A eurozone break-up would present many issues for fund managers, say legal experts Dale Gabbert and Jacqui Hatfield from Reed Smith.
While the legal issues around a eurozone break-up are complex, it is helpful to look at this from a practical point. If a country exits the euro, defaults on its debt or the euro is abolished, there will be widespread market disruption, which may include currency controls, mandatory redenomination or other state-driven responses. Nobody knows what will happen but fund managers need to be prepared for market turbulence.
The good news is that everyone has recent experience of dealing with market turbulence during the 2007/2008 financial crisis, so if you survived that, you can survive a eurozone crisis. Although the market is anticipating a crisis, it does not know what form it will take. Time is better spent focusing on practical steps to enable fund managers to respond to a number of scenarios, including unforeseen ones, than trying to predict exactly what will happen and exhaustively analyse the probable consequences.
Practicalities – running a fund in a crisis
The levels at which a fund manager/sponsor needs to analyse risk can be broken into portfolio risk (the risk that the securities, cash or derivatives positions may be impacted by insolvency, redenomination or currency controls); entity risk (risks at the fund level including liquidity, administration and governance); and service provider risk (the risk that service providers will be unable to cope with rapidly changing circumstances or to effectively deliver services during periods of market turbulence).
Most hedge funds focus on portfolio risk and have positioned their portfolio to reflect their view of eurozone risk and their appetite for that risk. By contrast, not all funds have looked at entity risk and service provider risk. Accordingly, we will focus on those.
This focuses on the governance of the fund and its ability to react to changing circumstances. For example, on an operational level: does the fund have the power to adjust its investment policy and approach in response to the crisis; can the fund suspend net asset values (nav) and subscriptions and redemptions on the occurrence of a crisis? Does the fund have the flexibility to side-pocket (this may be useful where assets become illiquid because of redenomination and/or exchange control)? Is there enough flexibility around valuations? For example, what happens if the fund does not agree with the valuation approach taken by its administrator during a crisis?
Fund managers also need to examine the functioning of the board. Is the board independent of the investment manager and robust enough to make decisions on short notice? Are the directors available and contactable at short notice? Does it make sense to add to the board or create a committee of the board with powers to deal with crisis situations without the need for full board meetings? Will the board want independent advice, and have you arranged for it?
It is also important to examine structural issues around the fund’s base currency. Is the fund’s base currency euros? If so, is there flexibility for an alternative base currency to be adopted? If the fund’s base currency is not euros but it has euro share classes, how will this be dealt with in the event the euro ceases to exist? If currency hedging is undertaken between the base currency and the euro, is there sufficient flexibility around the hedging obligation to ensure that in the event that it is not possible to hedge at reasonable market rates or at all, the fund will not be in breach of its obligations?
Service Provider Risk
As many funds outsource most or all of their functions, you need to consider whether the service providers can perform their job in a crisis. Some of this involves common sense.
Do they have adequate numbers of appropriately trained staff, bearing in mind that the workload of staff will increase dramatically during a crisis? Will they be able to respond in a timely fashion to emails and phone calls? Will their systems allow the portfolio to be assessed on various bases, including not just the location of the issuer, but in more complex products, such as derivatives, the location of the various counterparties or service providers and the flow of any monetary payments? Will the administrator be able to value the portfolio in the event of rapidly moving prices, illiquidity or the introduction of one or more new currencies?
If, as is hopefully the case, the fund’s service providers have prepared for a eurozone crisis do you understand and agree with their proposed approach? Does the administrator agree with the board’s proposed approach on suspensions and gating and are they able to apply the relevant rule(s) pursuant to which these occur? Can the administrator and custodian cope with redemptions in kind and side pocketing? Is the custodian prepared for redenomination and exchange controls? Will the custodian be able to settle trades in affected assets or with counterparties in affected countries? How will cash payments in redenominated currencies be settled?
As most service provider contracts permit delegation, you need to understand how much of the service provider’s obligations are delegated, to whom and what issues may arise as a result of this. For example, is the custodian exposed to sub-custodians who may collapse or be unable to service the custodian (and, therefore, the fund) if the country they are located in becomes subject to a eurozone event? How will cash and other assets held by sub-custodians in exiting countries be settled? Will the sub-custodians be able to effectively segregate assets?
Naturally, in a crisis everyone’s thoughts turn to potential liability. There are, in broad terms, four main ways an investor can sue the fund: for not having properly disclosed to the investor the nature of its rights and obligations and the risks attaching to the investment; for not doing anything (that is, not managing or taking decisions – paralysis in the face of events); for doing something that the fund is not permitted to do (either under its constitution or offering document); or for saying that the fund will do something and then doing something else (for example, giving investors a detailed crisis plan and then deviating from it).
In order to avoid these bases of claim, the fund should check the offering document to make sure it adequately discloses both the potential risks and the powers that might be used by the fund in a crisis and if necessary, supplement it or otherwise communicate with investors.
Funds should ensure that they understand the obligations of their service providers and check their constitutional documents to ensure that they have the powers they need on gating, suspensions, side pocketing, payment in kind, withholdings etc and if they do not have them, amend the constitution to obtain them.
Funds should plan their investor engagement strategy and engage with their service providers to ensure communication and continuity of approach. It is wise to avoid being overly prescriptive when telling investors what steps the fund intends to take in a crisis situation, but instead simply outline the powers that may be used.
The general market perception is that fund managers are not as prepared as they could be for a eurozone break up, which in part, may be because of the difficulty of predicting the likely outcomes. You don’t need a crystal ball to prepare an effective and practical plan. Your investors and the regulator will think better of you for doing so.
Dale Gabbert is a partner and head of investment funds, and Jacqui Hatfield is a partner and head of the financial services advisory at Reed Smith
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