In the current economic environment more than the usual number of alternative investment funds are falling into the "distressed" category, often caught between decreasing liquidity in their portfolios and a significant increase in requests from investors to redeem their equity interests. These funds may also have difficulty obtaining an accurate net asset value or have formally suspended net asset value calculations. Additionally, fewer leverage providers are willing to lend to hedge funds or accept certain classes of assets as collateral. In these circumstances many funds are finding it difficult to meet redemption requests and the fund's operators have the difficult job of trying to manage the issues fairly, in compliance with general law and the fund's constitutional and offering documents, and in a manner that, if possible, permits the fund to eventually resume normal trading.
The first recourse for the operators of a distressed fund is to the offering documents and constitutional documents, which will set out the rights the fund's operators have to restrict or halt redemption requests in adverse trading conditions. The exact provisions vary considerably however typical provisions include some or all of those described below.
The options open to a distressed fund are considered here in the context of a Cayman Islands fund using a corporate structure and issuing redeemable participating shares to investors. For the most part the topics discussed in this article would apply equally to other funds including those using a partnership structure, although in either case this article should not be used as a substitute for specific legal advice.
Delay Redemption Payments, Suspend NAV Calculation or Suspend Redemptions
Delay in Payments
Even where an investor has submitted a redemption request for its participating shares, most funds reserve the right to delay payment of some or all of the redemption proceeds beyond the normal repayment window; either in defined circumstances or at the general discretion of the directors.
A delay in redemption payments usually means that the share redemption will be administratively processed and the redeeming investor will become a creditor of the fund. This is an important point for the fund to consider since a creditor has more extensive legal rights than a shareholder.
If a delay in payments is not possible virtually all funds have the option of suspending NAV calculations, which has the effect of suspending all subscriptions and redemptions into and out of the fund. The decision may be at the general discretion of investors or restricted to certain prescribed circumstances. Generally a payment delay is preferred where possible as many investors view a formal suspension of NAV calculations as an indication that the fund is in serious, potentially terminal, trouble and many will try to redeem as soon as the suspension is lifted.
A fund may have the power to suspend or restrict redemptions alone without suspending NAV calculations. This can be useful because it enables the NAV to be calculated for purposes of subscriptions and determination of fees and may be viewed as slightly less serious than a formal NAV suspension.
The effect of suspending NAV calculations or suspending redemptions themselves is that pending redemptions will not be processed at all, so the redeeming investors will remain shareholders of the fund rather than creditors.
Redemption Payments In Kind
Payments in kind may be permitted by the fund's documentation. Investors obviously need to be informed that the fund is planning to pay them in kind and any investors with pending redemptions must be given an opportunity to withdraw their redemption request.
The most significant obstacle is ensuring an accurate valuation of the assets being used for the payment. There are potentially other complications; if the assets used are equity interests in an underlying fund, the investor may not be eligible to hold shares in that fund, or the shares may not be transferable. The type or location of the assets may also have tax consequences for the investor.
It is therefore important that in kind redemption payments are only made in consultation with the affected investors. As with other strategies for distressed funds, a decision to make in kind redemption payments should be authorised by the directors and communicated to all investors.
Impose a Redemption Gate
Redemption gates permit the fund to set an upper limit (usually as a percentage of NAV) that can be redeemed on any redemption date. This is a common provision found in the majority of offering documents.
The intention of a redemption gate is to manage substantial redemptions, whether from a single large investor or from multiple smaller investors, so as not to exhaust the liquidity of the fund. Redemption requests should be reduced proportionately across all redeemers, and the gated redemptions will have priority over subsequent redemption requests on the next redemption date subject, usually, to further gating on the next redemption date. A redemption gate may be ideal for acute liquidity shortages but is not suitable if liquidity issues are more significant. For example, a fund that has redemption requests for 50% of its NAV and gates at 10% will have 40% of the NAV pending for the next redemption date. Even if it receives no further redemption requests it will take a further four redemption dates to process all the requests. In practice the situation will likely be worse, since investors have a strong incentive to submit redemption requests once they learn that the fund has been gated so as to secure a position in the redemption queue.
Side Pocket Illiquid Assets
A side pocket is used to segregate illiquid assets from the main asset pool of the fund. Typically separate shares are issued for the side pocket and distributed to redeeming investors as an in-kind payment. The investor will receive part of his redemption payment in cash from the liquid part of the fund, and shares in the side pocket for the remainder. The illiquid assets are typically moved into the side pocket as redemption requests are received.
In order to ensure investors with side pocket shares are paid sequentially a new side pocket can be created for each redemption date. As the illiquid assets are realised the side pockets will be redeemed in the order they were created with the investors within each side pocket ranking equally.
If permitted by the fund's documentation a side pocket can be established within the fund company as a separate class of shares.
If the fund's documentation does not expressly permit side pockets but does permit payment of redemptions in kind, and if it is not prohibited by the fund's investment objective, a side pocket can be set up by transferring the illiquid assets to a company incorporated for the purpose as a special purpose vehicle ("SPV"), which will issue its shares to the fund in return.
If the SPV is set up as a Segregated Portfolio Company the side pocket can be used by more than one distressed fund.
The offering documents and Articles of Association form part of the contract between the fund and the investor and accordingly the fund's operators cannot change them without the agreement of investors. It is therefore important that mechanisms for dealing with a lack of liquidity are built into the fund structure at inception. Even where a strategy is explicitly permitted by a fund's documentation it is vital to ensure investors are fully informed and frequently updated. No investor likes to hear that their fund is in trouble but the fund's management team is often the best qualified to deal with the problems and to liquidate distressed assets. When investors are confident that the management has a clear strategy that is being implemented in a fair, responsible and transparent manner it is less likely they will try to oppose the plans or take legal action.
All the above options should be authorised by a board resolution and the decision communicated to all investors. It is also important that the fund's directors are involved in the decision-making process, rather than merely being asked to sign off resolutions. Although in practice it is often the fund's investment manager that drives the process, the final decision is ultimately the directors' responsibility and any action not permitted by law or that contravenes the fund's legal documentation could result in personal liability for the directors.
It seems likely that the recent economic downturn will influence the way Cayman funds are structured in future. As well as possible regulatory developments, a far more extensive set of provisions for managing liquidity constraints are likely to become standard so as to give managers more room to maneuver should the current situation be repeated.
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.