Managers of hedge funds domiciled in the Cayman Islands will be all too familiar with the extent of the outflows from the industry during 2008, a trend which seems set to continue into 2009 with the global economic downturn and continuing lack of market liquidity. The liquidity crisis and upheaval in the derivatives and credit markets has left many hedge funds with illiquid or difficult-to-value assets on their books. These problem assets make portfolio valuations harder and have a knock-on effect on redemptions. Large numbers of hedge funds the world over have been caught in a vicious circle sparked by investors demanding to be redeemed out, forcing the manager to sell portfolio assets (often at distressed prices), which has adverse consequences for the fund's NAV, which in turn triggers more redemptions, which causes more fire selling of assets. And so on, until it becomes uneconomical for the fund to continue.
The Cayman Islands financial services regulator, CIMA, reported in January 2009 that fund terminations over 2008 totalled 1,093, an increase of 29% on 2007. As at 31 January 2009, 123 CIMA-registered funds had suspended redemptions, 90 had suspended NAV calculations and 2 had suspended subscriptions. These numbers can be expected to grow as 2009 progresses.
Managers of Cayman Islands funds have been turning to Mourant du Feu & Jeune for advice on how liquidity can be managed and value in their fund preserved. The various techniques of managing liquidity available under Cayman Islands law have historically been utilised by a minority of funds registered in the jurisdiction, but are fast becoming mainstream. This re-calibration of funds has naturally been motivated largely by the short term objective of keeping investor monies in the fund and limiting outflows from the fund. On a macro level, however, this trend seems set to coincide with the development of "hybrid" funds blending illiquid, "private equity" styles with more liquid, "hedge" styles, a product which, in the current cycle of increased illiquidity and heavily discounted assets, seems to represent something of a life line for managers of struggling equities-focused hedge funds. See our briefing note entitled "Cayman Islands Hybrid Funds: The Convergence of Hedge and Private Equity".
This paper looks at the principal techniques used by managers of Cayman Islands funds to manage liquidity in their funds and to provide an acceptable rationale to investors for keeping their money in the fund. The key options available to managers are as follows:
- Redemptions for cash
- Redemptions in kind
- Side pockets and "synthetic" side pockets
- Suspension of NAV
- Suspension of redemptions
When presented in this order, these techniques represent a sliding scale of liquidity, with cash redemptions being optimum for investors when assets are liquid, redemptions in kind (or "in specie") being intended to preserve value represented by liquid assets or cash, side pockets being a means of returning value in a way that is fair to both redeeming and remaining investors, gates being used to limit outflows on a given dealing day, suspension of NAV and/or redemptions being a blanket prohibition on dealings in times of trouble and lock-ins (or "lock-ups") being a complete or partial prohibition on redemptions in times good or bad. Sometimes only a wholesale restructuring will suffice to save a distressed fund, with termination by means of voluntary liquidation being the ultimate step.
In this paper we use "illiquid" to signify both illiquid and difficult-to-value assets.
Redemptions for Cash
Funds with liquid portfolio assets and/or distributable cash reserves will seek to return value to redeeming investors in the form of cash, within a specified number of days following the dealing day in respect of which the redemption request was submitted. Cash payment is optimum for the investor and administratively easier for all concerned. But the fund's directors may wish to preserve the cash reserves, or the portfolio assets may not be capable of being realised in a timely fashion, and the articles of association of most Cayman Islands funds will provide the fund with the ability to pay over redemption proceeds in whole or in part in non-cash assets, otherwise known as redemptions "in kind" or "in specie".
Redemptions in Kind
A fund with a wholly or partially illiquid portfolio may make an in kind distribution of illiquid assets in satisfaction of redemption requests, provided it has power to do so in its articles of association. There are three principal drawbacks to this method of returning value: (i) the value of the assets to be distributed in kind can depreciate between the dealing day and the time of their realisation; (ii) it does nothing to maintain the balance of liquid and illiquid assets in the fund in favour of nonredeeming investors; and (iii) certain portfolio assets may be non-transferable, in which case they will not be capable of conveyance by the fund to redeeming investors. Side pockets are a technique intended to address these issues.
A side pocket is a separate account (represented by a separate class of shares) maintained in the books of the fund, to which illiquid assets are allocated. Side pockets are intended (a) to separate the illiquid assets from the liquid assets; (b) to avoid or redress the imbalance caused when liquid assets are realised to satisfy redeeming investors, leaving non-redeeming investors with increased exposure to illiquid assets; and (c) to give the fund control over how, when and at what value it realises illiquid assets and returns that value to investors.
Such proportion of each investor's shareholding represented by the segregated illiquid assets will in effect be converted into non-redeemable shares of a new class, capable only of repurchase by the fund when the illiquid assets are realised from time to time. The fund may also return value by way of distribution of the assets in kind. The fund's management and performance fees will typically be disapplied completely from this new class, or replaced by a fee structure tailored to the illiquid nature of the underlying assets and the projected length of time for which the fund will hold them (at cost), with a fee being calculated on any capital appreciation realised on disposal.
Investors will continue to hold shares representing the liquid assets, which may be redeemed in the normal course. New investors admitted to the fund will not obtain any participation in the side pocketed assets.
