The escalation of the coronavirus crisis and subsequent shutdown of much of the global economy has had a dramatic impact on many financial markets and asset prices. Alan Flanagan, Global Head of Alternatives, Managing Director, BNY Mellon looks at how increased volatility and economic uncertainty might affect valuation, liquidity and operational issues for various alternative asset classes.
All funds have policies that require them to assess valuations, either utilising an internal governance committee or external third party. Non-executive directors have an important role to play in this process, challenging and questioning the investment manager about all aspects of the funds, including valuation, to ensure it fulfils its fiduciary responsibilities. Funds are required to report (usually on a quarterly basis) in each market where a product is available, and as part of this process they are obliged to consider market events and the broader environment to ensure valuations are as accurate as possible. They must also consider IFRS and other accounting implications. Valuations take into account interest rates where relevant – recent cuts in benchmark rates will have a bearing on some debt funds, for instance.
The requirement to report on a quarterly basis is an important characteristic given the current environment, as the quarter closed immediately after steep declines in public markets in March. Reporting usually occurs 30 to 45-days after the quarter end – therefore changes in valuation have yet to be published.
MiFID II requires investment managers to notify clients when the value of their portfolio drops by 10% relative to the value at the beginning of each reporting period and a number of funds may need to do this. However, the MiFID II rule that requires investment managers to notify clients of any subsequent 10% drop has been suspended by the UK’s Financial Conduct Authority until October. Regulators in Luxembourg, Ireland and elsewhere are likely to pursue a similar policy. Under the new interpretation of the rule, managers are only obliged to inform a client of a 10% drop once within a reporting period, provided they continue to give general market updates to clients.
While it is very difficult to accurately gauge changes in valuations across alternative asset funds given that reporting has yet to occur in the private markets space, it is likely that different asset classes will have divergent valuation outcomes. The root cause of changes in valuation is important in this regard. For instance, in the hedge fund sector, funds often hold more liquid assets such as equities. The impact of such assets on a hedge fund’s value is straightforward to calculate and some may be significantly impacted – positively or negatively – by public market movements in March and April.
Similarly, in the private equity market, valuation is often based on a public market multiple. For assets where valuation is calculated in this way, recent market dislocations will have significant and immediate implications. However, in other instances private equity funds may use a discounted cash flow model for valuation purposes. Slower economic activity, and the virtual closure of some sectors such as retail and entertainment, could also have negative implications for valuation. However, for some venture capital funds invested in technology platforms that have benefited from people working at home, there may be a positive impact.
For less liquid alternative asset classes with no standard models, publicly quoted prices or borrower ratings, the repercussions of the volatile market environment and the steep downturn in economic activity, in March and April, is less clear at the current time. This could take many months to be reflected in valuations. For instance, in a private debt fund, a borrower may request an extension of payments because of the need to grant a rent holiday to their tenants in a shopping centre as stores are currently closed.
A key question for valuation in the current circumstances is whether any change in cash flows (or a breach of covenants) is short term and temporary or long term and possibly permanent. The strategy of a fund could be important in this regard. As of mid-April, collection rates remain relatively high across strategies such as commercial and industrial while they are significantly lower for retail. Rental abatement discussions are widespread. While there is much focus on government initiatives aimed at mitigating the impact of COVID-19 and the economic shutdown (such as the Small Business Administration initiative in the US), much of this funding is expected to be aimed at supporting wages rather than landlords.
It is important to note that any technical breach of a covenant (such as loan-to-value ratio) gives the lender the right to take action. But in most circumstances a good relationship between the borrower and lender will result in negotiations rather than enforcement of covenants (although this may depend on the extent to which any structure is leveraged and the broader risks involved). In the private debt space therefore, any adjustment in valuation may be significantly slower than in assets with links to public markets: depending on the shape of any economic recovery, and provided repayments continue and there remains sufficient cash on hand, there may be no need to adjust valuation for some assets.
The length of the economic downturn and the nature of recovery – whether a rapid V-shaped recovery following a clear trough, a more gradual U-shaped recovery or a W-shaped recovery, where growth returns in fits and starts – could have a bearing on valuations for less liquid alternative asset classes as it may impact the ability of borrowers to repay debt, for example. Different countries are likely to relax the lockdown in different ways, with consequent implications for economic activity, asset performance and valuation. Currently, there are limited expectations of deal creation during the rest of 2020; the hope is to stabilize assets as economic activity resumes (with a W-shaped recovery seen by many as most likely) while looking to 2021 for recovery.
There are as yet no statistics on outflows from alternative asset funds. Many funds require 30 days (or longer) notice to redeem, so the vast majority of redemptions have yet to take place. However, there is anecdotal evidence of investors seeking to exit investments. Some of these investors may be motivated by a belief that the falls in March and April are just the beginning of a larger correction and a potential global depression. Others, especially those leveraged and holding equities, may face margin calls and therefore be forced sellers (the significant increase in the utilisation of loan facilities to address margin calls has caused some nervousness in industry as it could become problematic if volatility continues). Yet other clients may need to reduce their alternative asset holdings to rebalance their portfolio given steep falls in public markets. It is important to note that there are also buyers in the current market – it is far from broken and the situation is not comparable to 2008.
