Not Too Big to Fail: Neil Woodford and the Legacy of a Scandal
Updated: Dec 23, 2020
MATTHEW FEARGRIEVE explains how the failure of a GBP10 billion "regulated" investment fund reveals how shockingly unprotected retail investors are from rogue investment managers.
THIS TIME LAST YEAR a municipal authority in the United Kingdom found itself in the bitter throes of buyer's remorse. Kent County Council had committed GBP263m of its pension fund's money to an investment fund called Woodford Equity Income Fund ("WEIF"). WEIF was a sub-fund of a United Kingdom investment company calling itself LF Woodford Investment Fund. The company and its sub-fund were regulated by the European UCITS scheme, arguably the world's most highly regulated retail investment protection regime.
Yet in June 2019, Kent County Council's chief investment officer was deriving little comfort from WEIF's status as a UCITS fund. This pension fund, like other institutional investors in WEIF, had been spooked by revelations of illiquid positions in this supposedly "liquid" fund. And, just like those other investors, Kent intended to make a dash for the exit, by submitting a request to redeem the whole of its multi-million pound investment from the fund.
A request of this kind was entirely legitimate. The constitution of WEIF permitted investors to redeem their investments at any time. This liquidity is indeed an integral aspect of the protections afforded investors by the UCITS regulatory regime. There was just one problem. After a series of increasingly panicky calls to WEIF's management, and then to its administrator, Kent's C-suite found that its redemption request had been blocked. Its GBP263m was trapped inside WEIF. Unlike other institutional investors, which had made it through the exit, Kent found itself locked inside.
FAST FORWARD one year, and Kent County Council, like many other investors large and small, remains trapped inside WEIF, which is now in liquidation and slowly distributing heavily discounted assets. Insider intelligence suggests that Kent has lost "at least" GBP120m on its GBP263m investment. So what went wrong? It's time to introduce Mr. Neil Woodford.
From Hero to Zero: Neil Woodford
After blocking investor's redemption requests in June 2019, WEIF was placed into liquidation in October 2019. The fund had been managed since its 2014 inception by Neil Woodford, an investment manager widely credited with “star” status following a successful career in the City. At its peak, WEIF had around £10 billion of assets under management.
WEIF was structured as an Undertaking for the Collective Investment in Transferable Securities (UCITS), a retail-friendly, regulated European investment product that is open-ended and strictly required by the regulatory regime to permit investors daily liquidity. Note those two words: daily liquidity. They would come to haunt Woodford and his investors. The regulatory regime permits managers of UCITs to place long-only bets on liquid stocks. But Woodford’s investors were soon in for a surprise. Within two years’ of WEIF’s launch in 2014, it was apparent that the fund’s portfolio comprised substantial allocations to mid-cap stocks with high yields, small caps and significant positions in unlisted — illiquid — companies. When these companies, in which WEIF had questionably large positions, issued profit warnings, his investors started asking questions. Their confidence in him started to wane; and they began to submit requests to redeem their holdings in the fund.
In order to meet redemption requests, the fund’s most liquid holdings were disposed of. But as the redemption requests continued to flow in, Woodford was left with no alternative but to try to dispose of the fund’s illiquid assets. And this proved difficult, precisely because of their illiquidity. As the liquid assets were disposed of, so the illiquid assets became an ever-bigger component of WEIF’s portfolio. This, in turn, caused the fund to breach the value limits that the UCITS regime places on illiquid portfolio investments. Which in turn spooked investors further, who continued to redeem out of the fund. Around this time (May 2019), the senior executives at Kent County Council were starting to sense the growing panic. But they would begin their dash for the exit a little too late.
WEIF Suspension & Liquidation
Woodford was trapped in a vicious cycle, the stuff of nightmares for any fund manager, though one entirely of his own making. The vortex was temporarily contained in June 2019, when redemptions in WEIF were suspended. This meant that investors were effectively trapped inside the fund, unable to withdraw their investments. After considerable mainstream and social media outcry, expressed by investors and industry commentators alike, WEIF’s administrator and corporate director decided in October 2019 to remove Woodford as the manager, and wind-down the fund with the assistance of two investment advisers appointed for the purpose.
