Ever wondered how a fund or a fund of funds manages liquidity?
Offering documents can include an arsenal of provisions for the moment when things go wrong – redemption gates, side pockets, suspension of NAV calculations, suspension of redemptions, revaluation of assets, creation of provisions and reserves, payment of redemptions in specie and the creation of separate classes with differing liquidity.
But these are all cures for the malady once management has to face up to a liquidity problem – what is far more interesting is the approach to prevention.
The spectre of the liquidity axe always hangs in the air – however well managed a fund – because if, for example, you take the case of a fund of funds with quarterly liquidity which only invests in funds with monthly liquidity you still have to manage for the prospect of the fund you wish to redeem from, suspending its normal redemption processes thereby impeding the liquidity flow on your investment. All funds will retain some form of rights and discretion to delay redeeming and paying out to an investor.
The obvious starting point will always be to try to ensure that the liquidity of your vehicle at least matches the liquidity of the underlying investments.
Is this always practical given lock up periods of 6 months to 6 years upon subscription? Some funds will try and cater for this issue by creating lock up periods for their own investment vehicles and by imposing charges for any financing they might need so as not to affect the portfolio as a consequence of a redemption – but that is not so easily done – sometimes because of the push back from the sales personnel linked to selling these funds to investors.
So what are some of the practical things that can be done?
- Ensure you have a liquidity profile for your portfolio which shows the time taken and the cash flows for the portfolio to go wholly in to cash by taking into account lock ups in force, notice periods, compulsory gates and any penalty charges that may be imposed
- Always maintain a cash buffer to meet ongoing expenses and to meet margin calls – a number of funds faced extreme liquidity constraints in 2008 in the absence of credit facilities because they were not prepared for the Euro/Dollar exchange rate movements for their currency hedges
- Ensure that your credit facilities will enable you to meet redemption calls equivalent to the proportion of your longest locked up investment outside the liquidity range of your own investment vehicle.
- Avoid investing in investment vehicles or investments that have liquidity mismatches with your investment vehicle.
- Ensure that you have given no covenants to your own providers of finance that could place your investments in jeopardy because “they would never happen” – do you know for example what cross default provisions there are in your financing agreements and what percentage reduction in assets triggers a default?
The best liquidity management is done from the perspective of decisions made on the assumption that the fund will need to go wholly into cash and ensuring that any borrowings and requirements for return of capital are properly catered for in the offering documents of your own investment vehicle for such an eventuality.
In order to do it well – assume that the worst will happen – that is the best form of liquidity management.
©Jaitly LLP