Earlier this year a trading frenzy engulfed a previously little-known US video games retailer, GameStop. Small investors waged a campaign, orchestrated via social media platform Reddit’s WallStreetBets forum, to drive the price of the company’s shares up, in a bid to force hedge funds shorting the stock to close out their positions. The closing price for GameStop on 29 January was US$325. A month earlier, in the 2020 year-end valuations, it had been US$18.84.
For some first-time investors, the price surge produced significant gains, while hedge funds struggled to stem their losses. It has also produced a dilemma for the boards of investment funds, when faced with wild fluctuations.
The inherent risk in any open-ended investment fund is that it provides liquidity to investors based on the unrealised gains of investments held by the fund. There are well-established valuation rules to ensure investors are treated fairly, which are set out in the fund’s offering document. Pricing a publicly quoted security is normally a straightforward exercise that usually involves using the closing price at the end of the period that you want to strike a valuation for.
These rules are based on the meaning of fair value, which IFRS 13, Fair Value Measurement, 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 [ie an exit price].’ Other definitions refer to ‘rational market participants’ and ‘transactions freely entered into’.
However, from an investment fund accountant’s point of view, terms such as ‘orderly market’, ‘rational’ and ‘freely’ have to be examined in light of the GameStop trading patterns in January.
Going into February, there was some comfort that trading volumes for GameStop remained high, but boards of investment funds will need to assess to what extent that volume relates to forced buying in order to close out short positions because of margin calls to cover losses.
At some point the activity to cover short positions will end.
From an investment fund accountant’s point of view, terms such as ‘orderly market’, ‘rational’ and ‘freely’ have to be examined in light of the GameStop trading craze
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.
Boards of investment funds will need to assess the extent to which the 29 January price of US$325 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.
Is it fair to value GameStop at US$325 for Investors subscribing or redeeming to a fund on 29 January when it closed at US$53.50 four days later on 4 February?
It is an issue that funds that offer daily liquidity to investors may already have considered. It may not be a significant issue for many such 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 the holding breached an investment restriction.
Hedge funds, which 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’s valuation are new, there are a number of existing playbooks for dealing with them, as follows:
- Valuation at closing price
A valuation at US$325 is likely to be consistent with the offering documents. Fund boards may therefore be challenged by investors subscribing to the fund on 1 February 2021 should GameStop’s price fall significantly later on. 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.
- Valuation at last price available for an orderly market
This approach would typically involve applying a deep haircut to the valuation of GameStop. Such a reduction would involve an analysis of trading volumes and price movements to determine a point where the market was functioning normally. The consequences of this would be that fund boards may be challenged by investors redeeming from the fund on 31 January, as the valuation would be inconsistent with the rules set out in the offering documents. Most offering documents will, however, provide flexibility to allow for circumstances that require a degree of judgment.
- Exclude GameStop from the valuation and provide an in-specie transfer
Using this approach, the redemptions for the 31 January valuation would exclude the GameStop holding, and those redeeming from the fund and the investor would receive a cash payment based on the value of the other holdings and their share (on a pro rata basis) of the GameStop holding. This kicks the can down the road for a while and allows more time for the issues to be considered by the industry and regulators. It also allows time for the market to normalise without having to make changes to the fund structure. In-specie transfers (ie transferring an asset in its current form rather than a cash equivalent) 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
After 2008, side pockets (segregated accounts) 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.
Not a one-off
The GameStop frenzy was unusual, but is unlikely to be the last example of a viral trading craze. The rise of ‘free’ stockbroking platforms and the power of social media forums mean it could happen again. As a result, this topic will be the subject of discussion between fund boards, fund administrators, advisers and auditors in the weeks ahead.