The Securities and Exchange Board of India (SEBI) has approved the proposal to create a ‘side pocket’ for mutual funds. This feature will be exclusive to debt mutual funds. Let us look at what the new feature is and how it will work:
What is a Side Pocket?
A ‘side pocket’ allows fund managers to segregate illiquid and distressed assets from other relatively liquid assets in a fund portfolio. Illiquid assets may include investments in stocks that are scarcely traded, delisted stocks of companies, over-the-counter stocks, among others.
In terms of mutual funds, a side pocket would mean creating a separate portfolio for illiquid, risky or stressed securities so that they do not affect other liquid assets in case of a credit event. A credit event is a sudden, usually negative, change in a borrower’s capacity to pay its loan obligations. Instances of a credit event are bankruptcy, debt restructuring and default of payments.
Two Separate NAVs
Side-pocketing enables the mutual fund scheme to split the NAV into two parts. One NAV is for the liquid assets of the scheme and the other is for the illiquid ones. The latter does not have an affect on the liquidity and value of the former. Doing so ensures that if a security is downgraded to ‘junk’ or ‘default’ status, the drop in NAV would not affect the entire scheme.
ABC Liquid Fund has assets under management of Rs. 1 crore as of November 2018. On December 10, 2018, ICRA downgrades the rating for XYZ bonds to ‘junk’. The liquid fund has investments of Rs. 10 lakh in these XYZ bonds and decides to create a side-pocket. Doing so would result in the scheme having two NAVs: one with AUM of Rs. 90 lakhs and the other with Rs. 10 lakhs. Investors would not be allowed to invest in or redeem units from the Rs. 10 lakh corpus but can do so from the Rs. 90 lakh corpus. The two NAVs will be tracked separately. Investors can redeem from the Rs. 10 lakh corpus in XYZ bonds once the fund house is able to sell these bonds.
Side Pocket Closed for Subscription
Once a side pocket is created, it is cordoned off and closed for subscription and redemption. Investors can, however, continue to invest or redeem their investments in the healthy bits of the schemes. In case the fund house receives any money from the side-pocketed funds in the future, it would pay back the unitholders.
Side-pocketing also has a bright side to it for the fund house. When a borrower’s rating is downgraded, investors want to redeem their units and that puts the fund house under pressure. Segregating risky securities would thus protect the fund house from this and help in better fund management. Fund houses do not have to close the entire fund for redemption, just the negatively affected part of the fund.
SEBI’s Approval for Side-Pocketing
This week, SEBI allowed debt mutual fund schemes in India to create side pockets for stressed assets. SEBI’s decision comes following the multiple payment defaults at IL&FS that triggered credit events and particularly impacted liquid fund schemes in a significant way earlier this year.
This was not the first time SEBI got a proposal for creation of a side pocket. In 2016, SEBI rejected the proposal, saying that it would encourage fund managers to take unnecessary risks.
JP Morgan Asset Management (India) – Amtek Auto: An Indian side-pocketing example
In 2015, credit rating agencies in India downgraded Amtek Auto Limited bonds, which resulted in the bonds becoming illiquid. Two schemes by JPMorgan Asset Management (India) had invested in Amtek bonds and their NAVs were severely impacted. Back in 2015, there was no provision for side-pocketing and the fund managers went ahead and created a side pocket after getting approvals from unitholders. This resulted in limiting redemptions after the downgrade of Amtek bonds.