In order to implement side pockets, the fund's articles of association must make provision both for the making of redemptions in kind and the creation of side pockets in a prescribed manner. In many cases, the articles will make provision for the side pocketing of new investments but not existing investments. Absent such provisions, the consent of the fund's investors will be required before the implementation of a side pocket can take effect in relation to existing assets, given the material variation of the economic rights entailed by the conversion of an investor's redeemable shares into non-redeemable shares.
It can be seen that a side pocket in some cases will resemble a closed-ended, single-asset sub-fund of the hedge fund, in which investors have no rights of withdrawal and will receive a return only upon periodic realisation of the underlying portfolio assets. Indeed, "hybrid" funds, designed to blend liquid and illiquid investment styles, are being newly established with a side pocket of illiquid assets as a planned part of their investment strategy, typically limited at 10% to 30% of the fund's total portfolio and to which private equity-style management and performance fees will apply. See our briefing note entitled "Cayman Islands Hybrid Funds: The Convergence of Hedge and Private Equity".
Synthetic side pockets
The side pocket arrangements just described have two principal drawbacks: (i) the illiquid assets may not be transferable, meaning that the fund will have to maintain them at cost, possibly for lengthy periods, until they are capable of being realised; and (ii) they might not be authorised by the fund's articles, in which case the prior consent of investors will be required, with attendant cost and hassle of convening general meetings or procuring written consents.
A "synthetic" side pocket is a technique designed to address these issues. At a minimum, its implementation requires a provision in the fund's articles for in kind distributions of redemption proceeds, and will involve the following steps:
- The manager of the fund will arrange the incorporation of a new Cayman Islands limited company ("CaymanCo").
- Because the fund's illiquid assets are nontransferable, the fund will enter into an agreement with CaymanCo by which the future proceeds of sale or other realised value of the assets will be assigned by the fund to CaymanCo.
- In consideration for the assignment, CaymanCo issues fully paid-up shares (in aggregate value equal to the value of the illiquid assets) to the fund; these shares are non-redeemable but may be freely transferable.
- Investors redeeming out of the fund receive a mixture of cash and CaymanCo shares in proportion equal to the ratio that the fund's liquid assets bears to its illiquid assets.
- The illiquid assets are liquidated over time by the fund with all amounts of realised value assigned to CaymanCo.
- When such value is received from time to time by CaymanCo it returns that value to its shareholders (the fund's investors) by way of dividend or compulsory share repurchase.
- Once all value has been distributed to investors in this way, CaymanCo can be terminated either by voluntary liquidation or strike-off procedure under Cayman Islands law.
CaymanCo will form an asset of the fund until the fund has distributed to investors all of the shares it holds in CaymanCo, and new investors admitted to the fund will in this way be exposed to the illiquid assets, something which could be avoided if a conventional side pocket were used. One means of alleviating this drawback is for the fund to compulsorily redeem a portion of each nonredeeming investor's shares in exchange for CaymanCo shares, as part of step 4 above, the net effect of which will be the exposure of non-redeeming investors to any upside or downside on realisation of the illiquid assets.
Given the publicity attracted by many hedge funds suffering liquidity crises, side pockets have been propelled to the fore and have received a mixed press. The truth is that they have always been permissible under Cayman Islands law, and provide a legitimate means of proportioning a distressed fund's liquid and illiquid assets fairly amongst redeeming and non-redeeming investors. They have also been used for some time already by managers of "hybrid" funds blending short term liquid and longer term illiquid investments (see our briefing note entitled "Cayman Islands Hybrid Funds: The Convergence of Hedge and Private Equity").
More hedge funds established in the Cayman Islands over the past 10 years have "gate" provisions hardwired into their articles of association than have side pocket provisions. The purpose of a gate is to limit the aggregate value of redemptions that the fund will honour on a given dealing day. This limit, or "gate", is commonly set between 10% and 20% of total NAV calculated with reference to the dealing day. Redemptions received in time order will be aggregated up to the level of the gate and given effect on the relevant dealing day. Any excess balance of redemption requests received will be deferred to the next following dealing day and will either be given priority over redemption requests submitted in respect of that day (a "stacked gate") or processed proportionately with such requests, subject again to the gate and with any excess balance carried forward to the next following dealing day, and so forth until all "gated" requests have been satisfied in full.
The liquidity crisis has left many Cayman funds facing higher than normal redemption requests from investors, a problem compounded by some investors submitting deliberately high requests in order to redeem as many of their shares as possible on a given dealing day and to obtain priority over later requests on the next dealing day, by virtue of a stacked gate. To deal with this, some funds have started to impose cut-off limits on carried forward requests, whilst others are returning discounted NAV to investors wanting to be exempted from the application of a gate (such discount typically being set at between 5% and 10% of NAV).
Suspension of NAV
Most hedge funds established in the Cayman Islands will have provisions already in their articles of association which will allow the suspension of NAV. The suspension will normally be stated in the articles to trigger upon the occurrence of certain prescribed events or situations set out in the offering document, for example a suspension of markets or other event which makes it impracticable or impossible for the fund's assets to be valued. It is legitimate in these circumstances for the fund to suspend NAV calculation (and, if the articles permit, dealings), until the circumstances giving rise to the suspension have passed and the suspension is lifted.
