THE LIQUIDITY LESSONS OF NEIL WOODFORD
What lessons can a GBP10 billion fund failure teach regulators and investors?
The Woodford Equity Income Fund (“WEIF”) was placed into liquidation in October 2019, after having suspended redemptions in June. The fund had been managed since its 2014 inception by Neil Woodford, an investment manager widely credited with “star” status following a successful career in the City. At its peak, WEIF had around £10 billion of assets under management.
In this piece we are going to focus on the liquidity management (and mismanagement) issues arsing out of what we now know about what WEIF was invested in, but you can read more about the whole implosion of WEIF and its aftermath in our blog here:
Portfolio illiquidity and asset sell-off
WEIF was structured as an Undertaking for the Collective Investment in Transferable Securities (UCITS), a retail-friendly, regulated European investment product that is open-ended and strictly required by the regulatory regime to permit investors daily liquidity. Note those two words: daily liquidity. They would come to haunt Woodford and his investors. The regulatory regime permits managers of UCITs to place long-only bets on liquid stocks. But Woodford’s investors were soon in for a surprise. Within two years’ of WEIF’s launch in 2014, it was apparent that the fund’s portfolio comprised substantial allocations to mid-cap stocks with high yields, small caps and significant positions in unlisted — illiquid — companies. When these companies, in which WEIF had questionably large positions, issued profit warnings, his investors started asking questions. Their confidence in him started to wane; and they began to submit requests to redeem their holdings in the fund.
In order to meet redemption requests, the fund’s most liquid holdings were disposed of. But as the redemption requests continued to flow in, Woodford was left with no alternative but to try to dispose of the fund’s illiquid assets. And this proved difficult, precisely because of their illiquidity. As the liquid assets were disposed of, so the illiquid assets became an ever-bigger component of WEIF’s portfolio. This, in turn, caused the fund to breach the value limits that the UCITS regime places on illiquid portfolio investments. Which in turn spooked investors further, who continued to redeem out of the fund.
WEIF Suspension & Liquidation
Woodford was trapped in a vicious cycle, the stuff of nightmares for any fund manager. The vortex was temporarily contained in June 2019, when redemptions in WEIF were suspended. This meant that investors were effectively trapped inside the fund, unable to withdraw their investments. After considerable mainstream and social media outcry, expressed by investors and industry commentators alike, WEIF’s administrator and corporate director decided in October 2019 to remove Woodford as the manager, and wind-down the fund with the assistance of two investment advisers appointed for the purpose.
The administrator was able to liquidate and distribute to WEIF investors £2.1 billion in January 2020, with a further £142 million expected at time of writing (March 2020) to be returned in March 2020, representing around 20% of the value of the £575 million of assets remaining in WEIF.
Liquidity Structure of WEIF
WEIF was a UCITS established in the UK, and was subject to regulatory oversight by the FCA, the UK’s financial regulator. UCITS are European investment products designed to be suitable for retail investors, offering “daily liquidity”, meaning that investors may withdraw their investment on any business day. So why were investors in WEIF unable to redeem out of the fund, and why did the FCA permit this state of affairs? Investors wishing to redeem out of WEIF found themselves faced with two problems, one of Woodford’s making, the other a component of being invested in a collective investment vehicle:
1. Woodford’s investment decisions led the fund’s portfolio to be dangerously misbalanced, with a preponderance of illiquid positions, ie small-cap, unlisted companies. Because the shares in these companies were unlisted, there was no objective valuation for them, and there was no market available to Woodford on which to sell the shares. He needed a willing buyer. And because these companies were issuing profit warnings, and found themselves in other difficulties, no buyer was forthcoming. In short, Woodford was stuck with these investments. And because he was unable to dispose of them, he was unable to raise funds to honour the redemption requests being submitted by worried investors in WEIF.
2. All investment funds like UCITS issue investors with a prospectus. Legally, the prospectus is essentially a contract between investors and the fund; commercially, the reality is that the investors have a contract with the fund’s manager. The terms of these contracts permit the fund to suspend redemption requests — in other words, to stop honouring redemption requests — in prescribed circumstances. This provision always — always — favours the manager, not the investors. A standard catch-all is that the fund may suspend redemptions “when it is in the investors’ best interests to do so”. This gives the fund’s management considerable discretion to lock investor monies into the fund. Watch our explanatory video to find out more about suspending redemptions here:
Both of these dynamics came to bear on Woodford’s investors. WEIF suspended redemptions in June 2019 because of the panic surrounding the fund, the loss of confidence in its manager and the ensuing fire-sale of assets that was ongoing as a result of the pressure to pay withdrawing investors. They were locked in because curtailing redemptions removed the pressure on Woodford to sell portfolio assets, meaning (in theory at least) that he could take more time and realise a better price for them: and so the suspension was “in the investors’ best interests”.
So, as unfortunate as the suspension was for WEIF investors trying to exit, was (on the face of it) imposed in a proper way. The liquidity of the fund’s portfolio, however, which originally caused investors to head for the exit, was far from proper. Woodford was subject to strict UCITS rules requiring him to keep a fixed percentage of the portfolio invested in liquid positions capable of being sold in order to provide investors with daily liquidity: ie., they must be able to redeem their investments in the UCITS on any business day. Woodford invested in excess of this value limitation in stocks which he knew to be illiquid. By the time the FCA, the overseeing regulator, came alive to these breaches, it was too late: the outflows from WEIF had already reached terminal velocity, and Woodford was unable to sell the illiquid holdings quickly enough.
Gating versus Suspending
What is significant about the percentage value of the WEIF portfolio that was illegally invested in illiquid positions, and the extent of the intrinsic illiquidity of those positions, is that Woodford did not gate the fund as a preliminary measure. A “gate” can be imposed by a manager on the aggregate value of redemption requests received on any day, and is strictly temporary measure. You can learn more about gates and gating in our explanatory video here:
A daily gate up to the regulatory maximum of 10% of the value of redemption requests would have bought Woodford some time and space to liquidate illiquid investments and maintain some control over outflows from WEIF. But no such interim step was taken, suggesting that Woodford was already under huge pressure from WEIF’s largest investors (including Jupiter Asset Management, which had £1 billion invested in the fund) and was forced immediately to suspend redemptions completely.
You can read the second part of this blog, in which we consider the response, post-Woodford, of European financial regulators to the limitations of the UCITS liquidity model, and the problem of policing manager breaches here: