In the middle of the Covid-19 crisis, Rikard Lundgren, CEO of Steendier, digs deeper in the liquidity question. An interview ran by Jerome Bloch.
Jerome Bloch: Our last interview has met with a lot of interest. Maybe because we are still in both a virus and financial market crisis. What do you think the consequences and lessons will be for the fund industry with regards to the liquidity mis-match issue?
Rikard Lundgren: All starts and ends with the promise made to investors about their access to the capital they have invested in a fund. During the past 10 years of good times, this promise has sometimes been extended too far. These cases now become painfully obvious.
JB: Why was too much promised?
RL: To attract a broader group of investors. It has been a marketing driven idea that investors want to hear that they can have access to their capital at any time. When the proverbial hits the fan, this promise is shown for what it in a few sad cases has been; make-up on a pig. In these, redemption liquidity was promised without discrimination. For some other funds, the redemption crisis seems to have come as a surprise. Maybe this was the result of over-optimism about their liquidity risk models predictive power or maybe they believed that the redemption restrictions in the prospectus would be sufficient. Regardless of the reasons, redemption liquidity has been over-promised and now several funds are struggling. Across Europe the press has found too many funds where redemption requests have been met with a closed door to investors. Even if these cases are a very small minority, it is not good for the credibility of the industry.
To suggest to investors that they can have both the returns associated with long term investments and redemption requests met at any time is dishonest by design.
JB: You mention that some of these could have been done knowingly. Can you give examples?
RL: If you invest in assets that are by their very nature not possible to sell except after long holding periods and yet you promise investors daily liquidity, i.e. access to their invested capital at any time, this is what I would call “dishonest by design”. The only way you can actually give money back is by attracting new investors. Then you can give the new investors’ freshly invested capital to those who want to leave. This is how Ponzi made a name for himself. Sometimes you see that there is a market-maker that promises to make markets in the shares of a fund. This may look good on paper, but in a crisis, it only stands up to redemptions of a small part of the total AUM, and then at heavily discounted bids. A market maker cannot transform illiquid assets into investor redemption liquidity.
JB: What kind of assets would you see in this category?
RL: The obvious ones; Infrastructure, Private Equity, Real Estate and some loan funds. None of these hold assets that are readily convertible into cash. This is why the industry standard for Private Equity and Real Estate funds is closed ended funds. In those you know when you make an investment that you will be locked-in for 10 years or even more. To suggest to investors that they can have both the returns associated with long term investments and redemption requests met at any time is dishonest by design. Some loan funds suggest that interest payments can be used to meet investor redemptions, but this is at best lip-gloss.
JB: But not all funds that promises access to invested capital is in this category, or?
RL: No, that is correct. Most are, in perfectly good faith, trying to make sure they can deliver the promised liquidity to investors. They often use statistical models to monitor and show investors that they have a portfolio that can be sold if and when investors want their money back. The problem is that these analytical tools are to a large extent fair-weather friends.
JB: Explain, please!
RL: The statistical models try to measure the depth of the market into which the assets would be sold. The assumption is that as long as the fund’s holding of a security is only representing a fraction of the market volume and the bid-offer spreads are fairly normal it should be possible to sell the position without problems. This is mostly true, under “normal market conditions”! This liquidity measure is an estimate. It is not an actual test of what can be sold by trying to hit the bid in a stressed market environment. Investors are, as the current crisis shows, much more likely to ask for large chunks of their capital back when markets are NOT normal. While it is very important to continuously measure the liquidity profile of the portfolio, such measures have less relevance when investors knock on the door in a crisis. To include also crisis scenarios, financial model builders have devised so called stress tests based on previous crises to try to quantify what can be sold if a crisis happens again.
JB: Is this also not good enough?
RL: Well yes and no. It is an important complementary tool for covering some of the market crisis scenarios that are outside the “normal market circumstances”. However, scenario stress testing mostly only include data on things that have already happened in a past crisis. Having lived and traded through all of the financial crises since 1987 it is clear that every crisis has introduced new elements that were not known before. These unknown unknowns are not possible to model as they have not happened yet, so there are no data to base a stress scenario simulation on. If all possible unknown unknowns were included in a stress test, the result would not be meaningful as they would show that the entire portfolio could potentially be un-sellable. Such a liquidity risk estimate would clearly be a nonsense number.
JB: So, what to do instead?
