Surviving the First Wave is Only the Start
The initial impact of the COVID-19 pandemic in March presented significant challenges for Q1 2020 valuations and an unusually volatile Q1 and Q2. In general, investment fund values globally are now looking healthier and the funds themselves are more stable, even if only relative to the March nadir.
Nevertheless, uncertainty remains a reality in the short-to-medium term, and market confidence and investor patience may not prove limitless. Liquidity, in its various guises, is likely to remain a significant issue.
Confidence is King
As many governments have found during the past months, however well prepared they were or thought they were, they are judged on their response to evolving issues, the decisions that they make and the actions that follow. If public confidence is not maintained, the situation can become very difficult to control. The same is true of investment funds. For directors, general partners (GPs) and investment managers, good governance, transparency and effective communication are essential in ensuring and demonstrating that matters are as under control as possible, and that discretion is being exercised in the best interests of the fund and its investors, in accordance with legal, regulatory and contractual or constitutional obligations. Doing so gives the best likelihood of retaining the confidence of stakeholders, be they investors, leverage providers or regulators.
Regular and frank communication between directors or GPs, managers and service providers will help to ensure a thorough understanding of any issues regarding fund performance, valuation and stakeholder confidence. Any difficulties in maintaining compliance with investment objectives, concentration risk ratios or financial covenants to lenders must be identified and addressed as early as possible. Similarly, directors need to be alert for any liquidity issues that may threaten the fund, including illiquidity of significant portfolio assets, withdrawal of financing facilities or unusual levels of redemptions.
And, just as when dealing with a pandemic, it may be considered necessary to take special measures to isolate certain assets or asset classes to maintain overall confidence, prevent contagion and retain control of the overall position.
Signs and Symptoms
Our experience has shown that liquidity issues can manifest themselves in many ways, often becoming self-reinforcing if not treated appropriately and decisively.
At the fund operational level, signs of potential liquidity issues could include an unusually high volume of redemption requests, which could indicate a lack of confidence in the fund, or investors seeking the safety of cash, especially if the fund typically allows redemptions on relatively short notice. Similarly, operational difficulties at fund service providers, such as delays in striking NAVs, could indicate that the portfolio is problematic.
Responses to such challenges could include gating or suspension of redemptions and NAV, neither of which are steps to be taken lightly.
Shifting Portfolio Composition
The root cause of such challenges may be the portfolio itself, especially if the liquidity profile of the assets changes and no longer suits the fund’s redemption terms. Heavy concentration in a badly hit sector of the economy such as travel, hospitality and leisure might cause a slump in value and a decline in liquidity. At the same time, hard-to-value, unlisted or other illiquid positions will increase as a proportion of the total assets, especially if more liquid positions are sold to realize cash to fund redemptions or margin calls or to service debt. Meanwhile, investments in other funds may themselves be subject to suspensions or gates or hold assets with an optimistic valuation. Portfolio companies or investments failing to make payments of interest, dividends or redemption proceeds will only exacerbate the fund’s own liquidity problems.
Steps may be necessary to rebalance the portfolio, perhaps including side-pockets or other liquidation strategies for less-liquid assets.
Changes in portfolio composition and efforts to manage short-term liquidity challenges may present issues of their own when it comes to credit and leverage providers. Default on debt interest or principle, or a breach of borrowing covenants or headroom requirements due to declining values or withdrawal of funds, may lead to the withdrawal of facilities and the recall of outstanding principal and interest. That alone may be unsustainable by the fund, unless new sources of borrowing can be accessed quickly on reasonable terms.
Other Warning Signs and Symptoms
Directors, GPs and investment managers may also become aware of other, less tangible but nevertheless significant developments which may indicate, or even precipitate, more fundamental issues. Changes in service providers, whether through resignation or termination by the fund, can have a negative impact on already skittish investors, so should be addressed swiftly and transparently. Regulatory inquiries into a fund or its managers can have an even greater impact, sometimes fatal for investor confidence even if ultimately unfounded.
Fund directors must always be mindful of the fund’s overall situation. Importantly, investors with valid redemption requests that are due for payment are creditors of the fund and will have an impact on threaten its solvency. Swift decisions and actions may be required.
Fund management should be alive to such issues within their portfolio and consider whether action is necessary should an investee entity exhibit problems. That may require divestment or more proactive steps such a petitioning for the winding up of the investee in order to recover monies due.
How Can Kroll Help?
The steps available to fund directors, GPs and managers will be governed law, regulation and the fund’s constitutional documents, and legal advice should be sought. Nevertheless, by obtaining input from experienced and independent experts, a fund’s management can demonstrate that they are acting decisively, transparently and with integrity, seeking the optimal outcome for the stakeholders.
Kroll has extensive experience working with onshore and offshore vehicles or structures facing liquidity or other issues. Our multi-disciplinary team of professionals can assist with matters such as:
Independent valuation of hard-to-value assets
Asset realization and sale
Managed workout of illiquid portfolios
Replacement or additional GP/director/trustee or independent oversight
Formal liquidation of the investment vehicle, including deploying formal powers of investigation and recovery available insolvency practitioners
Advice on governance issues and business continuity planning
Forensic accounting investigation and litigation support
Our professionals are used to working with clients and their in-house and external legal advisors to explore options to address liquidity or other difficulties. As the largest independent valuation firm globally, we have deep expertise in valuing the most complex financial assets and other illiquid tangible and intangible investments. Alongside our valuation practitioners, our regulatory advisory, secondary markets, restructuring and forensic accounting teams operate as a single firm with a global presence, including the key onshore and offshore financial centers. We have been involved in some of the most significant investment fund matters of the last 15 years, realizing value for investors, helping to control contagion and maintain stakeholder confidence and assisting management to fulfil their legal, regulatory and contractual duties.