We are seeing many offshore funds go into distress for a variety of reasons, most commonly where liquidity issues have resulted in an inability to meet redemptions. Devising a solution to manage the fund through its difficulties will always depend on the commercial circumstances and the desired outcome, but crucially any proposed solution must fall within the parameters of the fund's offering document and articles of association. It is also essential that the directors comply with their fiduciary duties in determining an appropriate course of action. The principal duties in a distressed funds context are the duty to act in good faith in the best interests of the fund, the duty to act for a proper purpose and the duty to treat investors fairly.
Most funds are formed with documents which provide the operators of the fund with a variety of defensive measures to provide stability for the fund in times of difficulty. Very few funds have a full complement of such measures, and even those funds that do have a range of techniques at their disposal are finding in the current environment that they do not always cater for every nuance.
The techniques that are most commonly used to manage a distressed fund are, in no particular order:
An ability to segregate illiquid or hard-to-value assets from the remainder of the fund's portfolio allows the fund to continue offering investors redeemable shares while preserving the potential value of the side-pocketed assets. The traditional approach is to permit the manager to identify assets that do not have a readily realisable market value. Upon establishment of the side pocket, a portion of the investors' redeemable shares are immediately converted into a new class of non-redeemable shares, representing the fund's investment in the illiquid asset. When the asset is realised or deemed realised, those investors who participated in the side-pocket are able to participate in the profits (or losses) of the now liquid asset.
Some funds have the ability to impose a gate to enable the fund to delay payment of redemption proceeds. Funds that permit the imposition of a gate usually provide for a particular level of redemptions (on an aggregated basis) to be reached before the gate is triggered. A fund may also have a "stacked gate" which permits gated investors to be given priority over investors subsequently seeking to redeem on the next redemption date.
The articles of association of a fund usually provide that the directors may suspend the determination of net asset value and redemptions. There may be tightly prescribed circumstances which must exist before the suspension may be effected, or the directors may be left with a broad discretion. It may be possible to interpret the articles as enabling suspension of redemptions without having to suspend determination of net asset value, or to partially suspend redemptions. Generally, it is not considered possible to retroactively invoke a suspension of redemptions after the relevant redemption day has passed. It is, however, common for the suspension provisions to enable the fund to delay payment of redemption proceeds to investors after they have redeemed.
Where a fund has insufficient liquid assets to meet all redemptions in cash, it may be possible to pay redemptions partly or wholly in-kind, by the transfer to the redeeming investors of assets of the fund. There must be clear authority in the fund's documents. Securities issued by a company are not considered to be assets of that company, so it is not permissible to create a new class of shares and to use such shares as a redemption in-kind.
Some managers are restructuring funds or moving investors to new funds with different terms, frequently with longer lock-up periods but lower fees. Typically, the fund compulsorily redeems the investors from the existing fund in exchange for an agreement to subscribe for shares in the new fund. The redeeming investor effectively directs the fund to transfer a pro rata portion of the assets in the old fund to the new fund. Unlike some of the other mechanisms, which must be built into the fund's documents, there are no real limits on what can be done with a restructuring because invariably it is done with the consent of the investors.
SYNTHETIC SIDE POCKET
Side pockets are very effective ways of managing illiquidity but they are commonly not authorised by a fund's documents; on the other hand, redemption in-kind in its pure form is less effective at managing illiquidity, especially where the underlying assets are not transferable, but it is usually permitted by the documents. A synthetic side pocket is a technique which seeks to create the effect of a side pocket where a fund's documents do not contain an express side pocket mechanism, by creating a new subsidiary of the fund and using the power to pay redemption proceeds in-kind to indirectly convey the illiquid assets to the investors.
The best way to illustrate this is with an example. The structure described below is simplified for illustrative purposes but the same principles are being used in typical onshore/offshore master-feeder structures as well.
For the purposes of this example, the key features of the structure (prior to effecting the synthetic side pocket) are:
1. Cayman Islands stand-alone corporate fund.
2. 80% liquid assets, 20% illiquid.
3. Redemption requests received for the next redemption day for 20% of the fund's NAV.
4. Fund documents do not permit the fund to create side pockets, but they do authorise the fund to pay out redemption proceeds in-kind.
5. Illiquid assets are not transferable.
6. Desired outcome is to keep the fund in operation and the manager does not want to suspend redemptions.
7. Manager considers it inequitable to pay redeeming investors 100% out of the liquid assets as this would increase the illiquid exposure for the non-redeemers.
8. Manager does not consider that the investors would consent to the creation of a normal side pocket mechanism.
The synthetic side pocket is effected as follows:
1. A new Cayman corporate SPV is formed.
2. Legal title to the illiquid assets remains with the fund, as they are non-transferable.
3. The fund assigns to the SPV the benefit of the future proceeds (if any) of the illiquid assets, documented in a participation agreement between the fund and the new SPV.
4. In return, the SPV issues shares to the fund which are not redeemable by the holder. The fund now holds an asset (ie the shares of the SPV) capable of being paid out in-kind on a redemption.
5. On the redemption day the redeeming investors are paid out 80% of their redemption proceeds in cash and 20% of their redemption proceeds in-kind by the transfer to them of shares of the SPV.
One decision to be made is what to do about the non-redeeming investors. It would be possible to leave them untouched: they would continue to hold their redeemable shares, and upon their future redemption they would receive cash and shares of the SPV. However, this would mean that (in our example) 80% of the shares of the SPV would remain as assets of the fund, so any new investors coming into the fund would acquire exposure to the illiquid assets.
An alternative approach is, therefore, at the same time as the fund pays out the in-kind redemption to the redeeming investors, for the fund compulsorily to redeem 20% of the redeemable shares held by the non-redeemers and transfer shares of the SPV to them as well. This may be particularly appropriate where the manager considers that it is the existing investors who suffered the original drop in the NAV of their shares when the assets became illiquid, and so only the existing investors should take the benefit of any upside when and if the illiquid assets are liquidated.
Termination of SPV
From here the process is conceptually simple:
1. Gradually liquidate the illiquid assets, the benefit of which would be received by the SPV under the terms of the participation agreement.
2. Distribute the proceeds received by the SPV, by way of dividend or by compulsory redemption of the shares of the SPV held by the investors.
3. Terminate the SPV.
The concept of a synthetic side pocket is relatively new, and we have already seen certain variations developed. It is too early to tell whether there will be any form of investor backlash against the use of this technique, but its principal advantage is that it relies on the use of mechanisms that are permitted by the fund's articles of association and (hopefully) disclosed to the investors in the fund's offering document.
British Virgin Islands
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.