Funds exposed to the Ukraine war have new liquidity management options following the recent publication of the CSSF’s guidance. To understand more about how the market is adapting , particularly during the current annual reporting season, we spoke to Nicolas Hennebert, partner and investment management leader audit & assurance at Deloitte Luxembourg.
Q: What is the context of current discussions about liquidity risk management and side-pocketing of fund assets with exposure to the Russian, Belarussian and Ukrainian markets?
NH: Most Ucits funds are calculating their net asset value, or NAV, daily, and those exposed to the Russian, Belarussian and Ukrainian markets have used liquidity management tools to protect their investors. Funds are also approving their financial statements for 2021, and if significantly exposed to these market crises, they will report on it in a subsequent event note. So, all actions taken in relation to the war in Ukraine will be disclosed and explained. The regulator asked funds to suspend NAV calculations if exposure to Russian assets was in excess of 10 percent of NAV, as these markets became frozen [editor’s note – this applied to 61 Luxembourg-domiciled funds].
Q: How have funds tended to treat the valuation of these suspended assets?
NH: When talking to market participants about their valuation procedures regarding the crisis, most, if not all, decided to value those investments at zero. This was simply because there was no market anymore.
Q: What are the risks with this approach?
NH: Funds significantly exposed and not suspended may suffer substantial redemptions and opportunistic subscriptions. Hence, investors leaving these funds are suffering losses, whereas investors subscribing see an opportunity of frozen markets rebounding in the future.
Q: How have fund managers sought to mitigate this risk?
NH: The CSSF, in its FAQs, made a distinction between funds with a limited exposure and high exposure to the Russian market. For those with a limited exposure, the CSSF indicates that the fund can choose to suspend subscriptions to the fund, while applying a haircut to the portfolio for existing investors, who can then exit the fund. For funds with a higher exposure, there is full suspension on subscriptions and redemptions to protect the interests of the investors.
Q: So this is where side pockets become relevant?
NH: Yes. The challenge now is what to do with the suspended NAVs, because this is not a viable situation over the longer term, and this is what the FAQs are seeking to address regarding side pockets. It is important to note that the Ucits regulation doesn’t explicitly envisage the use of side pockets, nor are they precluded. The side pocket allows the illiquid assets to be segregated, while the remaining liquid assets continue to be operated normally.
Q: What principles should guide funds when using side pockets?
NH: The FAQs underline that the protection of the investors’ interests is the priority. Also, the fund’s governing bodies have been asked to provide analysis of whether the use of side pockets could be contrary to the constitutional documents of the Ucits or breach the investment prospectus. This is something of a grey area. As it is currently the season of annual general meetings, the fund’s governing bodies have an ideal opportunity to discuss this matter with investors, where practicable, during those meetings.
Q: Would establishing a separate sub-fund unit for the distressed assets be a cleaner option?
NH: Creating a sub-fund with the illiquid assets is option 3 in the FAQs, but then this new sub-fund would need to be put into immediate liquidation. Given that these markets are suspended, the liquidation process may take a while. Also, this process of liquidation is a highly specialised operation that requires experienced specialists.
Q: Are there some early indications of the different options the market is taking?
NH: Not really, because this is very early in the process, and these changes require substantial preparation. It requires approval from the investors; there are legal, accounting and tax considerations; and it requires assessments of the transferability of assets.
Q: How did you see the market reacting before the start of the crisis?
NH: Most funds that had European and Eastern European strategies had already decreased their exposure before the war.
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