The LF Woodford Equity Income Fund Suspension - Part 2
Liquidity Mismatch Engulfs Famed Managed Fund
The LF Woodford Equity Income Fund Saga - Part 2
Aftermath post-mortem commences: Timespan 4 to 18 June 2019
According to copious British news media analyses published on the subject of the LF Woodford Equity Income Fund (WEIF) trading suspension debacle, the problem was not just that investor withdrawals were persistent against a background of sustained poor fund performance. Had WEIF been entirely composed of liquid assets, then every last investor should have been able to exit in an orderly manner, albeit possibly at a loss, and the fund disestablished when the final one was out the door.
Where things got sticky was that WEIF held substantial illiquid assets represented by sizeable stakes in both unquoted venture capital entities and listed smaller-capitalisation companies. The reasoning for holding on to so much of these harder-to-sell assets was attributed to the portfolio manager, Neil Woodford, insisting that Brexit would surprise on the upside for these kinds of firms. This same view caused him to downsize WEIF’s relative exposure to more liquid listed large-capitalisation corporates that he had been renowned for investing shrewdly in when working for Invesco Perpetual. There were also some bad choices made in companies invested into that subsequently disappointed.
In the case of unquoted stocks, WEIF was effectively exposed to more than the 10% maximum permitted by UCITS Directive rules. Reportedly the fund at one point had around 18% of illiquid assets spread across unlisted companies, according to detailed analysis in a March 2019 article published by Citywire Funds Insider. The high exposure was due to a legally permitted circumvention of the 10% rule effected by the fund owning shares in the listed Woodford Patient Capital Trust (WPCT), which in turn was invested heavily in unquoted assets. Other legal tactics to keep the unquoted exposure down involved listing some equities on The International Stock Exchange (TISE) in Guernsey or allegedly having venture capital companies cancel shares previously owned by Woodford-controlled funds and replaced with new shares issued on the promise of listing within 12 months.
An additional problem emerging for the Woodford stable of funds, coinciding with the suspension of trading in two of them, was prior commitment to injecting large cash calls into venture capital firms the funds were invested in. At the same time as investment manager Woodford Investment Management Limited (WIM) was selling assets to raise money to pay for investor redemptions and portfolio restructuring into more liquid assets, it had to continue placing tens of millions of pounds into start-up companies as previously promised, generating paper profits in the process, but increasing overall exposure to illiquid assets and soaking up much-needed cash.
Who is to Blame?
The gating of WEIF set much finger pointing in motion. The most immediate target was Mr Woodford, because he had made the decisions that led to WEIF having a portfolio that underperformed and was vulnerable to a liquidity squeeze in the face of sustained withdrawals. Moreover, Mr Woodford had vociferously defended his investment decisions and publicly encouraged investors to stay with WIM’s funds. Yet even before the illiquidity problem was exposed in the months before trading in WEIF’s shares was suspended, the fund had been performing persistently below its benchmark, something the fund manager, Link Fund Solutions Limited (Link), should have been concerned about. Questions were also raised not just about Link’s involvement, but also concerning that of depository Northern Trust Global Services SE (Northern Trust).
As to what could have been done earlier, there does not appear to be any easy answer. In light of WEIF’s poor return performance, Link or Northern Trust might have been able to influence how WIM managed the fund’s portfolio, or even have dismissed WIM and appointed another investment manager. However, the ongoing run of withdrawals from WEIF would still perhaps have precipitated trading suspension if investors were not reassured that such interventions would improve fund performance sufficiently and the liquidity mismatch was not corrected in time.
Where was the Regulator?
The City of London’s Financial Conduct Authority (FCA) had been monitoring the liquidity position of WEIF for more than a year before the collapse. It became involved in February 2018 when it contacted Link over liquidity concerns connected with WEIF’s compliance with the UCITS Directive 10% rule. Link set up a liquidity monitoring programme for WEIF as a consequence, and increased reporting to the FCA about fund withdrawals. WIM stated that, “liquidity of its funds was monitored in real time, shared monthly with the FCA and discussed at least every quarter with authorised corporate director Link and depository Northern Trust.” Yet all this monitoring and disclosure did not stave off a fund trading suspension.