RL: One way is to use risk modelling that asks the inverse question; “What scenarios would destroy X% of the liquidity of my portfolio?” I.e. how extreme would my assumptions have to be for the portfolio to not be able to meet at least X% of investor redemptions. This is a different approach to scenario thinking and may not make the risk analyst popular with the marketing department, but it would help to capture more of the landscape that is not covered by the more traditional stress test models.
JB: The current discussion about how to manage a fund’s potential liquidity mismatch is not simple. What can a regulator do when a crisis happens that includes unknown unknowns?
RL: It is extremely positive that regulators across Europe are since some time now, and already before this crisis addressing the over-promise of redemption liquidity vs. funds’ assets. The so-called mismatch. I am sure we all wish this work had gotten further before this crisis hit. As it is now, crisis management has to be first priority. For example, by allowing funds to change some of the rules set in the prospectus. This is a quick-fix and not good for investors’ long-term confidence in prospectuses. Emergency measures need to be complemented by long-term improvements that reduce the need for crisis measures. This needs to be worked on with vigor and include all market participants.
JB: What could these long-term improvements be?
RL: That is primarily the big question for regulators, so I am not the right person to answer it. I hope the “dishonest-by-design” type of funds will disappear with more stringent and detailed demands from regulators.
JB: Let’s go back to the honest but maybe over-optimistic funds. What can the Luxembourg service providers do to help these to avoid a liquidity mismatch?
RL: Some of the tools currently used, I am thinking of Swing pricing, Anti-Dilution Levies or other redemption penalty fees, are, in my opinion, not as precise as would be desirable as they give room for judgement calls. Such calls require a strong and very independent board, preferably with market crisis experience, to ensure fair and equal treatment of investors and their best interests even in the middle of a crisis.
JB: So what can we do instead?
RL: As mentioned earlier we cannot accurately foresee all the things that can negatively affect the liquidity of a portfolio, even with our most advanced statistical methods. The only part in the overall fund set-up we can do something about is the promise made to investors about their access to the invested capital. This should be an honest and accurate reflection of the portfolio’s real liquidity at the time of redemption even if the markets are stressed at that time. The FCA has suggested that ideally investors should have the same access to capital invested as if they owned the portfolio directly. This is not easy to transform into a collective investment fund format. Having said that, a realistic liquidity promise to investors would make them aware of the restrictions the markets may impose on their availability to the invested capital. This would in itself be a good thing as the risk of illiquidity would be part of the investors’ evaluation of a fund investment. To have both access to daily liquidity and get the high returns of long term assets proposition is a chimera. Higher returns come with risks, including the possibility of only having delayed access to the invested capital. The redemption promise should, in my view, highlight this.
JB: What would a better redemption promise look like?
RL: I am not an investment product designer but if the prospectus includes wording that clearly states that availability to invested capital may at times be restricted to a lesser part of invested capital and the “waiting time” for the rest of the capital could go as far as X months or years, such clarity would hopefully ensure there are no bad surprises. Illiquidity would become part of the investors’ expectations. Just like it already is in closed ended funds. A positive result of the current crisis may be that the fund industry comes up with new prospectus wording that better reflects the liquidity risks to investors. There are already some examples where funds have extended redemption notice periods to give more time to meet the demand for liquidity without being forced to sell assets at any price. Such hybrid solutions may work, up to a point! Making sure that investors, before they invest, are properly informed about and accept the fund’s assets real liquidity profile is the only way that will work regardless of market swings.
JB: would this not lead to an exodus of investors away from the higher-returning asset funds?
RL: I do not think so. We have after all previous crisis seen how investors move towards investments with the risk-reward they need to meet their objectives. An example; After the Swedish currency, real estate, banking and financial crisis in 91/92 investors switched into equities to, as it seemed at the time, make up for the valuation losses they had suffered on their houses. They did NOT, as some had expected, shy away from taking risk. Informing investors that getting a higher return comes with liquidity risk, could even lead to greater confidence in taking on such much-needed higher return investments. Well informed investors are less likely to panic and try to get out through the redemption door first if they know they can expect the same access to liquidity as if they had owned the portfolio directly.
JB: How does that translate into fair and equal treatment of investors?
RL: I am sure the industry will find ways. The less ad hoc and judgment is involved, the less room for potentially unfair treatment. The access to at times scarce liquidity should be transparently organized through rules in the prospectus. I would not be surprised if we see funds with new approaches that would have been good to have in place for this current crisis. We do learn from our mistakes, let’s not forget that.
JB: That optimistic note about the future is a good way to round this off I think. Thank you for sharing your thoughts and ideas.
RL: My pleasure!