The coronavirus pandemic is frazzling even the best trained middle-office operations managers of US fund management shops who are working in the trenches of a battlezone.
The war isn’t about setting up remote access to IT systems for employees having to work from home or deciding who should do which task and when. Following a basic disaster recovery plan should answer those questions. Instead, the war will be how to survive completing the core operational requirements during extreme market volatility and staffing constraints without knowing for certain when it will be over.
All of a fund manager’s employees will have their respective roles to play. Front-office portfolio managers and traders must keep track of and adjust to market conditions, while compliance managers must ensure their shops don’t fall astray of legal requirements. Investor relations managers will be in charge of assuaging nervous investors and legal counsel will be talking to boards of directors. Yet it is likely the army of middle-office employees that will shoulder the stress of ensuring that all the fund’s plumbing works correctly. The ability of middle-office managers to correctly strike net asset valuations, handle a tsunami of redemptions and manage liquidity will become paramount if a fund is to make it out of the crisis alive, albeit battered. Over-the-counter derivative contracts will also have to be more closely monitored.
Based on discussions and reports from legal counsel, compliance consultants and internal operations managers, FinOps Report explains some of the critical operational challenges middle-office operations directors will likely face during the coronavirus pandemic. Also offered are practical recommendations to how to avoid regulatory and contractual errors. No one needs to face a fine or lawsuit because of unintentional operational glitches.
Striking Net Asset Valuations: This task tops the list of operational requirements for fund complexes. Open-ended investment funds — aka– mutual funds — need to value their holdings each day at 4PM EST. If the market stops trading before that time the fund can either ignore the earlier close and still strike a NAV at 4PM; calculate its NAV at the close of an alternative exchange determined by the adviser; or calculate its NAV at the time US exchanges close.
“We wonder if any funds that reserve the right to price at 4PM EST, notwithstanding a trading halt, will exercise this option,” says the investment management practice group at the law firm of Perkins Coie in Pittsburgh and Washington, D.C. in a recent blog. The fund manager’s best bet, according to legal experts who spoke with FinOps Report, is to treat the time of the trading halt as the time for calculating an NAV to avoid having to potentially fair value an entire portfolio. However, taking that approach requires middle-office operations managers for funds investing in US-traded securities to check their funds’ feeds of the last available prices and to apply the NAV to orders received before any trading halt.
Calculating a NAV at any time of the day will require fund managers to have all hands on deck to handle all the data inputs and ensure external providers are up to snuff. “Fund boards will be asking whether there have been any issues with third-party service providers, particularly with respect to calculating a fund’s NAV each day,” notes Domenick Pugliese, a partner at the law firm of Sullivan & Worcester in New York. Those service providers include fund administrators and pricing services that provide independent valuations. The good news, he says: so far there haven’t been any public reports of fund administrators either delaying or not striking a NAV.
Despite fund administrators doing their best to live up to the new heightened operational challenges, fund managers can’t be too careful. “As fund boards remain responsible for accurate and timely NAV calculations they might want to consider their own contingency plans for striking NAVs in case their fund administrators can’t deliver for reasons out of their immediate control,” says Geoff Hodge, president of Sydney, Australia-based global NAV technology provider Milestone Group in the US. “Under such stressful times, fund administrators could make human errors in pricing, reconciliations or booking corporate action entitlements due to workforce disruptions in domestic or offshore processing centers.”
Hodge’s recommendation: middle-office operations employees must be more rigorous in overseeing NAV calculations by their administrators or better yet strike a contingent NAV, or a NAV that can be used in an emergency in case the fund administrator is either delayed striking a NAV temporarily or for some time. Milestone Group’s pControl platform allows for NAV oversight and contingent NAV calculations. Some custodian banks, such as Brown Brothers Harriman and State Street, also offer clients oversight and contingent NAV software, while BNY Mellon provides a full-fledged outsourced service for clients and non-clients.
All ten operations managers at mutual fund complexes contacted by FinOps Report, say that they will strike a NAV at either 4PM EST or earlier depending on when the US exchanges close. All of the operations managers have also spoken with fund administrators and have been reassured their contingency plans are in place. Still, three acknowledge they are looking into creating contingent NAVs.
Managing Redemptions: Middle-office operations managers at fund management shops are already feeling the tsunami of redemptions and there are no easy solutions. “Adding staff to mutual fund call centers won’t work if employees aren’t properly trained in how to answer questions,” explains Erik Olsen, managing director specializing in investment funds for New York-based financial services regulatory consultancy firm ACA Compliance Group. “The better alternative is to communicate with investors that there will be delays in responding to questions on redemptions.” Another good idea: contacting the transfer agent which is either an internal unit of a fund management firm, or an external provider to make certain it can handle the spike in redemptions. Now isn’t the time to fall flat on the job.
