Tom Otter and Elaina Bailes answer some frequently asked questions on the potential for disputes arising out of concerns regarding pension funds’ exposure to liability-driven investment (LDI) strategies.
An uncomfortable question is being asked around offices in the City at the moment: “Is it all feeling a bit 2008-y to you?” It is easy to see why the current economic turmoil echoes the prelude to the 2008 financial crisis: sudden changes to market conditions are beginning to expose issues with investment strategies previously considered safe, with high leverage often meaning that such issues have an outsized impact on the markets.
Edited versions of this article appeared in City AM and The Banker (subscription required) in November 2022.
What has happened?
This week, LDI strategies are attracting the most focus.
LDI strategies are largely run by or for pension funds and one of their functions is to manage interest rate risk and to mitigate the impact of sustained low interest rates with the intention that there is no shortfall in the money that the funds have to pay out to their beneficiaries.
The rapid rise in yields following the chancellor’s mini budget on 23 September has exposed potential shortcomings in collateral management under LDI strategies with the relevant derivative contracts exposing funds to a self-sustaining selling cycle which in turn drives up collateral requirements: the famed (and feared) “doom loop”.
As has been widely reported, this has led to the Bank of England buying up UK gilts to stabilise the market. That may (or may not) come to an end this Friday with the potential market disorder that could then follow.
Are LDI strategies that bad?
From a disputes and liability perspective, not all LDI strategies are equal, and an LDI strategy is not inherently a bad thing.
Each fund will be in a different position depending on exactly why an LDI strategy was decided on, the nature of that strategy, how it was implemented and the governance processes underlying its implementation.
What is appropriate for one fund may not be appropriate for another. Even within a fund, not all LDI strategies may give rise to meaningful litigation risk. The extent to which a fund may be exposed to the risk of claims will be fact sensitive and require detailed examination.
There is substantial variation between funds in this regard. A recent report on this issue found that the maximum permitted leverage in pension funds varied between 1x and 7x.
Is litigation imminent?
It seems probable that the more leveraged end is where litigation may arise as there is a higher risk of large losses. For example, where funds are forced to dispose of high-quality assets at fire-sale prices which may also mean that the trades underlying the LDI strategy no longer fulfil their intended function in the context of the portfolio as a whole.
Or, in a worst-case scenario, if the fund cannot meet collateral calls when required, this could result in contractual defaults and liquidation. Questions may be raised around the management of the fund.
It is worth noting that further claims may exist in relation to other parts of the LDI strategy ecosystem, for example, third-party advisors who promoted the strategies.
When the dust settles it will become clear where losses have landed, and claims may then crystallise.
Our experience of investigating and litigating the various financial issues that arose in the last financial crisis and subsequently suggests that it is not just the original positions which invite scrutiny, but also the actions taken in the immediate fallout. The sooner any concerned party takes litigation advice, the better protected they will be in any fights to come.
Stewarts has launched a ground-breaking after the event (ATE) insurance facility with Arthur J. Gallagher Insurance Brokers Limited. ‘Stewarts Litigate‘ is designed to work alongside our alternative funding agreements. The facility provides our commercial disputes clients with rapid access to comprehensive ATE insurance at pre-agreed market leading rates. The facility can provide coverage of up to £4 million in three business days and up to £18 million within ten business days.
Find out more about Stewarts Litigate here.
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