How to value GameStop – the dilemma facing Boards of Investment Funds…
The inherent risk in any open-ended Investment Fund is that it provides liquidity to Investors based on the unrealized gains and losses from Investments held by the fund.
There are well established valuation rules to ensure fair treatment of Investors.
The rules on how different types of Investments are to be valued for each fund are set out in the Fund’s Offering document. Pricing a publicly quoted security is normally straight forward, you would usually use the closing price at the end of the period that you want to strike a valuation for.
These rule are based on the meaning of fair value which International Financial Reporting Standard 13 (IFRS 13) defines as:
“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price).”
Other fair value definitions talk about “rational market participants” and “transactions freely entered into”.
“Orderly Market”, “Rational” and “Freely” have to be examined in light of the GameStop trading patterns in January.
There may be some comfort that trading volumes for GameStop have remained high into February, but Boards of Investment Funds will need to assess to what extent this relates to forced buying to close out Short positions because of margin calls to cover losses. At some point the activity to cover short positions will end.
Fund Elements helps Investment Funds document their Operating Model in an App that is secure and easy to access.
This includes the processes and controls to implement and consistent apply your Pricing and Valuation Policy. The App includes context based chat to allow quick escalation of issues from your Operations Teams to the Board of the Investment Fund.
In early February, Investment Fund Boards will have to consider if any rational investor would be prepared to buy GameStop at the January month end mark, given the underlying fundamentals of the business.
Background – the GameStop Valuation Dilemma
The closing price for GameStop on 29th January was US$325.00. A month earlier, for the 2020-year end valuations, it was US$18.84.
Boards of Investment Funds will need to assess the extent to which this price of US$325.00 is appropriate for the January Net Asset Value (NAV). They will need to consider whether a false market existed in GameStop (and other securities) during January.
It is an issue that funds such as UCITS, who offer daily liquidity to Investors, may already have considered. It may not be a significant issue for many of these funds as they tend to be well diversified and any holding would be small relative to the size of the fund. The Fund’s Depositary may have already flagged the issue if the increased valuation of a GameStop holding breached an Investment restriction.
Hedge Funds, which mainly provide monthly liquidity, tend to be more concentrated. They will have to consider a number of important issues for the first time. While the issues about GameStop valuation are new, there are a number of existing playbooks for dealing with them.
Valuation at Closing Price
A valuation at US$325.00 is likely to be consistent with the Offering documents.
The consequences are that Fund Boards may be challenged by Investors subscribing to the fund on the 1st February 2021, should GameStop’s price fall significantly later in February.
They may also face challenge from long term Investors who continue to hold their investments about whether it is appropriate to use the closing price as a basis for fund liquidity for redemptions in January.
Valuation at last price available for an Orderly Market
This might involve applying a deep haircut to the valuation of GameStop
It would involve an analysis of trading volumes and price movements to determine a point where the market was functioning normally.
The consequences are that Fund Boards may be challenged by Investors redeeming from the fund on 31st January, as the valuation is inconsistent with the rules set out in the Offering Documents.
Most Offering documents will however provide flexibility to allow for these types of circumstances that require a degree of judgement.
Exclude GameStop from the Valuation and provide an in-species transfer
The redemptions for the 31st January valuation would include the GameStop holding and those redeeming from the fund would receive a cash payment based on the value of the other holdings excluding GameStop and on a pro-rata basis their share of the GameStop holding.
This kicks the can down the road for another month and allows more time for the issues to be considered by the Industry and Regulators. It also allows time for the market to normalize without having to make changes to the fund structure.
In-species transfers are typically provided for in the Fund’s Offering documents.
There will be an Operational overhead which can be assessed based on the volume of redemptions for the January month end.
It is a short-term fix that should be fair to all investors.
Transfer the GameStop holding to a Side Pocket
Post 2008, side pockets were used for illiquid holdings and are an effective way to ensure liquidity in the main fund without having to deal with the issues of valuing illiquid securities.
If the issues relating to GameStop persist or become relevant for other holdings this may represent a longer-term solution. The main downside is it would require structural change to the fund.
No doubt this topic will be the subject of discussion between Fund Boards, Fund Administrators, Legal Advisers and Auditors in the weeks ahead.