The last financial markets meltdown, the financial crisis of 2007-2009, has much to teach us about how to respond to market crises, such as the one we are currently experiencing during the Covid-19 pandemic. True, the causes of the two crises are very different – the financial crisis being a bubble across many market sectors combined with lax regulation, and the current crisis being the result of a pandemic that came out of nowhere and has swept the world. Whatever the case, the effect on the financial markets betrays many similar features.
Forestalling a run on the fund
Fund managers and investors alike face difficult decisions during any market downturn. Of marked importance during the financial crisis was the significance of capital preservation. In periods of severe market declines, large numbers of investors can be expected to deliver requests for full or partial withdrawals of their capital. During the financial crisis such a ‘rush for the exit’ was a common event. A response was necessary; many funds had restrictions on withdrawal drafted by their fund counsel. Liquidity-preserving provisions in the fund’s operative agreements, such as gates (a limitation on when an investor can withdraw and how much can be withdrawn during any one period), proved invaluable. Such provisions permitting the manager to fail to honor redemption requests, usually phrased as being in the exercise of the sole discretion of the manager, proved to be of vital importance in the financial crisis and are just as important during the present crisis.
For managers that pursue an illiquid strategy, of which there are many, liquidity in the markets in which they participate can just dry up, as they did during the financial crisis. What we saw during the financial crisis is that those managers without liquidity-preserving provisions found that as redemption requests poured in, liquid positions had to be liquidated in order to fund redemptions because cash could not be extracted from illiquid positions.
The reverse side of having gates and similar provisions is that there are major investor relations negatives as investors find that they are locked in. Even though gates are built into the fund’s organic documents, this does not mean that investors understood these provisions (even if the investors read the documents).
Lesson #1: build into your fund documents provisions that give the manager the discretion to limit, or even deny completely, investor withdrawal requests. This is a must for investors that have a substantial part of the fund’s assets in illiquid positions. You want to avoid at all costs telling the investors that you do not have the authority under the agreement to deny their withdrawal requests, but you are going to deny anyway because the fund is without funds to pay redemptions.
Bad news is here
During the financial crisis many financial auditors had to analyse whether the financial statements they were preparing should contain what accountants term a ‘going concern’ footnote. This footnote, which can be viewed as a ‘kiss of death’ disclosure, signifies that the accountants, who, after all, have access to the reporting company’s financial records, have serious concerns about whether the company can survive financially. The auditors must apply certain financial parameters to the reporting entity to determine whether the company will survive as an independent entity or will be forced to apply for court protection from its creditors.
For certain types of companies, such as banks, insurance companies, broker-dealers, market makers, and regulated utilities, the receipt of a going concern footnote is tantamount to a call for liquidation of the company. For fund managers, it is not likely that the manager will receive a going concern footnote, although this cannot be ruled out given the severity of the pandemic. Worrying is more likely in cases where a venture capital fund finds that an investee company is failing and that its certified financial statement will contain a going concern footnote. We expect that in the great majority of cases the venture capital fund manager will know of the investee fund’s precarious financial state well before the financial statements are issued.
Lesson #2: fund managers also need to be aware that the going concern footnote was a big problem in the financial crisis and it is likely to be so again here, if only as it’s seen to be something of an official death sentence. Managers will want to forestall inquiries about going concern criteria at the earliest opportunity by demonstrating, if possible, that this is not an issue.
Tax losses are a big problem
The financial crisis caused massive tax losses for fund managers and their investors. Many funds, and their managers, ceased operating because these tax losses were a big problem. Offshore funds structured as a corporation under US tax rules (e.g., a Caymans LTD company that has not elected to be a pass-through for US tax purposes) that trade or invest in securities and/or commodities are only liable to US income taxes (so long as they are not carrying on a business in the US) on dividends paid by US corporations. Capital gains and losses of such offshore funds are not taxable in the US. As a result, the huge market losses suffered by offshore funds in the financial crisis were not usable in the US tax system. Because the majority of US tax-exempt investors invest through an offshore fund, the massive losses in the financial crisis were not used.
For individual US investors, there are very substantial limitations on using tax losses. First, where a fund’s strategy is to hold shares of RICS (regulated investment companies, such as mutual funds) and REITs (real estate investment trusts), the financial crisis led to enormous losses. The losses remained in the RICs and REITs (income is passed through but not losses) and could only be accessed by the fund by selling the shares. Where the fund owns the shares directly, the fund must dispose of the shares in a taxable event in order to generate capital losses for the investors. Where, as in the financial crisis and its following years, the investor has greater capital losses than capital gains, only a pittance ($3,000) of the excess is deductible, with the rest carried forward to the next year. If the individual dies before using all of the capital losses, the capital losses vanish.
These limitations on capital losses create a problem for managers contemplating the election under Section 475(f) (gains and losses are ordinary and all trading positions marked-to-market at year-end if not sold during the year). The election has certain tax benefits (such as freedom from the wash sale rules limiting losses on positions bought and sold in a 61-day period), but it comes at a price. It is certain that the pandemic will cause many potential investors to have large capital loss carryovers. However, if a fund makes the Section 475(f) election, all of its income is ordinary and capital losses cannot offset ordinary income. As a result, the potential investor’s capital losses cannot be used in this fund. In our experience, a well-advised potential investor (or their accountant) will ask about the utilisation of capital losses.
Congress has been diligent in shutting down avenues for creating capital gains with not much market risk. Therefore, as a practical matter, capital gains will have to be generated by managers using successful strategies.
Lesson #3: what to do with capital losses is always a big problem in any major market downturn. Many participants in the hedge fund industry learned this, to their dismay, during the financial crisis. As was true then, strategies that prove to be successful generators of capital gains (we do not care whether these are short-term or long-term as long as they are large and realised so as to be used by the investors and, of course, the manager group) will be at a premium.
This article was originally published in the April 24, 2020 issue of HFM Global.
For more information contact Gregory Zoraian, Financial Services Practice Leader, at gzoraian@grassiadvisors.com or 212-223-5082.
