The Coronavirus Exposes Hidden Structural Risks

Investment Magazine: The impact of the coronavirus on fund investors is beginning to extend well beyond due diligence issues on business continuity planning into major structural risks that could bring real damage to managed fund investors.

Last November, I wrote that valuing private assets was a challenge particularly where an externally managed fund (managed funds) permitted redemptions in an open-ended structure, specifically that “there is a pricing and liquidity mismatch to consider”.

Moreover, it was plain to see that accessing these strategies through open-ended structures is not for the faint-hearted, not least due to the issue of ensuring that applications and redemptions are done at the correct value and I argued that specialist due diligence was required.

Ultimately, those managed funds are owned by investors who may require access to capital. There is no problem of course if the fund is closed-ended and liquidation is scheduled in five years’ time and based on a genuine sale price.  
 However, many private asset managed funds are structured as open-ended and hence, in theory, investors are permitted to withdraw assets.

Super funds are facing an unprecedented situation of pre-retirement redemptions and the pressure is on to find liquidity and ensure assets are valued fairly to ensure redemptions and switches are done at a fair value. However, in respect of the managed fund, valuation is the responsibility of a fiduciary namely a responsible entity, trustee, board or general partner – depending on the fund structure.

For underlying funds with illiquid assets, valuations lag liquid markets by some considerable time (often six months) and whilst you don’t need a Ph.D. in actuarial theory to work out a shopping centre or airport isn’t worth what it was at Christmas, the process of determining the new value of that asset can be a lengthy and complex one.  Moreover, if investors are allowed to exit, it better be correct or thereabouts.  Of course if investors can withdraw from their super funds with these private assets at full value (say 31 December 2019) that makes for quite an attractive trade (if only for the redeemers!).

A deep understanding of the valuation policy and practice, applicable to that specific fund vehicle is vital in having confidence that a robust valuation process is followed.  Gaining such assurance involves detailed fund specific due diligence as often generic valuation policies are not legally enforceable and utilise unenforceable language such as “generally” or “typically” – hence the value of fund-specific reviews.

Globally, institutional investors make great efforts to understand valuation on each fund vehicle.  They obtain quarterly liquidity and valuation source information often from independent third parties such as fund administrators to obtain a better understanding of liquidity and the valuation process.

In many cases, the generic fund manager valuation policy doesn’t deal with fund specific issues and detailed due diligence on pricing sources for that fund are vital.  For instance, are prices externally sourced for that fund? Recently we heard from a global fund administrator that “manager marks” on illiquid assets are being increasingly used.  As managers receive asset-based fees (in many cases on unrealised gains) this should spark significant interest from investors.

Additionally, detailed due diligence on the underlying funds including in-depth analysis on fund-specific liquidity and valuation issues should include a review of externally validated sources such as the prior set Audited Financial Statements of the Fund.

For investors that don’t follow this process there is a very strong case to bring this in, at the very least to align with global standards.

 Closing the gate

Assuming the managed fund is open-ended and permits withdrawals, and assets are marked correctly using external validation, the underlying fund might legally elect not to pay out.

For investors that have conducted fund specific due diligence, those investors would have been aware of the underlying fund’s ability to stem redemptions under its legal documentation (often termed the “gate”). Whilst these mechanisms are vital if trustees or fund boards have to protect assets and avoid fire sales, they present obstacles to investors that require redemptions to be settled.

We are seeing an increasing number of managed fund vehicles stagger and restrict redemptions (namely “gating’ the fund).  So far, we have seen this in credit strategies, property and private lending.  Investors have long been cautioned, to have thoroughly understood any liquidity mismatch in fund co-mingled fund vehicles.

Many investors were ill-prepared during the GFC with provisions for gating applied without mercy on a global basis as well as in Australia.

In any event, investors will need to be sure of gate provisions for underlying funds if redemptions continue and managers will need to be mindful of what powers they or the managed fund maintains.

Asset owners that remain informed and on the front foot are less likely to face a nasty surprise.  Those that have a deep understanding of their underlying fund’s specific terms and valuation practices stand a strong chance of navigating the crisis in a way that is seen as being fair to all.