On 16 May 2022, the European Securities and Markets Authority (ESMA) issued a statement on the implications of Russia’s invasion of Ukraine on investment fund portfolios.
In the statement ESMA recalls some general principles that can be derived from EU law that are of relevance to the management of the impact of the Russian invasion of Ukraine on investment fund portfolios. This includes appropriate actions to deal with valuation issues in case of exposures to Russian, Belarusian and Ukrainian assets, including where the use of liquidity management tools (LMTs), specifically side pockets, may be warranted. The ESMA is conscious of the fact that the use of LMTs is not yet fully harmonised in EU law and still largely subject to national law. The ESMA also notes that the asset valuation and fund accounting rules are not harmonised in EU law and are also largely subject to national law.
Among other things the statement provides that:
- As a general principle, fund managers of investment funds with exposures to assets facing liquidity issues need to assess whether a fair value of these assets can still be determined and adapt the valuation without undue delay.
- Where fund managers of investment funds with material exposures to assets facing liquidity issues reach the conclusion that a fair value can no longer be determined, or that the subscription or redemption of shares or units at the current market price is not in the best interest of investors, consideration should be given to suspending temporarily both subscriptions and redemptions as an immediate measure aimed at mitigating the risks of dilution or arbitrage by incoming and outgoing investors.
- In the context of the Russian invasion of Ukraine, and in light of the material liquidity and related valuation issues, managers may consider whether other measures in some cases are preferable from an investor protection perspective compared to a prolonged temporary suspension that would not allow existing investors to access liquidity. These measures may include the total write off of the relevant assets, the liquidation of the fund or the segregation of the assets that have become illiquid or non-tradable. The solution to be chosen depends on a case-by-case assessment that takes into account: (i) the possible value that could be recovered, (ii) the amount of affected assets and their weight in the total portfolio, (iii) the cost of each measure and (iv) the tools available according to EU and national law.
- Side pockets may, in some, cases be preferable from an investor protection perspective compared to a temporary suspension that would not allow existing investors to access liquidity.
- Side pockets are recognised and explicitly referred to in the Alternative Investment Fund Managers Directive (AIFMD) framework. Without prejudice to any possible additional or restrictive measures stemming from national law or the constitutional documents of the fund, authorised alternative investment fund managers (AIFMs) may consider using side pockets where this is in the best interest of investors. The same considerations should, in principle, apply to other AIFs such as EuVECA and EuSEF managed by registered EuVECA and EuSEF managers, although the ESMA notes that this should be less relevant in practice given the closed-ended nature of these funds.
- Whilst the UCITS framework does not make reference to side pockets and without prejudice to national law, the ESMA views side pockets as permissible where the liquid and illiquid assets are segregated by way of transferring the liquid assets to a new UCITS or to a new compartment of the initial UCITS. However, the use of the side pocket arrangement should be in the best interest of investors and cannot result in a transformation of the UCITS into a non-UCITS in contravention of Article 1(5) of the UCITS Directive.
- It remains under the responsibility of the fund manager to perform a comprehensive analysis to ascertain, whether and which of the permissible side pocket arrangements could be implemented in the relevant case and under what circumstances and conditions.