When mutual fund regulator Sebi announced side pocketing norms in January 2019, it was secretly hoped by fund-houses that they will never need to implement this in reality. Many top AMC professionals had brushed side pocketing norms as an over-reaction by Sebi. Some months have passed between then and now. The Indian debt mutual fund ecosystem is no longer the holy cow it used to be. Poor credit selection has dogged the debt mutual funds. Outflows in select debt fund categories have led to more harm for continuing investors. High allocation of 10-20% to single debt security issuer or group has led to hair cuts, markdowns, and write-offs – making the investor actually pay for mistakes she/he did not commit. So, why are fund-houses not implementing side pocketing? Are AMCs shying away from side pocketing due to a negative impact on the fund manager, CIO pay?
“Side Pocketing” is a mechanism to separate distressed, illiquid and hard-to-value assets from other more liquid assets in a portfolio. This prevents the distressed assets from damaging the returns generated by more liquid, better-performing assets, according to Sebi.
The side pocket is generally formed by the creation of a separate portfolio of distressed, illiquid and hard-to-value assets. Each investor is allocated his / her pro rata interest in the side-pocketed portfolio.
When recovery is made in the side-pocketed portfolio, the same is distributed amongst those investors on a pro-rata basis.
Currently, in the absence of side pocketing, in case of credit events, the existing investors potentially lose all value. Any future recovery accrues to the investors in the scheme at the time of recovery. With side pockets, the investors – who take the hit when the credit event happens – get the full upside of future recovery.
Side pockets can be created if there is a downgrade of a debt or money market instrument to ‘below investment grade’ by a Credit Rating Agency (CRA), or subsequent downgrades from ‘below investment grade’ by a CRA, or similar downgrade of loan rating by a CRA. These things have happened in reality, but side pockets have not been created.
IL&FS, NBFCs, Essel issues
Over the past many months we have seen multiple credit events happening where big companies have had problems in repaying money to mutual funds. IL&FS defaults were the first. Some other NBFCs like DHFL faced troubles. Essel Group or Zee Group too has emerged onto the scene with its peculiar situation. Unable to recover full money from Essel, fund-houses like HDFC and Kotak have actually not repaid the full money to fixed maturity plan (FMP) investors. Yes, this too has happened to FMPs, aggressively sold as bank FD alternatives! There are new stories coming out almost every other week when rating agencies downgrade yet another company.
Still, side pockets have not been created. Sebi does not force fund-houses to create segregated portfolios. Is the ‘optionality’ why fund-houses are not opting for it? In the meantime, Sebi has sent show cause notices to fund-houses on investments in troubled firms of Essel Group. So, what is the hold-up?
Negative impact on pay
Many commentators have talked about how an instance of side pocketing can disturb the sentiments. Others have talked about how many AMCs are not keen to have the “first-mover disadvantage”. The more important reason could be purely economical. Yes, side pocketing will impact the fund-houses and the money that they usually generate.
The incentive to keep a problematic debt fund on the status quo is far greater than if they create side pockets. See, it is not just about investor protection. It is a ‘mutual’ fund. The focus is on the word ‘mutual’. Fund-houses are unlikely to take a step that hurts them.
How would side pocket hurt them?
1. As per Sebi norms, AMC trustees shall ensure that there is a mechanism in place to negatively impact the performance incentives of Fund Managers, Chief Investment Officers (CIOs), etc. involved in the investment process, mirroring the existing mechanism for performance incentives of the AMC, including claw back to the side-pocketed portfolio of the scheme.
This clearly tells you who will be impacted first by side pockets. When the performance incentives of fund managers, chief investment officers (CIOs), etc. involved in the investment process, are negatively impacted, it will take a huge heart for an AMC to do this.
2. No investment and advisory fees can be charged by the AMC on the side-pocketed portfolio.
This means that the AMC does not gain much by carving out a risky portfolio. What’s in it for them? Practically, nothing.
Sebi has, however, allowed that TER (excluding the investment and advisory fees) can be charged on the side-pocketed portfolio but that will only be upon recovery, on a pro-rata basis i.e. on the recovered amount. If the money does not return, no such TER for AMCs.
3. The costs related to the recovery of the assets side pocketed may be charged to the side-pocketed portfolio upon recovery, within the maximum TER limit. The recovery cost in excess of the TER limit shall be borne by the AMC.
This again shows that if the money cannot be recovered, AMCs will get back nothing. Even their recovery costs are bound by TER limits. If they spend more to recover, they do not gain anything until and unless the money is repaid by the borrower (corporate).