Long Only Diligence: It's Listed....Just Not Traded (Woodford Case Study #2)

Our second Woodford case study focuses on UCITS rules around holdings of unquoted securities in (daily liquidity) fund portfolios. UCITS rules limit funds to a maximum of 10% of the portfolio in unquoted securities, given that unquoted / private positions are likely hard to price and potentially highly illiquid. As we noted in our last blog, investors in regulated mutual funds, whether UCITS, OEICs, 40 Act Funds, Registered Unit Trusts or other public funds generally expect “someone” - a gatekeeper - to protect their interests. In this blog we will focus on the parallel expectation that funds will follow the "rules" - and that the "rules" are worth the paper they're written on.

Woodford's LF Woodford Equity Income Fund (the "Fund") faced two issues. First, the asset manager appeared to like unquoted positions, presumably reflecting an investment view that early stage, private / venture investments could generate significant excess returns. As a result, the Fund made investments in several unquoted companies.

Second, as investors began to redeem from the Fund due to poor performance, assets began to fall. As is often the case, the Fund faced a liquidity challenge - it is easier to sell quoted, liquid assets first to raise cash to pay (daily) redemptions. This just means that the pool of illiquid assets become a larger percentage of the remaining assets, exacerbating a potentially serious liquidity mismatch.

Due diligence recap

The key legal and compliance matters which would be uncovered from introductory due diligence on the Fund were as follows:

• The Fund was issued under the UCITS directive
• A cap of 10% of the Fund NAV in unquoted stock was included in the Prospectus
• The Channel Islands Stock Exchange ("TISE") was an “eligible exchange” under the Prospectus (under its former name The Channel Islands Stock Exchange)
• The Authorized Corporate Director ("ACD"), Link Fund Solutions Limited ("Link") was responsible for compliance with the Prospectus and the valuation of Fund securities. This would include valuation of any private, illiquid holdings.
• AIM quoted securities; unquoted securities; delisted securities; securities quoted on the TISE; and securities quoted on the TISE where "dealing is currently suspended" are identified in the Fund's financial statements (our next blog will focus on Fund financial statement presentation and footnote disclosure in more detail).

Listing on the The International Stock Exchange ("TISE")

1. On December 27, 2017, the Fund listed 5 series of Sabina Estates Preference Shares on the TISE. Sabina is in process of developing real estate on the island of Ibiza. As noted in our prior blog, the sponsor of these listings was Belasko Corporate Finance Limited, which appears (per the Times newspaper) to be linked through minority ownership to Anton Bilton, who is also involved in Sabina (and is also associated with Raven Property, another significant Woodford investment held in the Fund.)
2. On June 15, 2018 the Fund listed 5 series of preference shares in Ombu, which is an investment company focused on early stage environmental technology companies.
3. On October 10, 2018 the Fund listed series of preference shares in IH Holdings - or Industrial Heat -which, per the FT, is working to develop nuclear cold fusion technology. Citywire also commented that, just before the listing in September, Woodford marked up its holding in Industrial Heat by 357%.
4. Finally, the Fund's holdings in Benevolent AI were listed in March 2019. This excellent article from the FT discusses the business prospects and valuation for this portfolio company.

At the end of March, following the Benevolent AI listing, Citywire commented:

"The listings, amounting to a combined £425 million, or 9% of his portfolio, have enabled Woodford to keep below the Financial Conduct Authority’s 10% limit on the amount of unquoted company stocks a fund can hold. Without them, his equity income fund’s unquoted exposure would stand at over 16%."

