When considering the protection of assets a classic response is the requirement to segregate assets. What does this mean in practice? Everyone understands, for example, when buying a house in the UK, that the money that flows through the purchaser and vendor’s solicitors should be segregated as client money – but not many understand what this really means and how sometimes the risk is not in fact mitigated at all. Client money status, express and constructive trusts and segregation can all be complicated areas but the dangers can still be illustrated quite simply.
The same opaqueness to the implications of practical and legal segregation and their associated risks applies to assets held in fund structures too. The usual structure for fund investments is that the fund is a separate entity from that of the manager managing it, and that this separation or segregation helps avoid what is known as co-mingling risk. The irony of course is that sometimes this separation protects the manager far more than it protects the fund and its investors because the manager can introduce a whole range of risks into the fund without placing itself in any jeopardy (other than reputationally) – whether it is to introduce leverage, cross class liability (another form of co-mingling) or jurisdictional risk.
Lets start with leverage and cross class liability – take a fund with two different classes – one with no leverage and another with 2x leverage. If there is cross class liability – not untypical – then on a risk reward basis which is the class to invest in? I would argue the levered class. Why is this so? Lets take an extreme example to illustrate the point. If each class has one shareholder with $100, fully invested – then the NAV of both classes is $100 but the levered class is carrying a liability of $100 against its assets of $200. Lets say the value of the assets falls by 75%. The NAVs are now $25 for the unlevered class and negative $50 for the levered class because the liability for the $100 borrowed remains unchanged. Now lets assume the prime broker or other provider of finance declares a default on the fund because the fall in value of the assets of that magnitude has been defined as an automatic default event in its contract and it exercises its rights on the assets held as collateral. The $50 of assets in the levered class is taken by the prime broker but there is still a $50 dollar shortfall – if there is cross class liability then the $25 in the unlevered class can also be taken by the financier in satisfaction of the debt – either because the prime brokerage agreement allows for it or because the fund then goes into liquidation and the prime broker as the only creditor gets its hands on the remaining $25 as the sole asset of the liquidated fund thereby suffering an overall shortfall of $25 on its original lending. In such a scenario the shareholder in the unlevered class class is unprotected from the liabilities of the levered class, so they may as well benefit from the potential rewards of investing in the levered class if an investment in the fund can really be justified rather than having the illusion of safety from the fig leaf that is the unlevered class.
Of course the response to concerns such as this was to set up segregated liability structures such as Segregated Portfolio Companies in the Cayman and in Ireland. So that then must be the answer to the problem?
If only life were that simple. One of the standard risks that lawyers put in the prospectus of such a segregated portfolio company is that the segregation may not be recognised in a jurisdiction in which the assets are held. Is it a real risk?
The trouble is that the legal segregation is in the country of incorporation – but the assets are invariably not held in those offshore jurisdictions. The assets are held by financing parties in financial centres such as London, New York and Frankfurt. There has been a lot of work and analysis done in the last few years on protecting assets in different jurisdictions from the insolvency of counterparties but the Lehman Brothers Bankhaus AG case in Germany, for example, has thrown open a whole series of uncertainties in Germany on segregation in relation to client monies. France too has its own issues as to how segregation plays out in the event of insolvency – we are therefore far from having proper certainty of outcome for assets managed in these structures which can play out quite differently from what was originally envisaged and which are dependant on the type of investments, liabilities, operation of collateral and different legal rules. And, all of this is before taking into account that a lot of the broking agreements that funds enter into would in any event, more often than not, waive the segregation rights in order to enable assets to be used freely by the broker such as for re-hypothecation.
There is therefore much to be done before asset segregation really works and protects investors from the risk of contamination from other investment strategies and those of the counterparties with whom they are investing. Until that is sorted out, a lot of the so called asset segregation processes will not stand up to scrutiny and investors will remain unprotected at times of trouble and strife.
Good due diligence would examine these underlying arrangements for segregation to highlight the connected risks and not rely on the investment manager’s arrangements to provide adequate safeguards without detailed examination.
©Jaitly LLP