Part of the problem is that WIM appears to have acted at least nominally in compliance with the 10% cap on unquoted equities required under the UCITS Directive and thus there was no impulse on the part of the manager or the regulator to step in sooner because all the boxes had been ticked. Despite being awash with information about the Woodford funds, the FCA seems to have been of the view that with no obvious major rule breaches to act upon, it had no grounds to intervene.
When the fund trading suspension news broke, the FCA moved quickly to clear itself of any blame by posting a self-exculpation on 5 June 2019. In the published release, the regulator claimed that it had no responsibility for the decisions to suspend trading in WIM’s funds or list some previously unquoted stocks in Guernsey to skirt around the UCITS Directive.
To make its attitude perfectly clear, the FCA stated, “Suspension is not an outcome the FCA seeks to avoid if it is in the best interest of fund investors. Suspensions are recognised as a legitimate tool internationally via IOSCO guidelines. The firms responsible for deciding to suspend the Fund are its Authorised Corporate Director, Link Fund Solutions Limited, and its depositary, Northern Trust Global Services SE … The FCA plays no role in the listing decisions of TISE, which is licensed by the regulator, the Guernsey Financial Services Commission. Where the FCA believes there are circumstances suggesting serious misconduct or non-compliance with the rules it may open an investigation.”
End of story so far as the FCA was concerned, it seemed. Apparently a bad result for investors is alright so long as it goes by the book. However, this is not how critics saw the FCA’s role, with some questioning why the City regulator did not exercise more foresight and act sooner. As has been examined in our two articles across a representative sampling of what has been published about Woodford funds since 2017, there was no shortage of credible news media analyses to show that, despite vehement denials by Mr Woodford, there were serious problems with WEIF. The FCA itself was monitoring the fund’s liquidity for months on end. The Guernsey stock exchange, TISE, was at one stage so concerned about the listing on its board of illiquid WEIF stakes in venture capital companies that it temporarily suspended trading in the shares.
One critic, Lord Myners, former financial services secretary under British ex-prime minister Gordon Brown during the global financial crisis, was particularly scathing concerning the inaction of the FCA. Politicians got involved, with Nicky Morgan, chair of the British Parliament’s Treasury Select Committee, demanding that WIM cease to charge its substantial management fees, estimated to amount to 100,000 pounds per day, while the fund suspensions were worked through, something Mr Woodford refused to do. Belatedly Andrew Bailey, the chief executive of the FCA, echoed the fee-free call. The Guardian’s business reporter Nils Pratley summed up succinctly, “… but there are also questions for the regulator. Was [the FCA] asleep, or was it merely powerless to act under EU rules? Neither interpretation is good – but we need to know which is correct.”
On June 18 2019, 13 days after it first publicly washed its hands of the WEIF/WEIFF trading suspensions, the FCA published a letter addressed to Ms Morgan announcing that it had decided to investigate the suspensions after all. The letter revealed that the FCA had previously twice detected breaches of the UCITS Directive 10% rule by WEIF, in February and March of 2018, and had “engaged” with Link about resolving them. Also made public in the same letter, a worried TISE had initiated contact with the FCA via email on 15 April 2019, followed up by a teleconference on 8 May. In between these dates, the FCA missed TISE’s email until 26 April, allegedly because, “Unfortunately, TISE did not make contact with the areas of the FCA that processes and considers [sic] these sorts of requests.”
It now remains to be seen how the Woodford funds saga unfolds under the official scrutiny of an FCA investigation. There will be questions asked of Mr Woodford, WIM, Link and Northern Trust about how WEIF was managed on their watch. But the regulator itself should not escape investigation, especially given how it had been directly involved with Link concerning WEIF since February 2018, and it appears that the Treasury select committee will perform that role. All this financial sleuthing will provide little comfort to investors who have funds trapped in the two suspended WIM entities. They can only hope that they do not have to wait for long or lose much on their investments.
The Bank of England takes keen Interest
The Bank of England (BoE) has been drawn into the affray, with its deputy governor Ben Broadbent defending the WEIF suspension before Parliament by saying, “You cannot have a system where regulators collectively could reduce all risk to zero. I don’t think that’s possible or desirable. There is risk in these funds.” Nonetheless the governor of the BoE, Mark Carney, stated in Tokyo on 6 June 2019, when delivering a speech entitled, “Pull, push, pipes: sustainable capital flows for a new world order” that financial market authorities like his central bank must become much more active in policing liquidity risks in managed funds. In remarks relevant to the Woodford funds debacle, he stated:
“Over half of investment funds have a structural mismatch between the frequency with which they offer redemptions and the time it would take them to liquidate their assets. Under stress they may need to fire sell assets, magnifying market adjustments and triggering further redemptions – a vicious feedback loop that can ultimately disrupt market functioning.
