The Woodford Equity Income Fund ("WEIF") was placed into liquidation in October 2019, after having suspended redemptions in June. The fund had been managed since its 2014 inception by Neil Woodford, an investment manager widely credited with "star" status following a successful career in the City. Fast-forward five years and Woodford's funds are in wind-down, Woodford is removed as the manager, and his reputation is in ruins. This, the first part of a two-part blog, offers some reflections on this saga, and its implications for the future of UCITs for investors. 

From Hero to Zero. WEIF was structured as a UCITs, a retail-friendly, regulated product that is open-ended and strictly required by the regulatory regime to permit investors daily liquidity. Note those two words: daily liquidity. They would come to haunt Woodford and his investors. The regulatory regime permits managers of UCITs to place long-only bets on liquid stocks. But Woodford's investors were soon in for a surprise. Within two years' of WEIF's launch in 2014, it was apparent that the fund's portfolio comprised substantial allocations to mid-cap stocks with high yields, small caps and significant positions in unlisted - illiquid - companies.

In its first two years of trading, WEIF enjoyed a fair market tailwind, delivering performance that bettered the FTSE All-Share index. By May 2017, WEIF's AuM (assets under management) had a value in excess of £10 billion. Then, things started to change. Companies in which WEIF had questionably large positions issued well-publicized profit warnings. Investor confidence in Woodford's investment decisions started to wane; and investors submitted requests to redeem their holdings in the fund, which they were perfectly entitled to do. As WEIF experienced outflows of investor money, and this turned the fund's exposure to small caps and unlisted, illiquid stocks into a real problem. In order to meet redemption requests, the fund's most liquid holdings were disposed of. But as the redemption requests continued to flow in, Woodford was left with no alternative but to try to dispose of the fund's illiquid assets. And this proved difficult, precisely because of their illiquidity. As the liquid assets were disposed of, so the illiquid assets became an ever-bigger component of WEIF's portfolio. This, in turn, caused the fund to breach the value limits that the UCITs regime places on illiquid portfolio investments. Which in turn spooked investors further, who continued to redeem out of the fund.

Woodford was trapped in a vicious cycle, the stuff of nightmares for any fund manager. The vortex was contained in June 2019, when redemptions in WEIF were suspended. This meant that investors were effectively trapped inside the fund, unable to withdraw their investments. After considerable mainstream and social media outcry, expressed by investors and industry commentators alike, WEIF's administrator and corporate director decided in October 2019 to remove Woodford as the manager, and wind-down the fund with the assistance of two investment advisers appointed for the purpose. As at the time of writing (October 2019) those investors who failed to exit prior to the redemption suspension imposed in June remain trapped in the fund, with an exit date of January 2020 being indicated by the administrator.

The Role of the Regulator.  WEIF is a UCITs established in the UK, and is subject to regulatory oversight by the FCA. UCITs are investment products designed to be suitable for retail investors, offering "daily liquidity", meaning that investors may withdraw their investment on any business day. So why were investors in WEIF unable to redeem out of the fund, and why did the FCA permit this state of affairs? Investors wishing to redeem out of WEIF found themselves faced with two problems, one of Woodford's making, the other an unfortunate feature of being invested in an investment fund:

1. Woodford's investment decisions led the fund's portfolio to be dangerously misbalanced, with a preponderance of illiquid positions, ie small-cap, unlisted companies. Because the shares in these companies were unlisted, there was no objective valuation for them, and there was no market available to Woodford on which to sell the shares. He needs a willing buyer. And because these companies were issuing profit warnings, and found themselves in other difficulties, no buyer was forthcoming. In short, Woodford was stuck with these investments. And because he was unable to dispose of them, he was unable to raise funds to honour the redemption requests being submitted by worried investors in WEIF.

2. All investment funds like UCITs issue investors with a prospectus. Legally, the prospectus is essentially a contract between investors and the fund; commercially, the reality is that the investors have a contract with the fund's manager. The terms of these contracts permit the fund to suspend redemption requests - in other words, to stop honoring redemption requests - in prescribed circumstances. This provision always - always - favors the manager, not the investors. A standard catch-all is that the fund may suspend redemptions "when it is in the investors' best interests to do so".   

Both of these dynamics came to bear on Woodford's investors. WEIF suspended redemptions in June 2019 because of the panic surrounding the fund, the loss of confidence in its manager and the sell-off of assets (the "fire sale") that was ongoing as a result of the pressure to pay withdrawing investors. They were locked in because curtailing redemptions removed the pressure on Woodford to sell portfolio assets, meaning (in theory at least) that he could take more time and realise a better price for them: and so the suspension was "in the investors' best interests".

So, as unfortunate as the suspension was for WEIF investors trying to exit, was (on the face of it) imposed in a proper way. The liquidity of the fund's portfolio, however, which originally caused investors to head for the exit, was far from proper. Woodford, as manager of a UCITs product like WEIF, was subject to strict legal and regulatory rules that required him to keep a fixed percentage of the portfolio's value liquid, ie, invested in liquid positions capable of being sold in order to honour the central rule of UCITs that they must permit investors with daily liquidity: investors must be able to redeem their investments on any business day. Woodford invested in excess of this value limitation in stocks which he knew to be illiquid - small-cap, unlisted companies. The FCA, as the overseeing regulator, did not detect these breaches. By the time the breaches were detected, the outflows from WEIF were already reaching terminal velocity. The regulator came onto the scene too late to protect Woodford's investors.

Join us for the second part of this blog, in which we consider the role of the FCA in the Woodford saga, as well as the possible lessons that can be learned from it.

ABOUT THE AUTHOR

Matthew Feargrieve is an investment funds lawyer with more than twenty years' experience of advising managers of investment funds operating in the leading jurisdictions of the United Kingdom,  Luxembourg, Ireland, and the Cayman Islands.

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