Any suspension of NAV must be conditioned precisely by the prescribed events set out in the offering document and, furthermore, must be formally notified to investors prior to the suspension taking effect (unless the articles provide otherwise). If either of these conditions is not fulfilled, the likelihood is that the suspension has not been legitimately implemented.
Suspension of Redemptions
A suspension of NAV may (but not necessarily) entail a suspension of redemptions and payment of redemption proceeds. For some funds a suspension of redemptions may be effected independently of a NAV suspension (and vice versa), whilst for other funds suspension of one will automatically trigger suspension of the other. Again, the matter will be determined by a construction of the articles of association, often in conjunction with the offering document.
Suspensions of redemptions and payment of redemption proceeds must be conditioned precisely by the prescribed events set out in the offering document and, furthermore, must be formally notified to investors prior to the suspension taking effect (unless the articles provide otherwise). If either of these conditions is not fulfilled, the likelihood is that the suspension has not been legitimately implemented. By way of example, it will not be sufficient for a fund or its administrator merely to invoke the problems caused by the alleged Madoff fraud as a reason for failing to pay over redemption proceeds in respect of requests submitted on a dealing day falling before the scandal broke.
An investor in a Cayman fund validly submitting a redemption request and not subsequently receiving the redemption proceeds in the time specified for payment thereof in the articles and/or the offering document may be regarded as of the relevant dealing day as both a member and a creditor for the unpaid redemption proceeds, and in the fund's liquidation will rank ahead of other non-redeeming investors but behind ordinary unsecured creditors. However, a fund may legitimately suspend payment of redemption proceeds (provided adequate provision is made in its articles) if the date for payment has not been reached, in which case the debt will be similarly suspended so that it is not due, and the redeeming investor will lose its status as creditor. The investor may find itself having to consider carefully the delicate balance between seeking recourse qua member (in which case it will rank behind unsecured creditors, and recovery of redemption monies will terminate its status of member thereby precluding participation in distributable surplus on the fund's liquidation) and seeking recourse qua creditor (in which case it will rank ahead of all investors but will not participate in any surplus available to members). The legal position on recovery of redemption proceeds can be complex and advice should be taken from Cayman Islands legal counsel.
In the current illiquid markets, managers are increasingly seeking investor consent to amend the fund's articles to give the fund's directors discretion to suspend redemptions in a wide variety of circumstances, including a general discretion on the part of the directors to suspend when they believe in good faith that a suspension would be in the best interests of the fund.
The most obvious means of keeping investor money in the fund is to prohibit investors from redeeming during a specified period, often between twelve and thirty six months following subscription. The prohibition can be absolute or be subject to an "early redemption" fee (typically set between 3% and 5% of the payable redemption proceeds). Such fees can be structured on a sliding scale, with higher charges applying during the early part of the lock-in period and lower charges applying towards the end.
A Cayman Islands fund can be set up with lock-in periods, of which due disclosure is made in the offering document. More problematic is the imposition of a lock-in period to an existing fund. This will clearly be an extremely sensitive matter for existing investors, given that the imposition of a lock-in period will in effect amount to a material amendment of the economic rights attaching to their shares, and the prior consent of the investors will in most cases be required (unless, on proper construction, the articles provide otherwise). Many managers are being compelled to accept lower management and/or performance fees as a quid pro quo for the imposition of a lock-in period. The central issue is that lock-in periods cannot be unilaterally enforced by the manager without proper authority in the articles; our recommendation in most cases will be that the consent of investors is best sought in one form or another. Cayman Islands legal advice should be sought when a new or additional lock-in period is proposed.
Depending on the severity of the liquidity problems being experienced by the fund and the level of unhappiness being communicated to the manager by the fund's investors, the manager may decide to restructure the fund, ranging from designation of additional share classes with new fee and liquidity arrangements (sometimes as liquidating classes), to side pockets, to wholesale restructurings of the fund into a new entity with materially different investment styles, liquidity terms and fee structures. Such restructurings will invariably be conditioned by the prior consent of investors, so there is scope for the manager and its legal advisors to be creative.
In a vanilla restructuring, the fund may establish a new entity and transfer its assets to that entity simultaneously with the issue by the new entity of fully-paid shares to the investors. In this way the investors become shareholders in a brand new entity often with materially different liquidity terms and fee arrangements. If the new entity's assets are illiquid the manager may adopt a private equity-style arrangement wherein those assets are allocated to a closed-ended side pocket or sub-fund of the new entity, which will be managed on a long term basis with no upside fees payable until the realisation of the underlying assets. Indeed, the new entity may be wholly closedended, and may be listed or unlisted. Either way, the fund benefits from long term capital with significantly less exposure to withdrawals.
The tools of liquidity management have been around for some time, and are set to become standard structural features of hedge funds.
Managers should seek Cayman Islands legal advice when considering the options available to them. Mourant du Feu & Jeune's Cayman funds advisory team, based in London and the Cayman Islands, is well placed to provide this advice.
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.