Woodford: Learning (the Hard Way) from a Liquidity Mismatch

The saga of Woodford Investment Management is over, with a pretty dramatic ending. On October 14, the Authorised Corporate Director of the flagship Woodford Equity Fund, Link Fund Solutions, fired Woodford, appointing BlackRock and PJT Park Hill to wind up the portfolio. Neil Woodford thereafter announced that he would close his fund management business. Investors face losses of 30%, and potentially more. The root cause? A classic liquidity mismatch.

And Woodford is not the only one. In Korea, Lime Asset Management suspended redemptions on funds with net assets of more than $500 million. Per Bloomberg,

“We made this decision through consultations with regulators in order to minimize the losses of investors,” Won said. “Due to several issues surrounding the firm recently, some investors wanted withdrawals from our funds and we couldn’t liquidate them as fast as they want.”

The rise in redemption requests came after local media reported on a Korean regulatory probe into the company’s investments in convertible bonds. A call to the Financial Supervisory Service went unanswered. Won declined to comment on the allegations, saying that the investigation is ongoing.

Meanwhile, in London, the Arrowgrass hedge fund business is in the process of shutting down after receiving significant redemption requests. Castle Hall's discussions with investors indicate that return of capital will not be instantaneous as the firm works to liquidate holdings.

How can investors address liquidity mismatch issues?

Well, first of all, there is NEVER a simple answer to a complex question. A fund which holds illiquid assets in an open ended structure (especially a daily liquidity mutual fund) is inherently vulnerable to a "run on the bank". There is just no way round this basic fact - no matter how appealing that open ended property fund may look on paper.

A Due Diligence Checklist

In terms of Due Diligence – no matter the structure of the Fund, but in particular for open ended funds - investors need to pose the following ten questions as a starting point:

1. What is the percentage of illiquid assets in the Fund?
2. What is the percentage of level 2 and level 3 assets (according to ASC820)?
3. How long does the manager estimate that it would take to liquidate the portfolio?
4. Do any investors (or other funds) have preferred liquidity terms on the strategy?
5. What percentage of assets are in small/micro/nano cap equities?
6. Obtain an understanding of the credit quality of bond assets
7. What is an estimate of average portfolio turnover / average holding period?
8. Are there any side pockets (or the ability to create them)?
9. Are special purposes vehicles used to house assets?
10. Does the Manager invest into other managed funds (and what percentage of assets are allocated)?

Key documents also provide vital information when considering liquidity (as well as redemption terms). All must be reviewed in detail, including the fine print:

• The Fund’s Offering Document
• At least two years Financial Statements of the Fund
• An Administrator Transparency Report if available
• The Manager’s monthly investor letters (typically 1-2 years at a minimum).

And, of course, a call should be held with the Administrator to verify key representations concerning asset liquidity and valuations before investing in a new fund vehicle.

Finally, investors should always be conscious that due diligence only begins with the initial onboarding review when a manager / fund is added to a portfolio. Thereafter, investors should monitor developments each quarter (or every month if liquidity is disclosed more frequently by the Manager or Administrator). Annual or semi-annual financial statements should also be thoroughly reviewed. Any trends which suggest increasing illiquidity should be analyzed in detail - as we indicated in our earlier comments on Woodford, financial statement reviews can be particularly helpful.

In the UK, the demise of Woodford will have widespread repercussions. Per the Guardian:

“We have seen the complete demise of the most famous fund manager the UK has seen for years,” said Adrian Lowcock, head of personal investing at stockbroker Willis Owen. “Investors knew the scenario was bad but the indication from Woodford thus far had been that the fund would reopen. Sadly, many people will be looking at significant losses.”

“There are hundreds of thousands of individuals who will have put a lot of money into his hands,” Lowcock, said. “There will be people for whom Woodford was their one and only fund, and they could have lost a significant proportion of their pension.”

Oh, and there was also this:

"While investors were unable to withdraw money, Woodford continued to collect £65,000 a day in management fees, despite widespread public and political criticism."

Which begs other questions - how do you fire a manager, and how do you stop a "Zombie" manager being paid? Those sound like subjects for our next blog!