Hmm. What's more:

• The TISE listing rules appear to have had an exemption for Preference Shares in that those companies listing preference shares (not common equity) didn’t have to disclose trading activity. This allowed companies to have the benefits of “listing” - including making them technically eligible investments for UCITS funds - without any transparency into trading, or the lack of it.
• By listing preference shares, rules that require at least 25% of a company's equity to be listed (put into the float) - a rule which applies on the London Stock Exchange - did not apply.
• As noted in our prior blog, Citywire represents that none of the four "listed" stocks actually had any trading activity at all.
• Woodford held interests in the four listed companies not only through the Fund, but also through other vehicles - notably the listed Woodford Patient Capital investment trust and the Omnis Income and Growth Fund. However, only the investments owned by the Fund - and not the pro rata holdings in the same shares held through other Woodford funds - were listed in Guernsey. In other words, the Guernsey listings were used just to transfer assets held by the Fund, which are only a sub set of Woodford's aggregate holdings.

To put this into perspective, the FT reports that "flawed rules contributed to Woodford fund meltdown, says FCA". Per this article:

The meltdown at Neil Woodford’s flagship equity fund, which froze £3.7bn of investor money this month, was fuelled by “flawed” EU rules that may need to be jettisoned after Brexit, the head of the main UK financial regulator said on Tuesday.

Andrew Bailey, chief executive of the Financial Conduct Authority, denied the episode stemmed from supervisory failures and instead said Mr Woodford’s Equity Income Fund was using “to the full” an “excessively rules-based” EU regime that caps at 10 per cent the proportion of unlisted assets a fund can hold.

The one time star stockpicker’s fund listed on Guernsey’s stock exchange previously unlisted assets in an attempt to keep within the EU rules, known as UCITS. Mr Bailey told the Commons Treasury select committee that this manoeuvre — which the FCA was not alerted to in advance — was “regulatory arbitrage” and “sailing close to the wind”.

“Listing something on an exchange where trading does not actually happen, as far as I can see, does not actually count as liquidity,” he added.

Mr Bailey said Mr Woodford’s fund was just one of two in the UK that had breached the cap on unlisted assets in the past year, out of a cohort of 3,000. The second was a small fund."

And who says you don't need to do due diligence on long only vehicles!

Transfer of assets between fund vehicles

As a separate issue, transfer of portfolio securities from one fund to another is a clear diligence red flag, especially when dealing with illiquid, hard to value securities where fair value may be difficult to determine. (Sell the stock at too high a price and the selling fund benefits to the detriment of the purchasing fund; a too "conservative" value, however, harms the investors in the selling fund who do not receive fair value).

The December 31, 2018 Fund financial statements include a subsequent events note:

"Subsequent to the year end, on 6 March 2019, the Fund acquired 81,639,238 ordinary shares in Woodford Patient Capital Trust at a price of 96.67 pence per share, for a total value of £78,920,651. Payment for 75,432,424 of the ordinary shares was made by way of exchange of a portfolio of unquoted assets (Atom Bank; Carrick; Cell Medica; Ratesetter; and Spin Memory) and 6,206,814 ordinary shares for cash. This transaction is the start of a strategy to switch the Fund’s unquoted exposure from individual unquoted holdings to shares in Woodford Patient Capital Trust."

This transfer recategorizes (under UCITS rules) the Fund's holdings from illiquid stocks into a liquid investment trust. However - obviously - the question of liquidity and valuation is simply transferred to a separate fund entity. The aftermath of the transfer is discussed in this article from the London Evening Standard.

Indeed.

Due Diligence lessons

Cases such as Woodford are the catalyst for investors to become increasingly mindful of diligence issues in respect of long only portfolios. Irrespective of asset class, investors should:

• Ensure long only funds and their related asset managers are subject to thorough and independent diligence
• Conduct ODD checks on service providers (including Reputational Diligence searches for Trustees / ACDs / Directors)
• Review the Prospectus
• Review the fund Financial Statements thoroughly
• Obtain a copy of the Valuation Policy and check it thoroughly
• Carefully consider asset transfer to affiliated funds and the valuation of those transfers (for example, have transfers been subject to independent review and pricing?)
• Set up a daily media feeds to monitor breaking stories across investment managers and, indeed, material underlying portfolio companies.

In part 3 of this Blog we will look further at the LF Woodford Equity Income Fund's Financial Statements. What diligence information can come from a review of the accounts, even when dealing with a long only fund?