Nevertheless, a number of opened-ended funds have been forced to gate investors, temporarily blocking withdrawals, to stem redemptions and avoid the need for fire sales (the semantics of gating vary: some funds (notably in the credit market) have suspended redemptions claiming they do not want to be a forced seller in what they describe as a dysfunctional market). Gating is not unusual and has happened on a number of occasions in the past, most recently in response to Brexit in the UK when a number of property funds restricted exits. However, the current environment – with both markets and economies potentially in decline for some time – could prolong gating.
While gating is a recognised feature of funds, it comes with a potentially heavy cost. Although it protects an investment fund in the short term, clients are more likely to leave when the gates are lifted. On some occasions in the past, the longer-term reputational damage of gating has led to the demise of funds.
Closed end private equity funds do not face the same challenges, as redemptions are not allowed within the life of the fund. There has been some speculation that macroeconomic disruption will drive a sharp rise in capital calls in the near term (either to pay down subscription lines of credit or shore up existing investments). This assumption is not universal: a recent study by research firm Preqin and risk management firm FRG said a surge in capital calls is not expected until 20211 . Regardless, managers need to be aware of the risk that LPs may be unwilling, or unable, to fund capital calls and could instead default. One alternative could be for such investors to sell in the secondary market to avoid the reputational damage that comes with a default and recoup at least part of their investment.
The secondary market has matured considerably since the financial crisis, when it was extremely illiquid and usually only used as a last resort. In recent years, volumes have increased as strong private equity vintages (such as 2008 and 2009) have been in high demand; the secondary market has provided liquidity for investors wanting to realise gains or rationalise the number of managers they work with. The crucial question is whether the secondary market will continue to function in this relatively orderly way – at prices that are acceptable to sellers – if the number of sellers increases markedly.
Another related issue is the extent to which managers will allow investors to exit investments, where funds have structures that allow exits (usually relating to a specific proportion of liquidity) at various points (usually after a long lock up period), at the manager’s discretion. This will be the first time these structures have been tested in a major market downturn. Managers may be reluctant to let investors exit – and the terms for funds will be written to make it clear that investors do not have a right to exit. However, managers will need to balance this against maintaining a longer-term relationship with the client: options to leave at the manager’s discretion could ultimately form the basis of a partial negotiated exit.
Volatility and liquidity concerns have prompted some changes in liquidity management across the alternatives asset industry in a ‘flight to safety’. Deleveraging has prompted a significant increase (as much as 120%) in unencumbered money market fund balances and a movement of excess balances away from trading counterparties where the main attraction was yield or operational convenience. Many clients are rotating out of Treasuries to MMFs given the simplicity of liquidity management they offer and likely outperformance in the light of negative Treasury yields. A number of real estate funds have drawn on revolvers to support their liquidity management and anticipated cash burn or are seeking short-duration, funded facilities to build liquidity; many are using MMFs for yield preservation and liquidity, while rotating out of Prime funds due to liquidity issues.
To varying degrees, alternative asset funds are laggards when it comes to the adoption of digital technologies when compared to mainstream asset class funds. In private markets, administration is likely to be in-house. Partly as a result, and also due to the nature of the assets themselves, paper-based processes are common. In the private equity sector for instance, paper-based documentation (or at best PDF-based) remains standard while in parts of the private debt markets, such as loan trading, the trading process itself is paper-based. Increased trading volumes could make it hard to keep pace with settlement demands.
Hedge funds are usually more advanced in their adoption of digital technologies and automation. All trade electronically but some continue to have paper-based record keeping and investor-facing interaction. However, the vast majority of hedge funds outsource record keeping, net asset value per share calculation, share application and redemption processes, shareholder services and financial reporting to fund administrators, which are more likely to have digital systems.
The experience of March and April could prove to be a boon for fund administrators as the benefits of greater automation and digitisation come to the fore. Similarly, there may be a significant increase in demand for high quality custody services as asset managers seek partners with strong business continuity planning capabilities and robust technological infrastructure. The extreme market volatility prompted by the coronavirus crisis may encourage asset managers to seek a partner that enables them to operate efficiently in volatile markets, continue to meet their regulatory and investor obligations, and gain the visibility and control needed to effectively manage risk.
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Managing Director, Global Head of Alternatives
Alan is responsible for the Alternatives business within BNY Mellon Asset Servicing globally, which provides operational support to alternative asset managers, as well as asset owners investing in alternatives. The services span the full range of alternative investments including hedge funds, private equity funds, credit funds and real estate funds. Alan is a Non-Executive Director of BNY Mellon Trust Company (Ireland) Ltd, a member of BNY Mellon’s corporate senior leadership team and BNY Mellon’s Alternatives Global Executive Council.View Profile