Side pockets for UK authorised funds: a tool with limited use?

The war in Ukraine has caused problems for some asset managers. Russian, Belarussian, and Ukrainian assets have become so illiquid as to be impossible to value correctly.

Certain investments are now also subject to financial sanctions; others are subject to trading restrictions. Funds holding those assets face a double bind: an inability to sell the assets, while also being unable to price the assets to achieve an accurate unit price for the fund. These problems are compounded by managers' regulatory duty to treat the fund's investors fairly and, specifically for UK authorised funds, to undertake an annual fund value assessment. Consequently, many managers have written down the value of those assets to zero and/or have suspended their affected funds.

The solution

On 16 March, the Financial Conduct Authority (FCA) publicly suggested that side pockets might be a solution for retail fund managers.

A side pocket will carve out a fund's highly illiquid and hard-to-value assets from the other assets in the fund by attributing them to a separate new unit class. Existing investors in the fund will be issued with units in the side pocket class in proportion to their existing holding in the fund, giving them a share in the side pocket's "difficult" assets. This side pocket class will not be open to new investment and will be valued separately from the other unit classes however they will still bear proportionate costs incurred for the benefit of all investors in the fund. By segregating the difficult assets, the side pocket can allow new investors to enter the fund without getting exposure to the affected, illiquid assets, existing investors can redeem the units they hold which relate to the liquid assets in the fund and some funds might be able to end their current suspension on dealings.

While more common in hedge funds, regulators have typically been cautious about side pockets for retail funds because of the concern that managers might be encouraged to make poor, speculative investments to the detriment of existing investors in a fund and be largely insulated from the consequences of their decisions.

However, the FCA's view is that side pockets present a useful measure following the Russian invasion of Ukraine.

Following a consultation setting out its proposals for the operation of side pockets, the FCA has now published the final rules which will be effective from 11 July 2022.

The new rules will amend COLL 7 to ensure that:

• The mechanism will be available to UK UCITS and NURS that have affected assets. Affected assets are investments issued, traded, or listed in the relevant countries; assets backed by those investments; funds suspended due to their exposures to those assets; and companies with operations severely affected by the war or by sanctions imposed.
• The manager should decide on whether a side pocket is in the best interests of the fund's investors, subject to a set of conditions defined by the FCA, spanning five main areas, and including determining that the overall benefits outweigh the costs.
• Fund documents will need to be amended to provide for the use of a side pocket and the FCA will fast-track applications accordingly.
• Investors in the fund will not need to give explicit consent or receive the usual notifications, but only if the manager can determine that the expected costs will not be disproportionately large.
• The side pocket would apply to investors in the fund up to the point of the creation of the side pocket, but not to investors that have redeemed their units since the start of the war on 24 February 2022.
• Managers can receive remuneration for managing the side pocket class however the fee should fairly reflect the services provided and activities carried out by the manager for investors in that class.

Will it work?

The FCA is not the only regulator permitting the use of side pockets by retail funds. In the EU, side pockets are emerging as a potential liquidity risk management tool that should be available as a contingency to all AIFs and UCITS. Currently, different Member States take different approaches - for instance, side pockets are permitted for French UCITS and have been used in response to specific problems such as the Madoff fraud and the sub-prime crisis.

Following responses to its consultation, the FCA has considered and sought to address some of the problems that might arise in the context of the UK's regulatory and tax regime. However, we find that some challenges remain.

• Costs: managers must consider the benefits and costs to investors before deciding to set up a side pocket. The costs might only be worthwhile for funds with significant exposures to affected assets, such as emerging market funds. However, funds with very significant exposures might find it more cost-effective to remain suspended or to be permanently closed. Consequently, the benefits of a side pocket might outweigh the costs and complexity for a narrow sub-stratum of funds.
• Operational barriers: third-party service providers, such as fund administrators, are generally not currently set up to deal with side pockets. Similarly, distributors will need to prepare for conversations with their clients, or revisit ongoing advice, and may need to change their systems.
• Timing: managers will need to engage with the FCA prior to submitting an application. Once applications are submitted, the FCA aims to fast-track approvals and to minimise the administrative barriers. Nonetheless, preparatory analysis and decisions, changes to fund documents, and becoming operationally ready along the value chain could take several months - in which time, the current illiquidity of the affected assets might have passed.
• Regulatory implications: when proposing a side pocket, managers must consider the implications of s235(4) of the Financial Services and Markets Act 2000 and whether they can treat the fund and the side pocket as a single collective investment scheme. This may turn out to be a quite a challenge for managers to overcome.

Regardless of these difficulties, the FCA's efforts to find a solution is welcomed and for some funds side pockets will be a viable alternative to the currently available options.