Two-thirds of investment funds with structural mismatches are domiciled in the US and Europe so, as is the case for banks, ensuring leverage and liquidity risks are managed in funds investing abroad is both a national asset and a global public good.
System-wide stress simulations are currently being developed, including at the Bank of England, to assess these risks. And authorities are beginning to consider macroprudential policy tools to guard against the build-up of systemic risks in non-banks.
Regulators currently have far less sight of risks within funds compared to the core banking system ….
The upcoming FSB-IOSCO evaluation of implementation and effectiveness of recommendations to address liquidity mismatch in funds will be crucial to improve our understanding of best practice, including the merits of adjustments to redemption periods to be more consistent with investments.
We are mindful that these decisions could have global as well as local implications.”
Could something Similar happen in New Zealand?
In our own country we have the Financial Markets Authority (FMA) and the Reserve Bank of New Zealand standing in place of the UK’s FCA and BoE respectively. Our regulators work under a flexible principles-based regime rather than the rigid “box-ticking” approach that pulled the FCA into murky waters over its involvement in WEIF. FMA-licensed supervisors, fund managers and custodians operate under the Financial Markets Conduct Act 2013 and the Financial Markets Conduct Regulations 2014 (Regulations) across a range of roles similar to the UK’s authorised corporate directors and depositaries. The big area of managed fund growth in New Zealand has been in KiwiSaver, but there are substantial funds under management also in non-Kiwisaver managed investment schemes (MIS).
Questions similar to those raised over the Woodford funds affair could surface in New Zealand if a significantly sized managed fund based in this country was obliged to suspend unit transactions because of a liquidity squeeze. We have seen this before. In the wake of the global financial crisis (GFC), New Zealand-based funds invested in illiquid mortgages, property, or collateralised debt obligations (CDOs) were forced to cease unit transactions until assets could be run off, liquidated or restructured. Some fund types like KiwiSaver schemes already come with “gates” in the form of legislated restrictions on withdrawals, but there should be no room for complacency at the level of regulators, supervisors, and fund managers.
The Regulations provide investor protection against a managed fund liquidity crisis, in that under Regulation 5 Interpretation, the definition of a managed fund includes detailed prescriptions about market liquidity rules applicable and makes clear that these rules cover “a KiwiSaver scheme, superannuation scheme, or workplace savings scheme”. The means of calculating managed fund liquidity is further specified under Regulation 53 Fund Information, in particular under subclauses 53(1)(c)(ix) and 53(5). The Regulations also include multiple requirements for the statement of investment policy and objectives (SIPO). A SIPO is a published document containing detailed information about the investment policies of a managed fund, including liquidity management, as disclosed by the fund manager.
The FMA monitors fund liquidity in KiwiSaver schemes and other retail managed funds it regulates. Unless a New Zealand-based managed fund is able to obtain an exemption from standard liquidity requirements as stated in the Regulations, which exemption would itself need to be publicly disclosed, a WIM-style fund liquidity crisis is probably not likely to affect its retail investors. However, extreme market dislocations, such as occurred during the GFC, cannot be ruled out as a potential risk to continuous fund withdrawals. Even less severe market disruptions or panics could from time-to-time adversely affect market liquidity for fund assets. A fund manager’s investment policies could aggravate these periods of instability, such as happened with the WEIF concentration on less liquid unlisted stocks and listed small capitalisation companies.
The fundamental problem persists, as described by BoE governor Carney, that runs on managed funds can entail liquidity mismatches and investor repayment crises just like runs on banks. For investor protection, transparency is required concerning the liquidity of assets held by managed investment schemes. Fund investors should know the true level of liquidity risk their investments are exposed to. Managed funds, including KiwiSaver schemes, should be regularly stress-tested for liquidity mismatch events. More will be known upon publication of FSB-IOSCO’s report on managed fund liquidity mismatches and best practice requirements. New Zealand’s regulators, supervisors and fund managers can be expected to take keen interest in this development.
In Part 1 we examine the chain of events that led to the trading suspension of WEIF.