While managers of open-ended mutual funds are obligated to honor daily redemptions, hedge fund managers can more easily negotiate with investors as to when they can cash in. “Their offering documents should allow them to reduce the volume of redemptions under certain circumstances by enforcing gating policies,” says Daniel Viola, a partner with the law firm of Sadis & Goldberg in New York. “Alternatively, they can consider offering in-kind compensation, but that might be too operationally challenging.” In-kind compensation allows investors to receive shares, rather than cash, so fund managers don’t have to sell any assets.
If redemptions are made middle-office managers are the ones in the thick of making the wire transfers to investors. Doing so while working remotely won’t be easy as multiple approvals and connectivity to multiple banks could be needed. Middle-office and IT managers need to verify now rather than later that contingency procedures work before having to tell an investor a payment can’t be made or has to be delayed for purely operational reasons.
Five operations managers at hedge fund management shops tell FinOps Report that their firms’ compliance managers are meeting with external legal counsel to verify the conditions for redemptions based on their offering documents. Two of the five operations managers say their portfolio managers are also hard at work trying to convince investors to invest rather than redeem. All of the operations managers claim they have verified that their back-up wire transfer plans are working.
Managing Liquidity: Market volatility and increased redemptions will put liquidity management programs to the test. To honor redemptions daily, liquidity managers must decide whether to use cash, sell assets, access lines of credit, or rely on interfund lending. Selling assets alone could require fund managers to readjust their holdings within the guidelines of their investment strategy to ensure that some investors don’t benefit at the expense of others.
Middle-office operations managers will need to keep an even closer watch on asset classifications and make certain there are no deviations from the SEC’s requirements or their own. Open-ended funds must restrict the level of illiquid assets to only 15 percent of the value of their portfolios and at a time of high market flux, some liquid assets could easily turn into illiquid ones quickly.
“If net redemptions and reclassifications cause the fund to exceed the 15 percent limit on iliquid instruments develop a plan to bring the fund back into compliance and notify the board,” recommends Perkins Coie in its blog. “If net redemptions, portfolio sales and reclassifications have caused the fund to fall below its highly liquid investment minimum assess the chances of alleviating the shortfall within the prescribed seven-day period. If the outcome is in doubt, consider notifying the board before the period has expired.”
All ten operations managers at US mutual fund complexes contacted by FinOps Report say that they are reclassifying their assets daily and speaking with portfolio managers to ensure they have sufficient liquid assets or cash on hand to meet redemption requirements. Fortunately, the SEC has provided some temporary relief– until at least June 30– from complying with regulatory requirements under the Investment Company Act of 1940 to allow open-ended funds to more easily borrow money from certain affiliates, rely on interfund lending arrangements, or enter into borrowing or lending arrangements that deviate from fundamental policies as long as they have board approval.
Managing OTC Derivatives: Fund management firms that have to fulfill initial margin requirements for uncleared swaps either under phase five or phase six of global regulations in September 2020 and September 2021 haven’t been given any delays so far, although there are plenty of calls for postponing the timetables, In the meantime, collateral managers and other middle-office managers will need to keep close tabs on margin calls for variation margin to ensure they aren’t giving up too much collateral. Middle-office managers already know what collateral is eligible and what haircuts apply for each OTC derivative contract, but they will need to understand if and when broker-dealer counterparties can unilaterally modify the types of collateral they require and the haircuts that apply. If so, does the broker-dealer have to give advance notice or not? No fund manager’s middle office wants to be blindsided with changes it didn’t anticipate.
Fund managers might also have to unwind contracts — under certain conditions– so it is important to review what those circumstances are. Middle-office managers have to keep an eye on the trigger points, such as declining NAV levels under specific timeframes based on the terms of their firms’ agreements. Just as important is knowing if the declining NAV level is to be measured on a rolling basis or on the prior month’s end.
Four of the ten operations managers at US mutual fund complexes who spoke with FinOps Report say that they are monitoring their margin calls and are in talks with counterparties on how to renegotiate collateral requirements, if necessary. None would disclose whether they have unwound or will unwind any OTC derivative contracts.
Whatever decisions fund management firms make, they had better be certain they can defend their actions to the SEC. “Ensuring the right communications to counterparties, investors and internally is critical because when the dust settles the US regulatory agency will want to know the fund manager did its utmost to protect the interest of investors,” says Viola.
What fund managers should never do is digress from their documented policies, particularly when it comes to valuations. Those policies dictate the methodology the fund management firm can use to price securities depending on which of three categories they fall under. For Level I securities — typically exchange-traded instruments– the last traded price will suffice– while for semi-liquid or illiquid Level III securities some judgment calls will have to be made on any data inputs and pricing models used. The SEC won’t hesitate to penalize fund managers for overpricing semi-liquid or illiquid assets which can ultimately harm investors if the fund’s NAV is inflated. Therefore, middle-office data managers must be even more vigilant when it comes to monitoring changes in asset liquidity.
Despite all the market and personal turmoil middle-office operations managers will face dealing with the coronavirus pandemic, there is a silver lining. They will learn to be more efficient. “Middle-office operations managers will have time to think about how their firms’ processes can be improved,” says Hodge. “The benefit will last long after the crisis is over.”