Third Avenue attracted considerable attention last week with the announcement that it would restrict withdrawals from its high-yield Focused Credit Fund. And rightly so: Any investment management company that limits investors’ access to their capital is taking a major decision with consequential implications not just for its clients, but also for its own future. The move raises questions about the fund’s investment strategy as well as market liquidity more generally, especially during periods of uncertainty and increasing market dislocations.
Extrapolating from the specifics of this case, here are nine lessons that investors and policy makers can draw at this early stage:
1. The bigger the outflows from an asset class in general, the greater the potential for accidents. High yield is particularly vulnerable to mishaps, having already experienced significant investor withdrawals and related technical damage. (This is part of the reason I had classified it among the three big unhinged asset classes, along with energy and emerging- market currencies.)
2. The scale of the accident increases significantly if individual managers within the asset class have ventured to more exotic and less liquid securities in search of returns. I don’t mean to say that it isn’t worthwhile to pursue such investments, especially when underpinned by solid credit research. It is, but in the proper context and size. Such investments can be particularly dangerous to an open-fund structure during periods of market dislocations if a significant part of the investor base acts on the belief that daily liquidity for exit is available at a decent valuation.
3. In such circumstances, the fund, already in a state of growing distress, will find it increasingly hard to generate sufficient cash. The more this becomes apparent within the fund’s close circle of counterparties and competitors, the faster the difficulties will accumulate, providing an incentive for the fund’s investors to exit even more rapidly.
4. The daily and hourly management of the fund’s liquidity becomes a huge operational challenge, and can even overwhelm sensible investment considerations. As outflows accelerate, broker-dealers step back from the fund en masse, rendering liquidity and collateral management even more complicated. Meanwhile, the incentive grows for competitors to accentuate the scarcity by pressuring the holdings, known and perceived, of the troubled fund.
5. This environment makes it virtually impossible to persuade existing investors to increase their capital allocations, let alone attract new investors. Past a certain point, the fund may feel compelled to put up gates as a way to preserve value as it attempts to liquidate in a more orderly fashion to meet what have become huge redemption requests.
6. Once those limitations on withdrawal are made public, a broader set of investors can begin to question assumptions about the inherent liquidity of the asset class. This is a particular danger these days given that investors have been over-comforted by central bank injections and the deployment of corporate cash held on balance sheets. They have fallen victim to the illusion of liquidity — or, to be more accurate, the delusion. The resulting reassessment of liquidity risks fueling a more general repricing of the asset class and can induce greater outflows.
7. Depending on how far the situation deteriorates, price overshoots can take valuations well beyond what is warranted by credit and economic fundamentals, as well as fuel contagion within the asset class. Then, investor outflows are likely to accelerate further, putting pressure on both liquid and illiquid names. And even though the turmoil can create attractive investment opportunities, fresh cash takes time to engage.
8. The greater the dislocation of the asset class, the higher the risk of spillovers to other types of investments, starting with the asset classes that share the same characteristics of credit, default and liquidity risks.
9. Broker-dealers will be less willing and able to act as stabilizers by stepping up with their own balance sheets. Both regulatory and market forces have limited their appetite for this countercyclical role. In addition, their willingness to accumulate such inventory decreases as we get closer to the close of their fiscal year (which, for many, is December).
To maintain financial stability, particularly within high yield, the hope is that Third Avenue’s problems are quickly seen as specific to that manager’s investment style and strategy rather than a reflection of the asset class as a whole. The biggest risk is that this episode rouses investors who were lulled into complacency by the belief that ample liquidity would be available to them when market consensus changed and they looked to reposition their portfolios.
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