It’s becoming more and more difficult to predict which way the world will turn – so is it remotely possible to protect funds against every eventuality?
We live in uncertain times. For the funds industry in the Channel Islands, this uncertainty primarily falls into three categories. First, there’s the political instability caused by Brexit. Then there’s the economic volatility in the Middle East and Russia, with the related headwind of falling oil prices. Finally, there’s the regulatory waiting game with regard to Alternative Investment Fund Managers Directive (AIFMD) third-country passporting.
OK, this may be simplifying things slightly, but with so many factors pulling at the funds industry, it’s not surprising that many insiders are asking whether it’s possible to stress test (or future-proof) funds against such matters.
Joel Hernandez, Partner at Mourant Ozannes in Jersey, believes the Brexit vote has had the most evident impact on the island so far. “Jersey looks after a lot of structures that invest in UK real estate,” he says.
“With Brexit having a direct effect on property valuations, we’ve already seen high-profile, open-ended property funds being suspended. In Jersey we haven’t seen funds suspensions in the same way as in the UK, but there are still difficult questions being asked on valuations and the effect this has on redemptions, asset disposals and fund covenants.”
In terms of stress testing real estate funds in the aftermath of Brexit, Hernandez says the UK’s Financial Conduct Authority introduced extra guidelines on fund suspension rules after the referendum vote. And while they haven’t yet been seen in the Channel Islands, these new rules might be picked up in the future.
As to economic volatility in the Middle East and Russia (and falling oil prices), Oliver Morris, Advisory Director at KPMG Channel Islands, believes Jersey and Guernsey are pretty resilient and not overly dependent on money flows from specific regions or countries.
“We have diverse capital inflows. If there’s a slowdown in the Middle East, we might see greater inflows from the US. The Channel Islands aren’t overly exposed to one jurisdiction,” he explains.
This point is largely echoed by Hernandez, who notes: “In 2005, most money coming into Jersey was from UK pension funds – after 2008/09 those flows reduced but there were increased flows from south-east Asia. We’re now seeing flows from south-east Asia reducing, but more money coming in from the US and Canada, with particular interest in UK real estate.”
He adds: “There might be a dip somewhere across the globe, but money flows increase from other areas to counter that. For instance, following the appreciation of the rand, UK commercial real estate becomes more attractive to South African investors. The same is true for US investors.”
There’s no easily prescribed solution that will fully immunise the Channel Islands from major economic downturns in regions or sectors, but the combination of a globally diversified pool of investors and a respected and well-regulated funds industry does offer vital support.
Attractive proposition
The future health of the fund industry as a whole comes down to making sure it’s attractive to people who want to raise money. And Guernsey and Jersey are leading the way by doing what they can to provide a robust funds industry – for instance, by meeting international standards and by having a well-regulated and transparent industry.
Morris agrees that the reputation of the Channel Islands is keeping them front of mind. He argues, however, that the islands need to remain nimble to adapt to new scenarios – notably AIFMD. “You can have the best fund structures in the world but you need to adapt or you may no longer be the jurisdictions of choice.”
Hernandez takes a similar line, citing Jersey as a case in point. “Being front of mind means having something that suits the client model. We need to streamline the fund options in Jersey and make them less complex. Breadth of offering has been seen as a strong point but with Jersey now, there’s an over-population of funds, so rationalisation is being undertaken.”
Looking at individual funds as opposed to the industry as a whole, Morris argues that as far as private funds are concerned (most are closed-ended), stress testing is not a concept that really applies. “It’s more about stress testing the client before they become a promoter rather than the strategy of the fund itself. Should we be looking at parties from jurisdictions with a chequered past – for instance, Russian private equity that isn’t regulated?”
Wayne Atkinson, Group Partner at Collas Crill, agrees that stress testing the promoter is important. “It may be that the fee structure is such that the manager only gets paid for positive performance. While this seems good news for the investor, what if the global economy shifts? The manager might be doing as good a job as anyone, but with no fees coming in, how does the company pay its staff? There may well need to be a restructuring of the fund.”
He adds that with some funds there is a charismatic figure at the helm who may not be in the best physical shape. How does the fund keep going if he or she has a heart-attack? The fund price might crash because of the perception of the star manager not being there. Is there a strong, well-resourced team in place to reassure investors that the fund is in safe hands while the manager is absent?
Asking the questions
Fund promoters should be asking the question ‘what if X happens?’. “Nobody launches a fund for it to fail,” Atkinson says. “But many funds are set up on the basis that their strategy is a good idea, that ‘in normal conditions, this works’. The real stress test comes when major events like Brexit or the collapse of the banking sector happen. How well has the fund been prepared for the one-in-a-100-year storm?”
He concedes that making a fund stress-proof for that one event might not always be cost-effective but that the onus in those circumstances should be on spelling out the risks of the fund clearly to investors.
“There’s nothing wrong in itself with investment risk, but people need to know when they’re betting on a long shot. This is why improvements in investor relations are so important. Guernsey’s Code of Corporate Governance, for example, has helped to ensure shareholder interests are better looked after.”
Hernandez makes the point that individual funds underwent the first round of stress tests back in 2008/09 after the financial crisis. He believes lessons were learned then with more recently launched funds stipulating 10 per cent redemption gates and market volatility clauses. He suggests it is legacy funds (funds from before the crisis) that have the greatest requirement for stress testing.
Patricia White, Managing Director at Vistra Guernsey, insists that astute cash management is essential to sensible fund stewardship, particularly when investing in illiquid assets. “Sterling’s value remains about nine per cent below pre-referendum levels and 13 per cent lower than a year ago [at the time of writing]. While there is never a perfect hedge, managers with multi-currency funds, who hold sterling-based assets without a considered currency hedging policy during this uncertain period, will find themselves with some explaining to do to their investors.”
As far as regulation goes, White is in no doubt AIFMD will have a direct impact on the Channel Islands funds industry. However, the positive assessment by the European Securities and Markets Authority (ESMA) and approval for recommendation for passporting expected imminently from the EU mean the Channel Islands are in a position of strength.
Hernandez agrees that the ESMA recommendation is good news but he insists there are still concerns over how the regulatory landscape will finally look. “We don’t want local private placement regimes being taken away. Currently we can access the EU through private placement. However, countries like Germany may insist in future that local rules no longer apply and the only route of access is via full passporting.”
There are other grey areas too. As Atkinson points out, to obtain a passport the Channel Islands will require an EU member state of reference – which, pre-Brexit, would have been the UK. Now there needs to be a rethink.
“Both islands had contingency plans and had reached out to alternative jurisdictions other than the UK. Holland would be one of the obvious names on the list now. The important thing is that we now have contacts with regulators in, for instance, Germany, Belgium and Holland that we didn’t have before, and that’s a positive step.”
The Channel Islands are arguably as prepared as they can be in the current climate, but contingency plans and efforts to future-proof can only go so far – you can never manage the unknown.
As White concludes: “Stress tests can be highly sophisticated, based on complex computer models, but they’re only as good as the future scenarios on which they’re based. As such, they can be limited in effect – as the inability of experts to predict the crash of 2008 proved.”