Northern Trust Loan Fuels Fund's Risky Illiquid Bets -- WSJ

By Paul J. Davies 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (June 26, 2019).

U.S. financial giant Northern Trust could be on the hook for losses related to the unraveling of a star U.K. fund manager, in a case that is drawing attention to the dangers of hard-to-sell assets hiding inside retail investment products.

The Chicago-based bank lent GBP150 million ($190 million) to a fund managed by Neil Woodford, whose investment empire is in serious trouble as clients have fled and U.K. regulators have launched an investigation. The Northern Trust loan is backed mainly by private shares in risky young companies. The loans were disclosed in fund documents.

Northern Trust, Woodford Investment Management and the board of the Woodford Patient Capital Trust, the fund in question, declined to comment. Shares in Woodford Patient Capital Trust, which manages close to GBP1 billion in assets, have plunged by more than a quarter since early June.

Woodford's problems come as several European fund managers have tripped up after straying too far into assets that are illiquid, or hard to buy and sell. Shares in French bank Natixis SA dropped sharply last week after a Financial Times report highlighted illiquid assets in a fund run by the bank's H2O Asset Management arm. Switzerland's GAM Holding AG is still recovering from a scandal at one of its credit funds that took concentrated bets in illiquid bonds, many of which were linked to a single group of companies.

Investors have taken more risks as a consequence of the low-yield environment, said Ryan Hughes, head of active portfolios at AJ Bell, a U.K.-based retail-focused fund distributor. "It becomes bad when managers get into things that they, or more likely their investors, don't fully understand," he said. He predicts similar incidents could arise in the future.

Mr. Woodford built a reputation for making winning, contrarian bets on large, unloved stocks over 25 years at U.S. company Invesco Perpetual. While there, he managed at his peak more than GBP30 billion. He avoided internet companies in the dot-com bust and steered clear of banks ahead of the 2008 financial crisis.

He struck out on his own in 2013. Since then, Mr. Woodford's investment focus shifted toward unlisted stocks in companies with unproven technologies or pharmaceutical products.

Now his company, Woodford Investment Management, faces a battle to survive. In early June, it suspended withdrawals from its flagship GBP3.7 billion Woodford Equity Income Fund.

That mutual fund breached its own limits on unlisted stockholdings during 2018, according to the Financial Conduct Authority, the U.K. regulator. It is now investigating the events that prompted the fund to suspend withdrawals.

Northern Trust's loan to the Woodford Patient Capital Trust is unusual. No other fund in the U.K. that invests in risky, early-stage companies uses any leverage at all, according to Britain's Association of Investment Companies. Two similar U.K. trusts run by Baillie Gifford and Merian Global Investors said they expected their investments to generate high returns without leverage.

The U.K. trust sector in general has average leverage of 9% of net asset value. The Woodford Patient Capital Trust runs with leverage close to its limit of 20% net asset value.

Share-backed loans are normally low risk because listed equities can be sold swiftly to repay the debt. And the Northern Trust loan is backed more than six times by the fund's assets. But more than three-quarters of those are either unlisted equities or listed stocks that don't trade at all.

There are other risks. Many of the assets supporting Northern Trust's loan are also held by Mr. Woodford's bigger, suspended fund. That fund has promised to exit all its illiquid and unlisted holdings. As it sells, the value of companies in which the Patient Capital Trust also invests are likely to get hit.

Some of the biggest unlisted shares that both held in early 2019 included early-stage medical technology companies Oxford Nanopore, Proton Partners and Kymab.

The most recent published list of holdings from March and April 2019 showed that the Patient Capital Trust owned securities in 35 companies that the bigger suspended mutual fund also owned. They accounted for nearly 77% of the trust's portfolio.

Both funds also each hold or have held stakes in a series of other investment companies that in turn hold stakes in some of the same unlisted stocks that the Woodford funds own. These investment companies include Dublin-listed Malin Corp., Guernsey-listed Ombu Group, and London-listed companies IP Group PLC and Allied Minds PLC.

Further connecting the two funds: Earlier this year, the now-suspended Equity Income Fund received a 9% stake in Patient Capital Trust. In exchange, Patient Capital took on some of the mutual fund's unlisted stockholdings.

Patient Capital Trust's original rules called for no long-term borrowing and a limit of 60% of net asset value in unquoted stocks. That changed progressively, mainly during 2017, when the constraints were changed or ditched. The limit on unlisted shares was first lifted to 80% of net asset value, then again to 80% of gross asset value, the value of all assets before debt is subtracted.

That same year, Northern Trust doubled the size of the credit facility from GBP75 million to GBP150 million. It increased the interest rate on the loan slightly and doubled the fees it charged for separate administrative services, according to the trust's annual reports.

Write to Paul J. Davies at [e-mail]

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June 26, 2019 02:47 ET (06:47 GMT)

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