The Securities and Exchange Board of India (Sebi) has allowed mutual funds to segregate distressed, illiquid debt and money market instruments in the portfolio arising out of a credit event. This practice, commonly known as creating a side pocket, involves transferring the identified asset into a separate portfolio to limit the impact on the main portfolio.
When the segregation is done, the fund is effectively divided into a standard portfolio consisting of liquid investments and a side pocket housing distressed assets. Investors in the scheme at the time of the segregation will be allotted units in the side pocket. The usual rules for purchase and redemption will apply to existing investors in the main portfolio or fund.
New investors who buy into the main fund will have no participating interest in the side pocket. Typically, the side pocket is like a closed-end fund that prohibits any further participation or redemption. Investors who have been allotted units can exit only when the investments are realised or become liquid and can be sold at a fair value in the market.
The need for side pockets
The recent credit scare related to debt fund investments in IL&FS group of companies and its subsidiaries brought to the forefront the need for a mechanism to deal with situations when a fear of deteriorating asset quality triggers large-scale redemption, typically from institutional and other large investors. In such situations, the liquid assets are sold to meet redemption requests and the investors staying on in the fund or who do not redeem their investments early are left holding a portfolio of increasingly illiquid and stressed investments. Typically, these are retail investors.
According to R. Sivakumar, head, fixed income, Axis Asset Management Pvt. Ltd, “Creating a side pocket can help in reducing panic redemptions like what we saw recently. Conceptually, it works to halt a systemic spread in liquidity pressure due to default in one security. However, we will have to wait for detailed guidelines on how this will work in practice.” When a side pocket is created, the illiquid asset is removed from the main portfolio and what remains is a standard, liquid portfolio. There is equitable sharing of risk because all the investors at the time of the event will participate proportionately in the liquid and illiquid assets.
What is in it for investors
Fund managers see the provision to create side pockets as a positive development. “This is an enabler. With slightly less than $20 billion in credit funds, events of downgrades and defaults will be seen. This provision will help in being better equipped to manage the fallout from such an event risk,” said Lakshmi Iyer, head, fixed income, Kotak Asset Management Co. Ltd.
Retail investors will benefit because the risk of holding units in a portfolio that has diminished in credit quality and liquidity as larger investors exit will get reduced. To be effective, the segregation should be done before any class of investor redeems in bulk in response to an anticipated credit event. Purchases and redemption into the standard portfolio will happen normally. They will also participate in any gains subsequently made in the segregated portfolio. The side pockets preserve potential value for investors if the asset becomes good and starts paying its dues. The drawback is that the holdings in the side-pocketed asset will be locked in till such time the assets are realised or become standard again.
New investors can purchase units in the main fund at the current NAV. There will be no participation in the side pocket. This means that the pool of investors in the main fund and the side pocket will be different as new investors buy into the main fund and existing investors redeem their holdings.
The need for safeguards
The detailed guidelines are awaited on how side pockets will be operationalised. And there are certain concerns that the regulations must address.
According to Jimmy Patel, chief executive officer, Quantum Asset Management Co. Ltd, “It will help investors in case of a default event. However, the concern is that a fund manager can now take aggressive credit positions in debt securities to earn that extra yield without adequate thought to the risk analysis. Side pocketing gives this type of risk-taking a legal way out.”
The conditions under which assets can be segregated should be clearly laid out. Sebi requires that the approval of the trustees be obtained for activating the side pockets. There should also be guidelines for valuation of the assets that are transferred, distribution of any income or gains on these assets and withdrawal by investors. It should not become a means to boost performance in the parent fund. The frequency of using this facility should be controlled and there should be consequences for using it. This may be in the form of low or no fees to be charged on side-pocketed assets and rules to ensure that side-pocketing is not overlooked while evaluating the fund manager’s performance, and others. Sebi’s norms make it optional for fund managers to use side pockets. Once the detailed guidelines are out it would give greater clarity on what the implications are for fund managers to resort to side pockets. Watch this space for updates.