This is the second article in a series by Lloyd Kavanagh and Miko Bradford about the implications of the continuing euro-crisis for different types of New Zealand businesses.
It remains a volatile time for investors into Europe. First it was Greece, Spain, Italy and Portugal, and now Cyprus is the latest eurozone nation to have required a bail-out.
Cyprus' banking crisis was triggered by the write-down of Greek government debt. In turn, part of the Cyprus bail-out plan involves a good bank/bad bank restructuring which sees deposits under EUR100,000 protected, and bad balances over that amount subject to a 60% "haircut" with 37.5% of deposits over EUR100,000 converted into Class A shares and an additional 22.5% of deposits over EUR100,000 held as a buffer for possible conversion in the future. A further 30% of deposits over EUR100,000 will be temporarily frozen as interest bearing but non withdrawable deposits. Constraints on Euro capital flows in and out of Cyprus have also been imposed.
Cyprus accepted the bail-out conditions after a parliamentary vote on 30 April 2013 that passed by two votes. Cyprus appears to be committed to remaining in the Euro, though a former Cypriot central bank president has said it would be better off leaving and rumours circulate that an exit may be considered. Meanwhile speculation continues as to whether other nations in the PIIGS group may find the austerity programmes required too much of them and seek a managed exit from the Euro.
The potential for any of these events should cause investment managers of either European funds or funds which have significant indirect exposure to Europe to look at the following areas:
- Fund structure flexibility - is it sufficiently flexible to allow the fund manager to react quickly and decisively to a significant market event – contingency planning is key.
- Underlying asset ownership and quality – do investors have a proprietary claim or merely a contractual right to underlying securities? How may the underlying investments be impacted?
- Public offer document disclosure – have the risks been adequately disclosed, in relation to increased volatility or other impacts resulting from a possible euro break up require disclosure.
These issues will be familiar to New Zealand managers from other contexts, for example, the impact of the recent global financial crisis on NZ mortgage funds and finance companies, but may not have been considered before in relation to overseas investments.
Fund structure flexibility
Issues to consider include:
- Valuation methodology – are valuation processes sufficiently flexible to respond to potential changes? This would particularly be an issue where investments change their fundamental nature, or currency. Is there a fall-back mechanism if market prices cannot be obtained? Also would the fund manager or the trustee be responsible for determining the valuation? Where managed funds have direct investments that could be affected, valuation procedures should be carefully scrutinised to ensure they are sufficiently robust.
- Changes in the nature of investments, and illiquidity – does the trust deed and the statement of investment policy and objectives (SIPO) permit continued holding of altered securities, eg equity received on a conversion of debt securities or of securities re-denominated in a different currency – or will it require immediate disposal? Do the trust deed and the SIPO permit this kind of reclassification? Has this been communicated to investors?
- Redemption obligations – following a significant market event, fund managers may face logistical and liquidity issues resulting from an increased volume of redemption requests of increased value. Fund managers should therefore consider whether the trust deed includes flexibility to use gates (which enable fund managers to restrict the amount of redemptions permitted on a specific redemption date and allow redemption requests not granted to be deferred), pay in-kind or suspend redemptions/redemption payments? – do fund managers have the ability to establish side pockets to hold illiquid assets?
- Hedging – managers may wish to hedge the currency and interest rate risks inherent in fund portfolios. Where existing derivatives contracts are in place fund managers should review existing contracts to ensure adequate protection is provided in the case of a partial or complete break up of the euro – for example, are they able to terminate the transaction due to a force majeure event – what happens if the currency in which the underlying asset is denominated changes?
- Investor consent – to the extent any changes are required to the SIPO or trust deed, fund managers should consider whether the consent of investors is required. Even if consent is not strictly required, fund managers should consider whether communication with investors is appropriate.
Asset ownership and quality
Issues to consider include:
- Custody - how the underlying investments are held may affect the outcome. Does the fund have a proprietary (ie ownership) interest in the underlying asset, or merely a contractual right to delivery against an intermediary institution such as a custodian. This distinction can be critical in the event of the insolvency of the intermediary, when a proprietary claim may give a priority over other creditors, but a contractual claim may not or may be subject to a haircut.
- Government bonds – debt issued by Governments of highly-indebted eurozone countries is more susceptible to write down or the introduction of collective action provisions because it is often issued under the governing law of the relevant government. Bank deposits may similarly be governed by local law. This may make them more vulnerable to a domestic restructuring. For example, private creditors holding Greek government debt were forced to accept lower interest rates and a more than 50 per cent write down on the face value of their assets.
- Corporate or bank bonds – Eurobonds are often issued under English or another foreign law. That may provide a degree of insulation from a domestic law restructuring. Fund managers should consider undertaking due diligence as to whether an instruments of this type invested in contain "euro" definitions, and appropriate governing law, jurisdiction and place of payment provisions. They should also consider the jurisdiction of incorporation of the issuer and any guarantors.
- European equities – a euro break up and the associated market trauma would have a clear impact on the value of European equities.
- Capital controls – these may mean that even if assets are able to be sold, it is not easy to extract the proceeds from the relevant jurisdiction.
- New Zealand and international equities (excluding Europe) – where Europe is a significant trading partner of non-European businesses, those non-European businesses may still be significantly impacted by a euro break up. Fund managers should carefully diligence the level of exposure the businesses or instruments in which they invest have to the euro generally and heavily indebted euro nations in particular.
Public offer document disclosure
It is unlawful for a registered prospectus to be distributed by an issuer in New Zealand if it is false or misleading in a material particular by reason of failing to refer, or give proper emphasis, to adverse circumstances. An investment statement must describe the nature of the returns including key factors that determine the returns. It must also include a brief description of the principal risks that a subscriber may not receive the returns described.
The key question for a fund is whether its investment strategy could be adversely affected by a full or partial break up of the euro, a sovereign ratings downgrade or the general market disruption that could result from any of those events. Volatility has almost become the norm for any fund investing in instruments or businesses tied closely to the euro or Europe (either directly in the case of European funds or indirectly through trading exposures).
In describing disclosure requirements, managers should consider:
- have any changes been made to the SIPO which warrant disclosure
- currency impacts – how would a full or partial euro break up impact investments
- credit ratings of relevant investments – how would either sovereign or corporate ratings downgrades impact the fund? Are there ratings requirements in the SIPO? What is the fund obliged to do if downgrades occur?
In considering the risks and their impact on returns, fund managers should also consider describing how any such risks are being mitigated by the fund and the fund's strategy for managing what has become inevitable volatility.
In a world where financial market volatility is the new norm yet investors seek reliable returns on their investments, fund managers should carefully consider the implications of significant market events like a full or partial euro break up for their funds. From the terms of the SIPO to the impact on asset quality and disclosure to investors, it is appropriate to reconsider the tools that could be required to manage the challenges of this new environment and how this message is communicated to investors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.