IPO Allocation and a Stale Bond Price
A fund management company manages three unit trust funds: Growth Fund, Balanced Fund and Income Fund. Growth Fund represents 40% of the company's total assets under management and carries a performance fee above an 8% hurdle. In June, the company is allocated 2 million shares in an oversubscribed IPO. The investment committee allocates 1.2 million shares to Growth Fund, 500,000 to Balanced Fund and 300,000 to Income Fund. Growth Fund is close to its hurdle and the IPO is expected to trade at a premium. Separately, Income Fund holds RM40 million of a corporate bond that has just been downgraded from AA to BBB. There have been no trades in the bond for three weeks, and the fund manager continues to value it at the last traded price, which is above the only broker quote. Balanced Fund is expected to receive a RM30 million redemption at month-end. The trustee has asked for the valuation policy and the basis for the IPO allocation.
1. Evaluate the IPO allocation against the fund manager's duties.
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The allocation is questionable because Growth Fund receives 60% of the IPO shares while representing only 40% of assets under management. The allocation policy should be pre-defined and applied consistently, with shares allocated according to each fund's objectives, size, cash available, investment restrictions and existing portfolio. A hot IPO should not be used to push a performance-fee fund over its hurdle at the expense of other funds. The investment committee should be able to show why the allocation was in the best interests of each fund. If the allocation was driven by the performance fee, that is a conflict of interest that should have been managed and disclosed. The fund manager should review the allocation, document its rationale and consider reallocating on a fair and equitable basis. The trustee should be given a clear explanation and the policy should be reviewed.
2. What should the fund manager do about the bond valuation?
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The fund manager cannot rely on a stale last traded price when the credit quality has changed and the only broker quote is lower. It should value the bond at fair value, using observable inputs where available and an independent valuation or model where the market is illiquid. The downgrade from AA to BBB is material and should be reflected in the price, the fund's net asset value and its risk disclosures. The valuation committee should document the method, the inputs and the reasons for any override. The trustee should be informed and asked to approve the valuation approach. The manager should also consider whether the bond remains within Income Fund's investment mandate and whether the fund's liquidity profile is still appropriate. Continuing to carry the bond at the old price would overstate the fund's value and disadvantage redeeming and remaining unitholders.
3. How should the redemption and the valuation issue be managed and disclosed?
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The manager should prepare a liquidity plan for the RM30 million redemption without forcing a distressed sale of the illiquid bond. It should use cash and more liquid assets first, and consider borrowing or other permitted liquidity tools if the fund's rules allow. It must not let redeeming unitholders exit at an overstated price while remaining unitholders bear the loss. The valuation should be corrected before the redemption is processed, and the trustee should be involved. The manager should disclose the valuation uncertainty and the downgrade in the fund's reports and to affected investors as required. It should also review whether the fund's redemption terms, liquidity risk management and product disclosure are adequate. The aim is fair treatment across unitholders, not simply meeting the redemption date.