Redemption Gates and Liquidity Management
There are some interesting discussions going around concerning redemption gates. This has been raised at SEC money market hearings over the past year or so. Jennifer Marietta-Westberg, Deputy Director and Deputy Chief Economist in the Division of Economic and Risk Analysis (DERA), stated:
“Redemption gates will provide a fund’s board with tools to stop heavy redemptions and that the delay would allow: 1) time for the board to assess the condition of the fund and determine strategy to meet redemptions; 2) liquidity buffers to grow as the fund’s holdings mature and produce cash; 3) investors to assess the value of their holdings; and 4) market panic to subside.”
However an academic paper1 disputes the wisdom of imposing gates:
“As the chance that a gate will be imposed increases, investors will have a strong incentive to rush to redeem ahead of others to avoid the uncertainty of losing access to their capital… More importantly, a run in one fund could incite a system-wide run”.
Reuters last summer carried a story suggesting that investment manager lobbying efforts to stop intrusion in the funds industry has back fired. “Details of the new proposals are still sketchy, but fund management industry sources, who declined to be identified because of the sensitivity of the plans, said the tools being considered include directly clamping down temporarily on a fund’s market activities in times of a crisis to ensure stability. This could include curbs on inflows and outflows of a particular asset class like a government bond, perhaps through having to impose “gates” or redemption fees to avoid runs.”
So not really a surprise that some academics (perhaps ironically based at the New York Fed) disagree with the regulators on which is the optimal route to take. It’s obvious that if you think there is a chance of a gate being imposed you will exit immediately. So this has to create more instability and there is a cost for remaining investors (particularly if there is a constant NAV)2.
Another less talked about issue is the risk of large institutional investors bullying the underlying manager into letting them exit (and the manger concedes for relationship reasons). A strong board should put a stop to this but there is no doubting it has happened in the past.
AIFMD has lots to say about liquidity management – whole sections (articles 46-49 in the Level 2 text) are dedicated to liquidity management in the legislation so it was very much at the forefront of the regulators minds that investors should not be trapped in funds indefinitely. Portfolios need to be monitored to “ensure that the liquidity profile of the AIF’s investments complies with its underlying obligations”. An AIFM must also “ensure that there are appropriate liquidity management systems and procedures for each AIF in line with the requirements laid down in Article 46“.
How Liquid Are You?
Interestingly Article 108 relating to periodic disclosures to investors states that “When disclosing the percentage of the AIF’s assets which are subject to special arrangements arising from their illiquid nature in accordance with Article 23(4)(a) of Directive 2011/61/EU the AIFM shall….provide an overview of any special arrangements in place including whether they relate to side pockets, gates or other similar arrangements, the valuation methodology applied to assets which are subject to such arrangements and how management and performance fees apply to these assets;”.
So AIFMD doesn’t ban gates or side-pockets but they must be disclosed. Of course the random imposition of gates does change carefully constructed liquidity profiles. A fund of funds for example might believe that according to their liquidity management profile they have the ability to redeem enough underlying positions to meet their obligations only to find a gate is slammed down. It is not obvious how AIFMD has helped here.
Taking a broader view and looking at the financial environment today gives cause for concern. In an article in Institutional Investor s which discussed the disappearance of volatility from financial markets Michael Hintze of CQS commented “The central banks very much believe that they can control the exit and the unwind of these (Quantative Easing) policies, But remember, their balance sheets have never been as large while at the same time private sector banks’ ability to absorb volatility has been diminished by regulation. The challenge is that if we’re all in the same trade, the exit will be incredibly crowded”. Reemphasising the point Bhanu Baweja, global head of emerging-markets cross asset strategy at UBS says “If there is a vol trigger that leads to even modest outflows from asset managers’ funds, the current liquidity configuration will amplify volatility.”
So in conclusion the debate around redemption gates and liquidity perhaps can be postponed as volatility grinds even lower (with its implications for alpha generation). However the inevitable spike in volatility that will shake the financial markets out of their complacency will mean those fund managers and boards that have planned for an increase in volatility (a return to normality?) and are carefully monitoring the liquidity of both their investments and their investors redemption profiles stand a far better chance of being able to meet their liquidity obligations to their investors.
2 There is a proposal to introduce a four decimal place calculation of the NAV which is meant to adress this issue)