices in determining the Net Asset Value of the Company and shall not be liable to the Company, any investor in the Company, the Investment Adviser or any other person in so doing.
As such, investors cannot assume that administrators will be actively engaged to prevent inaccurate valuations should pricing data be provided by asset managers in accordance with contracts such as the example above.
4) Expect some frauds
Well, as Warren Buffet so famously said, it's when the tide goes out you see who's swimming naked.....
5) Expect disruptions due to "follow the sun" service models
A key risk in the asset management industry is dependence on third party service providers, notably administrators and banks, who have often offshored significant functions to lower cost locations in India and Asia. Castle Hall, equally, has an office in Manila which has been integral to our own corporate growth.
It is unavoidable, however, to note that many cities in these regions have very large populations and a lesser level of funding for healthcare systems. As such, preparedness of the administration industry, as well as banks and other service providers reliant on offshored locations, will be key. Inability of a major administrator to provide uninterrupted servicing could have significant ripple effects across the industry.
To conclude, we repeat our comments from our first blog addressing the novel coronavirus.
Above all coronavirus is not a time for "gotcha" ODD. Rather, this is a time when everyone in the asset management community can collaborate to share ideas and best practices. Working together, we can help protect our colleagues and their families, and support our businesses across the industry.
Castle Hall Diligence
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