William Callewaert, Steve Desmond and Amanda de Carteret from BDO Limited share their experience of how to deal with so called ‘Zombie funds’.
‘Zombie funds’ fall into two categories. They may be funds that are nearing or have exceeded the end of their lifecycle and are left holding assets which are limited by there being no ready market for their disposal.
Secondly, they could be funds that have realizable assets but have reached a point in terms of net assets either from insufficient fund raising at launch, or through a decline in NAV or combination of both, where any returns are being swallowed up by the fund’s expenses.
Both categories still accrue management and service provider fees and tie up investor capital that could be deployed elsewhere in better performing assets. There is a natural conflict of interest between all parties that needs to be carefully resolved.
Parties should note section 3 of Schedule 3 to the Protection of Investors (Bailiwick of Guernsey) Law, 1987 (“POI”) requires that “The purposes of the scheme must be reasonably capable of being successfully carried into effect.” When a Collective Investment Scheme can no longer achieve its investment objectives, it can be argued that it no longer meets the regulatory requirements and therefore the promoter must consider the future of the scheme.
We know from many examples that Administrators are not above reproach for ignoring the situation and taking a passive stance, even if none of their employees are on the board of the client fund. Take for example two UK examples: Link Fund Solutions and Capita Financial Managers. Link Fund Solutions is being held accountable for apparent failures in respect of the Woodford fund. Capita Financial Managers is in a similar position for its role in the Connaught Income Fund collapse. The Administrator has a role to play in the protection of investors as set out in the POI Law.
What’s a good course of action for the Administrator?
IOSCO published a report on Good Practices for the Termination of Investment Funds in November 2017. As guidance goes, this sets out a useful framework with 14 Good Practices that should form part of any Administrator’s checklist in launching and running a third-party investment fund from launch to closure.
From the time of investment, there should be disclosures relating to the ability to terminate an investment fund as well as the process that will be implemented. Similarly, clarity is needed in respect of how the responsible entity will deal with uncontactable investors; the so called ‘gone-aways’? Taking into account any national legal or regulatory regime for unclaimed redemption monies, (of which there is none in Guernsey), the proper handling of these monies should not delay the termination of the fund for other investors.
Administrators need a plan that is in accordance with the Prospectus. Opening up communication with a representative of the Guernsey Financial Services Commission to outline plans is a good idea. There will be issues to consider such as who bears the cost of the exercise. If the investors will be paying out of the assets of the fund, then this will need to be clearly stated in the Prospectus as the time of investment.
Ensure that there is open and transparent communication between the manager, non-executive directors and other service providers, where matters are discussed and documented.
Here are some additional points to consider with the board in recognizing that the lifespan of the fund is indeed nearing the end;
- Set a deadline along with a firm commitment on timeframes from the promoter.
- Set interim performance measurements for the fund.
- Keep a close eye on the Total Expense Ratio (“TER”) to monitor expenses as a percentage of the gross assets. For example, bear in mind that if gross performance is 5% and the TER is 2%, then the investors are paying 40% of their return in fees!
- Control management fees, director fees, administrator fees and any other third-party service provider fees too. Original fees would have been based on certain assumptions. It is reasonable to ask for these to be revisited based on the current circumstances.
- Identify other ancillary costs such as listing, regulatory approvals and anything that adds to the third-party costs schedule.
- Consider restructuring the fee basis.
- Consider if the fund still needs a manager or whether this is a cost that could be removed.
- Liaise with the regulator early in the process to obtain guidance and ensure there are no concerns raised with the proposed strategy.
- Consider possible consolidation as an alternative to a solvent distribution of assets – look for funds from the same manager or from other fund houses that may have suitably aligned underlying strategies with similar investment objectives, policies and risk profiles to the terminating investment fund. Investors must be given a cash option so note this from the outset.
So much more than reputation is at stake for the Administrator. Even if you are not on the board of the investment fund and escape any litigious investors, the Administrator still has a responsibility as Designated Manager and the regulator has the authority to impose conditions and even suspend the Administrator’s licence.
Finally, consider whether the board is best placed to administer a solvent realisation and distribution of assets with the risk of an ultimate insolvent position. The use of a third-party liquidator frees up board resources to be focused elsewhere and gives an element of independence and expertise which demonstrates that the directors have made a decision in the best interests of the company and its members.
For more information on how BDO can assist in providing strategic guidance to boards, contact William Callewaert or Steve Desmond, Business Advisory, BDO Limited.