Funds begin parking sanction-hit Russian assets in 'side pockets'

© Reuters. FILE PHOTO: Skyscrapers in The City of London financial district are seen in London, Britain, September 14, 2020. REUTERS/Hannah McKay/

By Carolyn Cohn and Huw Jones

LONDON (Reuters) - Some of the world's biggest money managers are talking to investors and regulators about stripping Russian assets from their funds, helping them unlock billions of dollars of investments which became illiquid due to the war in Ukraine.

So-called "side pockets", used by hedge funds in the global financial crisis, but previously not allowed for mainstream European funds, separate out illiquid often risky assets so main funds can trade freely and attract new investors who would not share in any gains or losses from those assets.

Schroders (LON:SDR) last month set up side pockets for Russian assets in its Luxembourg-domiciled emerging Europe fund, which has total assets of more than 200 million euros ($207 million), the company said.

Austria's Erste told Reuters it was considering a similar move for Russian assets in its suspended emerging Europe fund.

PIMCO, one of the world's biggest credit asset managers, said it too was seeking permission to have side pockets as a future option for some of its funds.

Until a few months ago, mainstream funds sold to retail investors known as UCITS or 'undertakings for the collective investment in transferable securities' funds were not allowed to create side pockets.

Regulators have historically taken the view that writing off assets from the outset would be better value for investors than charging additional fees to create a side pocket.

However, watchdogs in Britain and in the European Union along with EU listing centres Dublin and Luxembourg, have in recent weeks published guidelines to allow side pockets purely for sanction-hit Russian assets, indicating that approval would be given on a case-by-case basis.

UNDER WATER

Increased interest in side-pockets for stranded Russian assets coincides with expectations that some U.S. and European banks and trading firms will begin trading in Russian government bonds.

The U.S. Treasury's Office of Foreign Assets Control (OFAC), which enforces U.S. sanctions, last month cleared the way for U.S. financial institutions to arrange transactions of Russian securities if this helped U.S. holders wind up their positions. OFAC had previously banned purchases of Russian stocks and bonds in both primary and secondary markets.

Fund managers in Europe suspended around $6 billion in Russia-dedicated and emerging Europe funds following the invasion of Ukraine, according to Morningstar data, to prevent a disorderly scramble for the exits. Russian assets could not trade and were generally marked down to zero.

Most have not reopened because of the trading difficulties, while asset managers including BlackRock (NYSE:BLK), Danske, Jupiter and Nordea have closed such funds altogether.

Side pockets could free up those funds, said Patrick Kehoe, strategic solutions lead for hedge funds at consultants Lionpoint.

"These (Russian) assets could be under water for 20 years," he said.

"Retail funds don’t have the ability to wait for a long time to unwind these assets."

Schroders on July 18 reopened its suspended fund. The fund's assets under management (AUM) has more than halved since the invasion, however, according to Morningstar data.

The side pockets containing the Russian assets remain suspended, but once Russian assets start trading "more normally", existing investors will benefit from any uplift, Schroders said in a letter to investors on its website dated July 4.

Luxembourg's securities watchdog CSSF told Reuters that a limited number of funds in the Grand Duchy have set up a side pocket, as lawyers point to the cost and complexity of setting them up.

PIMCO will ask its shareholders on Sept. 14 for permission to have them as an option in some UCITS funds.

A spokesperson said this was to reflect the new policy from PIMCO's regulator, the Central Bank of Ireland. PIMCO said it has no plans to establish side pockets for UCITS funds and would first seek regulatory and shareholder approval if this changed.

Britain's Financial Conduct Authority said it has had "conversations" with some firms but no formal applications.

Julian Brown, a partner at law firm Eversheds Sutherland, said side pockets were complex, and simply closing the fund may be easier.

Law firm Macfarlanes said asset managers may be deterred by the cost, and continued suspension or permanent closure may be more cost-effective.

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