After a “run on the fund,” triggered when people figured out it was loaded up with crappy illiquid assets.
By Nick Corbishley, for WOLF STREET:
Hundreds of thousands of investors trapped in the imploded and shuttered Woodford Equity Income (WEI) fund, which is now down to £3.1 billion, could lose a third or more of their remaining investment by the time the fund is wound up, according to an analysis commissioned by the fund’s administrator Link Fund Solutions.
In a base case scenario modeled by private equity specialists PJT Park Hill last month, losses could reach 32.5% of total funds as the fund is liquidated. Under the worst-case scenario, the fund’s value would fall by 42.6%.
In other words, the fund’s investors could collectively lose between £1 billion and £1.3 billion of their remaining funds. This would be on top of the losses they already suffered in the years preceding the gating of the fund five months ago. Between 2015 and June 2019, when the fund was shuttered, the total amount under management at WEI shrank by almost two thirds, from £10.2 billion to £3.1 billion, as its portfolio has unwound dramatically.
As an “open-end” mutual fund, WEI had to sell some of its assets each time an investor asked to redeem their funds, which they could do at just about any time. This is not a problem when the assets in question are highly liquid, such as large-cap stocks. But when the assets are bonds, loans, real estate, large positions of thinly traded small-cap stocks, or unlisted shares that can take days, weeks or even months to sell, there is a mismatch in liquidity between what the fund offers to its investors (daily liquidity) and what the fund holds (largely illiquid assets). A “run on the fund” can be catastrophic for this type of fund, one of the oft-undisclosed risks of investing in open-end mutual funds.
In the case of Woodford, his specialty was small-cap stocks and holdings of unlisted start-ups in the tech or biotech sectors — assets that can take a long time to offload. When, at the beginning of June, Kent County Council, a longstanding backer of Woodford, requested the return of approximately £250 million, there was no way he could sell assets quickly enough to redeem the funds. Instead, he placed a ban on redemptions, meaning that investors who hadn’t already yanked out their money, including Kent County Council, were trapped. Now, they stand to lose as much as 42% of their money.
By EU law, equity funds like Woodford’s are allowed to hold a maximum of 10% of their portfolio in transferable securities that are not traded in an “eligible market” such as the FTSE 250. To circumvent this rule, Woodford bundled up his fund’s most illiquid unlisted assets and listed them on the minuscule Guernsey-headquartered International Stock Exchange, which despite its impressive-sounding name has barely any trading activity at all. This was enough to lend his most illiquid assets the appearance of liquidity.
Many of those bets went bad, resulting in huge losses, which in turn triggered a cascade of redemptions as the sharpest investors — those that keep a close eye on the markets and the asset classes that the open-end fund is invested in — began pulling out their money.
In October, Neil Woodford resigned as manager of Woodford Investment Management, just days after Link announced its decision to wind up his flagship fund, WEI. The task of overseeing the sale of the fund’s holdings was awarded to BlackRock, which will offload the lion’s share of the fund’s quoted stocks, and PJT Park Hill, which has been tasked with the much more difficult job of selling unquoted companies and listed but hard-to-trade small companies, before making a first pay out to investors in January.
Investors could end up receiving a lot less than they had hoped, according to PJT Park Hill. The NY-based investment bank based its analysis on the assumption that the only assets they or BlackRock will be able to sell at market price are the most liquid FTSE 100 stocks. For most of the remaining portfolio, they will have little choice but to accept a discounted price as they offload the fund’s stocks.
The sharpest discounts are expected to come from the sales of the fund’s “unquoted and listed, but hard-to-trade, technology stocks.” Even Woodford himself had been anticipating problems in this area of the portfolio. His worse-case scenario for the fund assumed that some of these unquoted stocks would be written down to zero.
Yet despite that, Woodford still expected the average discount on sales to be no more than 3%. But that was before taking into consideration the recent rout in the shares of a number of the fund’s key holdings, as investors priced in the manager’s exit. Many of the times Woodford tried to offload one of his more liquid assets, hedge funds would be one step ahead, mercilessly shorting the listed stock before it was sold. As WOLF STREET reported in August, many of WEI’s largest investments, from its holdings of cold fusion developer Industrial Heat to its shares in litigation funding specialist Burford Capital, had plunged by between 30% and 70% YTD.
Now, thanks to the leaked results of PJT Park Hill’s modeling, we know that 23% of Woodford Equity Income’s portfolio is still held in illiquid stocks, down from 32% at the time of suspension. Link estimates that these “assets” will take anywhere between 181 and 365 days or more to offload. In other words, it could take as long as a year for investors to receive their full payout.
UK market regulators, once again, were found wanting, reacting to events once they’d happened rather than anticipating them or taking action to preempt them. They couldn’t, or chose not to, prevent Woodford from raking in more than £8 million in management fees from the investors stuck in his toxic fund.
By the time the dust has finally settled from the Woodford scandal, hundreds of thousands of those clients, many of them retail investors, will have lost a large chunk of their savings. The reverberations are already being felt across the industry, as investors begin asking themselves just how safe it is to entrust their savings with active fund managers that may have similar liquidity mismatches to Woodford’s. By Nick Corbishley, for WOLF STREET.