The ongoing conflict in Ukraine and rising global inflationary pressures have increased market volatility, reduced stock market returns and dampened general revenue and profitability forecasts. We are currently in tough market conditions and the thorny issue of fund liquidity management has reared its head once more. In recent years novel fund events like Woodford Capital¹ and H20 Asset Management² placed the ability of retail investors to redeem from funds at the forefront of regulators’ minds. Now with specific sanctions and restrictions placed on Russian securities, fund liquidity is high on asset managers’ agendas and in particular the use of “Side-Pockets” is being debated intensely.

Let’s look at the key questions around use of side-pockets for UCITS funds:

What is a Side-Pocket?

A side-pocket is a tool used by funds to ring fence certain assets away from the rest of the portfolio. When used, the valuation of the wider fund and the side-pocket tend to be treated differently. Only investors who hold fund units/shares on record date or which are specifically associated with the side-pocket are entitled to share the proceeds generated from the sale of the segregated assets of the side-pocket.

Why are Side-Pockets in Such Sharp Focus Now?

The Russia invasion of Ukraine has prompted asset managers to make important decisions regarding fund positions held that are impacted by the conflict and the global sanctions regimes imposed in reaction to it. Trading in Russian, Ukrainian and Belarussian securities have been significantly curtailed and there is no certainty as to when, or even if, such securities will return to a “business as usual” state. As such, asset managers’ decisions have ranged from deciding whether to trade in Russia in the future should markets reopen to committing to full divestment.

With some securities with exposure to Russia, Ukraine and Belarus becoming wholly impaired and untradeable or completely illiquid, they have become impossible to price accurately even with fair value principles applied. Many funds have marked down valuations significantly or even priced at zero due to the exceptional market conditions and the heightened possibility of these assets becoming stranded indefinitely.

In the context of the ongoing sanctions imposed on Russian or Belarusian securities, side-pockets could allow:

• existing investors to redeem the rest of their investment, while illiquid Russian/Belarusian assets remain in the side-pocket (marked down as appropriate), while retaining rights to any eventual price increase
• the liquid fund to shed its exposure to Russian/Belarusian assets and continue to allow new investors into their fund, and
• some funds to end their current dealing suspensions.  

It should be noted that sanctions have also targeted classes of investors (e.g. Russian nationals), which require different approaches.

What Have Regulators Done About Side-Pockets?

Liquidity concerns stemming from Russian and related sanctions have spurred most of the major European investment fund supervisory authorities to make pronouncements on side-pockets - specifically:

ESMA

On May 16, the European Securities Markets Authority (ESMA) issued a Public Statement outlining the appropriate actions that could be taken by funds experiencing valuation issues, as a result of the Russian invasion of Ukraine. For UCITS funds, ESMA noted that the UCITS framework does not currently consider the use of side-pockets but that creation of a side-pocket in a UCITS could be permitted provided certain conditions are met. AIFMD also doesn’t currently explicitly envisage side-pockets within its legal framework. While ESMA acknowledge a range of Liquidity management Tools (“LMTs”) may achieve the same aim, they do suggest that side-pockets might be preferable to fund suspensions as liquidity can be maintained for the rest of the portfolio thereby protecting against dilution and cost impacts especially where only certain assets are impaired.

U.K. Financial Conduct Authority

The FCA has opened an industry consultation on use of side-pockets for retail funds, including both UCITS and non-UCITS retail schemes. The consultation is directly linked to the significant practical challenges in disposing of Russian and Belarussian assets in the context of suspensions and global sanctions. The FCA paper seems to put more emphasis on the cost of operating side-pockets since they have “the potential to increase the fees and charges paid by investors”. The FCA suggest there should be no fees, exit charges or performance fees taken for side-pockets. The FCA proposal foresees use of such side-pockets as being at the discretion of the manager and not necessarily requiring a shareholder vote or notice period, making side-pocket implementation quicker and cheaper for funds who choose this path.

Central Bank of Ireland (CBI)

Following on from the ESMA statement, the CBI published proposed guidance on the use of side-pocket arrangements by Irish UCITS funds impacted by the conflict. Their proposal suggests the creation of a new “clone” UCITS fund to which the liquid assets of the fund could be transferred. It is essentially a “de-merger” of one fund from the other and not a classic “side-pocket” arrangement. The proposed rules foresee liquid assets and current investors moving to a new fund which could continue to trade as normal, including new investor subscriptions. Meanwhile the original UCITS would retain the illiquid securities, freeze its investor register and begin the “wind down” process. All such changes would require investor and regulatory approvals and be subject to a number of investor best interest requirements. The CBI - conscious of the time sensitivity of these actions - intends to implement a 5-day fast track approval process for such authorizations. 

Luxembourg Commission de Surveillance du Sector Financier (CSSF)

The CSSF were perhaps first out the gate on the Russia/Ukraine impacts and options to deal with the crisis. In March they issued a frequently-asked-questions document relating to the application of liquidity management tools by investment funds. The CSSF paper addresses side-pocket usage in UCITS funds but also wider considerations of LMT available to funds impacted or impaired by liquidity events. They outline three avenues to illiquid asset segregation: (1) share class (2) de-merger and (3) side-pocket.

Why Are These Side-Pocket Guidelines Particularly Notable?

There are three reasons why recent regulatory actions are a change from the norm:

1. Side-pockets historically are a tool mainly used in less liquid hedge/alternatives funds rather than retail daily dealing funds. The nature of side-pockets in those cases recognizes that the assets contained in them are likely to be illiquid or untradeable for a significant amount of time.
2. The rules are specific to a very narrow pocket of affected securities, namely those materially impacted by the Russia/Ukraine conflict. This marks a significant divergence from the usual practice where LMT principles would cover all asset classes. The targeted revisions apply only to holdings that are directly or indirectly impacted by the invasion of Ukraine, including those that have been impacted by the imposition of sanctions requirements. Regulators are at pains to state that the additional UCITS dispensation applies only to the current wartime situation and should not be construed as setting precedent for other current or future fund liquidity events.
3. Side-pockets come with risks as well as benefits. One of the biggest risks inherent in side-pockets is the “moral hazard” of using them inappropriately or where not really needed.

What Are the Operational Challenges of Operating Side-Pockets?

• There are costs involved with set-up and continued operation of a side-pocket arrangement, so a cost-benefit analysis and proportionality must weigh into the decision whether to avail of the UCITS side-pocket guidance.
• It is difficult for retail investors to track a side-pocket holding which may not change price frequently and with respect to which the investors are unable to divest for a long period of time. This could generate frustration if they are used to being able to trade in or out as they wish. The same point could be made for investment platforms where the side-pocket fund will not fit into their natural or usual construct.
• Managers utilizing side-pockets must guard against the perception that side-pockets are being used merely to generate fees or to hide poorly performing assets or poor liquidity management practices.
• Side-pockets foresee the legal segregation of UCITS compartments. There are uncertainties in certain EU member states about such segregation at share class or sub-fund level.

Asset managers will now review these regulatory releases and make decisions regarding whether the number of affected securities in their portfolios warrant giving further attention to the addition of side-pockets. Regardless, it is worth noting that regulators seem open to providing managers with additional liquidity management tools in certain “black swan” events - pragmatism that is to be welcomed in these volatile times.