Liquidity Structure of WEIF
WEIF was a UCITS established in the UK, and was subject to regulatory oversight by the FCA, the UK’s financial regulator. UCITS are European investment products designed to be suitable for retail investors, offering “daily liquidity”, meaning that investors may withdraw their investment on any business day. So why were investors in WEIF unable to redeem out of the fund, and why did the FCA permit this state of affairs? Investors wishing to redeem out of WEIF found themselves faced with two problems, one of Woodford’s making, the other a component of being invested in a collective investment vehicle:
1. Woodford’s investment decisions led the fund’s portfolio to be dangerously misbalanced, with a preponderance of illiquid positions, ie small-cap, unlisted companies. Because the shares in these companies were unlisted, there was no objective valuation for them, and there was no market available to Woodford on which to sell the shares. He needed a willing buyer. And because these companies were issuing profit warnings, and found themselves in other difficulties, no buyer was forthcoming. In short, Woodford was stuck with these investments. And because he was unable to dispose of them, he was unable to raise funds to honour the redemption requests being submitted by worried investors in WEIF.
2. All investment funds like UCITS issue investors with a prospectus. Legally, the prospectus is essentially a contract between investors and the fund; commercially, the reality is that the investors have a contract with the fund’s manager. The terms of these contracts permit the fund to suspend redemption requests — in other words, to stop honouring redemption requests — in prescribed circumstances. This provision always — always — favours the manager, not the investors. A standard catch-all is that the fund may suspend redemptions “when it is in the investors’ best interests to do so”. This gives the fund’s management considerable discretion to lock investor monies into the fund.
You can watch our explanatory video to find out more about suspending redemptions by clicking here.
Both of these dynamics came to bear on Woodford’s investors. WEIF suspended redemptions in June 2019 because of the panic surrounding the fund, the loss of confidence in its manager and the ensuing fire-sale of assets that was ongoing as a result of the pressure to pay withdrawing investors. They were locked in because curtailing redemptions removed the pressure on Woodford to sell portfolio assets, meaning (in theory at least) that he could take more time and realise a better price for them: and so the suspension was “in the investors’ best interests”.
So, as unfortunate as the suspension was for WEIF investors trying to exit, it was (on the face of it) imposed in a proper way. The liquidity of the fund’s portfolio, however, which originally caused investors to head for the exit, was far from proper. Woodford was subject to strict UCITS rules requiring him to keep a fixed percentage of the portfolio invested in liquid positions capable of being sold in order to provide investors with daily liquidity: ie., they must be able to redeem their investments in the UCITS on any business day. Woodford invested in excess of this value limitation in stocks which he knew to be illiquid. By the time the FCA, the overseeing regulator, came alive to these breaches, it was too late: the outflows from WEIF had already reached terminal velocity, and Woodford was unable to sell the illiquid holdings quickly enough.
Gating versus Suspending
What is significant about the percentage value of the WEIF portfolio that was illegally invested in illiquid positions, and the extent of the intrinsic illiquidity of those positions, is that Woodford did not gate the fund as a preliminary measure. A “gate” can be imposed by a manager on the aggregate value of redemption requests received on any day, and is strictly temporary measure.
You can learn more about gates and gating in our explanatory video by clicking here.
A daily gate up to the regulatory maximum of 10% of the value of redemption requests would have bought Woodford some time and space to liquidate illiquid investments and maintain some control over outflows from WEIF. But no such interim step was taken, suggesting that Woodford was already under huge pressure from WEIF’s largest investors (including Jupiter Asset Management, which had £1 billion invested in the fund, as well as Kent County Council) and was forced immediately to suspend redemptions completely.
ONE YEAR ON and the liquidator of WEIF has reportedly been able to liquidate and distribute to investors around £2.3 billion, with around £558m remaining in the portfolio at the end of May 2020. As the liquidator struggles to find buyers for illiquid positions in COVID19 market conditions, it has warned that WEIF's net aset value stands at £444.2m; more than £100m less than investors were led to believe they would have returned to them. The liquidator has indicated that an update will be circulated to WEIF investors at the end of July 2020.
The misery of Kent County Council, and hundreds of other investors large and small, is not over yet.
Written by MATTHEW FEARGRIEVE, investment management consultant. You can read more about Matthew, and his investment blogs, by clicking his photo below.