CAPE TOWN – On 15 August the Financial Services Board (FSB) announced that unit trust funds which held African Bank (Abil) debt would be able to separate this out of their main portfolios. This process, known as side-pocketing, was intended to provide some protection to investors.
Since the Abil debt could not be traded and was not earning any interest, the FSB allowed asset managers to create separate funds that contained only the Abil paper. Investors would not lose any money, but would now hold units in two funds where before they only held one – both the original fund and the new side-pocketed Abil fund. However, the investment in the side-pocket fund could not be sold.
A total of 50 funds took this option. The list of those that did is available here on the FSB website.
The advantages of doing this were twofold:
Firstly, it meant that anyone who was already invested in the fund could not just exit and leave everyone else with the Abil debt. They would continue to hold their Abil exposure, even if they sold out of the original fund.
And secondly it meant that any new investors into the fund would not be exposed to what is essentially a non-performing asset. Since the Abil paper was separated out, they would only buy units in the newly-constituted fund that was Abil-free.
Not all funds with Abil debt in their portfolios followed this option, however. It tended to be those with larger exposures that took this route.
“The larger the Abil position the more challenging the issue becomes as, even after the write-down, any subsequent outflows can mean that the illiquid Abil holding would become a bigger and bigger portion of the fund,” explains John Kinsley, the MD for unit trusts at Prudential. “Thus, in an extreme scenario the ‘last man standing’ could be left holding the Abil exposure. To protect against this, and to protect new investors buying into a large Abil exposure, side-pocketing has its merits.”
So in theory, this sounds pretty appealing. It means that new investors would not be prejudiced and old investors couldn’t run off and leave others to face the Abil problem.
But unfortunately it wasn’t quite that simple. The FSB’s announcement came four days after Abil was placed under curatorship and the date set for side-pocketing to take place was 18 August, ten days after any Abil assets were last traded.
In other words, there was a period of a week in which the Abil debt was still “in play”.
Investors who exited these funds during that time would have got out without having to hang onto the Abil portion of their holding. And any investors entering these funds would have become victims of unfortunate timing.
This was brought to Moneyweb’s attention by a reader who made a significant investment in a money market fund on 15 August. Even though this investment was made after Abil was placed under curatorship, Abil was part of the fund’s portfolio. So when the side-pocketing was implemented on 18 August, this new investment would have been subject to it as well.
It is quite obvious that this is not fair and that side-pocketing in this instance did exactly what it was meant to avoid. A new investor was prejudiced even though he made the investment after the Abil debt was already non-performing.
For the side-pocketing to have the desired effect, it should have happened on the same day as the haircut. That would have been the only way to ensure that only those investors who were in the fund at the time were affected by it.
By waiting a week before allowing side-pocketing, the FSB created this inconsistency. Perhaps this happened because side-pocketing has not happened in South Africa before and the FSB was caught unprepared. But it should be a lesson learnt.
It is not within the FSB’s power to implement regulation retroactively, so side-pocketing could not be back-dated. It would also not have been possible to do that anyway, since the amounts invested in funds would have changed in the period between the haircut and the FSB’s decision.
Funds will probably argue that side-pocketing was fair to the majority of investors, and that some either benefited unduly or suffered unfortunately could not be helped. They are a small minority in relation to the whole.
However, that is no consolation to the small minority affected. They would have every reason to be extremely displeased.
Kinsley also points out that there are other potential problems with side-pocketing. Prudential did not employ side-pocketing as they believed that their exposure was not large enough.
“Our concerns were primarily administrative,” he says. “You essentially have to run two separate portfolios with increasingly different unit holders, reporting and possibly even tax consequences. When liquidity eventually returns to the Abil instruments I am also not sure that side-pocketing will help manage the strong desire to liquidate any better than holding the exposure in the main fund.”
He also suggests that because side-pocketing is unprecedented it may result in consequences that are as yet unforeseen.
“Already, Morningstar has its work cut out trying to determine what the genuine performance of a portfolio is where the election to side-pocket has been made,” Kinsley says. “For the retirement fund industry it could become a major challenge – how does someone exit a fund at retirement when some of the proceeds have to remain invested in the side-pocket. How do you issue the correct tax directive in such an instance?”