Lightning striking coins

Image: Getty Images

Following September’s jump in gilt yields, overleveraged LDI strategies are potentially exposing certain funds to litigation. Analysis by Elaina Bailes and Tom Otter of UK law firm Stewarts.

An uncomfortable question is being asked around offices in the City of London 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.

Such strategies that result in highly leveraged positions often have an outsized impact on the markets, meaning there is a higher likelihood they will attract litigation.

What has happened?

Recently, liability-driven investment (LDI) strategies have attracted the most focus.

LDI strategies are largely run by or for pension funds operating defined benefit schemes (which are based on career earnings and linked to inflation) and encompass a wide range of structures and products of varying complexity and leverage. 

LDI strategies are aimed at balancing the pension fund’s current assets with the present value of their future liabilities (i.e. the liabilities to pay beneficiaries their defined benefit pensions). 

One of the attractions of a leveraged LDI strategy is that the fund may be able to increase its amount of liability-matching assets whilst maintaining investments in other asset classes.  

As was widely reported, the rapid rise in gilt yields following the chancellor’s ‘mini’ Budget on September 23 exposed potential shortcomings in collateral and risk management arising from LDI strategies. Structures exposed funds (or their third-party managers) to a self-sustaining selling cycle, which in turn drove up collateral requirements: the famed and feared ‘doom loop’.

This led to intervention by the Bank of England, which provided support to the gilt market by buying up gilts and delaying the start of its intended ‘quantitative tightening’ programme with a view to providing time for the gilt market to stabilise and for the pension funds to seek to exit positions and replenish collateral buffers.

Are LDI strategies that bad?

From a disputes and liability perspective, not all LDI strategies are equal, and they are not inherently a bad thing. Each strategy should be designed to fit the specific circumstances (and portfolio) of the fund in question.

LDI strategies have a legitimate risk management purpose and whether or not any one example is inappropriate and/or ill-advised will be a fact- and fund-specific question. 

It is worth noting that LDI strategies have largely functioned successfully since they were initially adopted by the pension industry in around 2003.

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. 

The extent of any loss suffered by a fund will be a key factor driving any litigation

What is appropriate for one fund may not be appropriate for another. Even within a fund, not all of its 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 report on this issue by The Pensions Regulator found that the maximum permitted leverage in pension funds varied between 1x and 7x.

Is litigation imminent?

The extent of any loss suffered by a fund will be a key factor driving any litigation. It seems probable that the more leveraged end of the spectrum is where litigation may arise as there is a higher risk of large losses. 

Loss is likely to be a complex and disputed area of any claim. This is particularly true given that the rise in yields means that, following the LDI crisis, certain funds may have a funding surplus even if they appear to have been left with differently weighted portfolios – for example, if they had to sell growth assets to meet collateral calls – and may be more exposed to certain risks than before.    

It is worth noting that further claims may exist in relation to other parts of the LDI strategy ecosystem, for example in relation to third-party advisors who promoted the strategies. 

There may be consequential claims relating to how and why third-party managers went about raising liquidity in order to meet collateral calls.

Contracts and investment mandates will need to be carefully scrutinised in this regard and, again, whether a meaningful claim can be brought successfully will likely be fact-sensitive and depend on the contractual relationship between the relevant parties. 

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 during 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.

 
Elaina and Tom Stewarts

Elaina Bailes is a partner and Tom Otter is a senior associate in the commercial litigation department at UK law firm Stewarts.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter