First it was the shocking junk bond fiasco at Third Avenue which led to a premature end for the asset manager, then the three largest UK property funds suddenly froze over $12 billion in assets in the aftermath of the Brexit vote; two years later the Swiss multi-billion fund manager GAM blocked redemptions, followed by iconic UK investor Neil Woodford also suddenly gating investors despite representations of solid returns and liquid assets, and most recently the ill-named, Nataxis-owned H20 Asset Management decided to freeze redemptions.
By this point, a pattern had emerged, one which Bank of England Governor Mark Carney described best when he said that investment funds that promise to allow customers to withdraw their money on a daily basis are "built on a lie." At roughly the same time, the chief investment officer of Europe’s biggest independent asset manager agreed with him, because while for much of 2019 the biggest risk bogeymen were corporate credit, leveraged loans, and trillions in negative yielding debt, gradually consensus emerged that investment funds themselves - and specifically their illiquid investments- gradually emerged as the basis for the next financial crisis.
"There is no point denying we are faced with a looming liquidity mismatch problem,” said Pascal Blanque, who oversees more than 1.4 trillion euros ($1.6 trillion) as the CIO of Amundi SA, adding that the prospect of melting liquidity is one of "various things keeping me awake at night."
Fast forward to today, when the recently shuttered Arrowgrass Capital Partners became the latest fund to remind investors just how toxic the threat of illiquid securities is, when it slashed the valuation of its stake in Britain’s oldest surviving amusement park, piling further losses on investors in Nick Niell’s closed hedge fund.
According to Bloomberg, Arrowgrass wrote down its stake in the Dreamland park owner in the seaside town of Margate to 19.7 million euros ($21.6 million) over the last month, down 70% from its previous valuation. The massive write down resulted from a third-party valuation of Dreamland, a revised business forecast for the property and the closure of Arrowgrass, said the Bloomberg source.
While this particular investment was modest, and accounted for a small portion of Arrowgrass’s $3.2 billion in (liquidating) assets, the firm’s dealings in Margate, located 75 miles from London, have once again "raised eyebrows in the industry" as Bloomberg puts it. The reason: Niell was buying properties worth millions of pounds around the resort as the hedge fund was pouring clients’ money into an effort to revitalize the amusement park. In retrospect, it was a terrible idea.
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While we previously discussed "The $1.6 Trillion Ticking Time Bomb In The Market", the Arrowgrass fiasco is merely the latest example of how pervasive investment in hard-to-mark illqiuid assets have become in Europe where money managers from Neil Woodford to H2O Asset Management have come under fire from politicians, regulators and investors. But really it's the central bankers' fault: having injected trillions in the market to crush yields and push investors into the riskiest assets, investment firms have had no choice but to venture into harder-to-sell assets such as real estate in a search for yield.
According to Bloomberg, Arrowgrass’s investments in hard-to-sell assets were also one of the drivers behind the fund's eventual closure "as they raised concerns among investors months before it decided to shut its doors after about $1 billion of redemption requests and a 50% drop in assets since 2017." Predictably, the hedge fund blamed central bank policies for its demise; it wasn't wrong - it just had no other choice.
At one point earlier this year, the firm’s exposure to so-called Level 3, or hard-to-value, assets was just under 10%, the person said. The Margate investment attracted particular attention. It was one of the firm’s most difficult-to-sell assets, yet Arrowgrass had plans to raise external capital and build hotels in Margate, the person said.
The bigger problem is that all those investors who thought they were generating a positive return in 2019 are now looking at massive haircuts as the fund is forced to liquidate its assets at any price. Arrowgrass’s main hedge fund lost about 3% in August, bringing the drop this year to more than 6%, after never posting a full-year loss since starting in 11 years ago. It's about to get much worse: the firm is now expected to return about 75% of clients’ cash by the end of this year, according to a letter to investors sent by the firm last month. The rest of the investments will take longer to liquidate, and may return pennies on the dollar, if anything, largely due to the "liquidity illusion" created by asset managers in conjunction with central banks that have now terminally broken markets, which now only work on the way up and freeze up any time there is selling.
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Incidentally, for those wondering if liquidity remains an illusion - a test that can only be confirmed when there is a crash and the market is indefinitely halted, an outcome that is now virtually inevitable - Deutsche Bank has a simple test: it all has to do with the sequence of events unleashed by widening spreads, where redemptions and first movers rush to sell, collapsing the market's liquidity, freezing refinancings, and resulting in a surge in defaults and firesales, which in turn leads to even wider spreads and so on, until central banks have to step in to short circuit this toxic loop.
This also explains why GAM, Woodford, H20, Arrowgrass and many more funds (in the near future), will be similarly gated once their investors discover there is no liquidity to sell into and the only "real time" liquidity is offered to those who have a "first
seller mover advantage", to wit:
- If investors anticipate severe losses on the fund’s investments, they could be incentivised to “run for the exit” to be the first to redeem their shares.
- The first-mover advantage in open-ended funds arises because losses on asset sales to meet redemptions are incurred by investors which remain in the fund.
- As in a ‘bank run’, the asset manager is, in principle, forced to sell assets in a fire sale in order to meet its short-dated liabilities
This dramatic imbalance of asset holdings at market making banks and buyside "bagholders" of illiquid securities, is now posing a major problem for regulators, something the Bank of England acknowledged in a working paper published earlier this month, and highlighted by Mark Gilbert, to wit: "as the funds industry has supplanted banks as a source of credit in the past decade, households and companies have benefited from a useful alternative source of financing. But, the report warned, we don’t know how this market-based system will respond under stress."
Modelling such a scenario “can generate an adverse feedback loop in which lower asset prices cause solvency/liquidity constraints to bind, pushing asset prices lower still,” the BOE found. In other words, the new market structure may be worse than the old.
The feedback loop discussed by the BOE is the one we showed above. Here it is again:
And, as recent notable fund "gates" and/or collapses have shown, the difficulty for asset managers in such an eventuality is finding sufficient cash to repay exiting investors while preserving the structure of the portfolio without distorting market prices, according to Amundi's Blanque.
According to Bloomberg, part of Amundi’s response to this seemingly intractable issue is to include liquidity buffers in its portfolios, which may mean holding securities such as German bunds and U.S. Treasuries, which should always trade freely. But the industry needs to come up with a common definition so that liquidity is included along with risk and return when assessing a portfolio’s robustness, Blanque says. Additionally, this band aid only works for modest redemptions. A wholesale liquidation would crush even the most "buffered" up fund.
For now, asset managers have to cope with what Blanque called "the sacred cow" - although a better phrase would be "constant risk" of allowing clients to withdraw funds on a daily basis.
"It is a bomb, given the risks of liquidity mismatch," he warns. “We don’t know if what is sellable today will be sellable in six months’ time."
That's not the only we don't know. As Blanque concluded, "we don’t know the channels of transmission, we don’t know how the actors will act. It is uncharted territory."
And that, precisely, is why central banks can never again allow risk asset prices to drop: the alternative means gating not one, or two, or a hundred funds, but halting the entire market, because once everyone start selling and price discovery finally returns to a market that has been dominated by central banks for the past decade, several generations of traders and investors who have grown up without price discovery will be shocked to discover just where "fair" market prices reside.