This article is intended to highlight a number of the common restrictions on realisation of an investment which are typically included in hedge fund’s terms and also looks at some of the other tools available to funds seeking to restrict the ability of investors to withdraw money.
Most European investors will invest in hedge funds structured as open-ended investment companies. Investors subscribe for shares in these funds and are then able to realise their investment by redeeming those shares. US taxpaying investors tend to invest in funds structured as partnerships, where they are able to withdraw capital from the capital account created for their investment in the partnership.
In broad terms, redemption rights and withdrawal rights tend to be similar (particularly in master/feeder structures and in parallel fund structures). The majority of this article focuses on redemption rights, rather than withdrawal rights, but many of the terms referred to below will exist in similar terms in funds structured aspartnerships.
Redemption of shares in a fund is not, however, the only means by which an investor might realise their investment. It might be possible for them to sell the investment privately to a willing buyer, subject to the consent of the fund. In some circumstances, where an investor and the manager of the relevant fund remain on good terms and there is ongoing demand for investment in the fund, the manager may be able to put an investor wishing to realise their investment through this route in touch with parties who may be a willing buyer. This method of realisation tends to be used more frequently in circumstances where other methods highlighted below are not available to the investor, particularly during lock-up periods.
The majority of funds will permit shares to be redeemed on certain predetermined dates (“redemption days”). The frequency of redemption days will vary from fund to fund and will be influenced by the nature of the strategy pursued by the investment manager in managing the fund’s portfolio. As a general proposition, funds investing in less liquid investments will offer less frequent redemption days than funds investing in highly liquid investments which may be easily realised. Typically, funds will offer shares on the basis of redemption days either monthly or quarterly. The redemption days will usually coincide with a date upon which the net asset value of the fund and the net asset value per share is calculated (typically, the last day in any given month).
The majority of funds will require the investor to give prior notice to the fund’s administrator of their wish to redeem on any given redemption day. Again, the length of the notice period varies from fund to fund and is influenced substantially by the nature of the underlying portfolio of investments and the liquidity inherent in it. Upon the redemption of shares, accrued fees payable to the investment manager will crystallise, so that any investor withdrawing money from the fund bears all of the fees relating to their investment.
The fund’s terms will also typically prescribe a period during which redemption proceeds may be paid. In some funds this may be structured as an absolute period (eg. redemption proceeds to be payable within 30 calendar days of the relevant redemption day) whilst in others the arrangements may be more complicated (eg. 95% of redemption proceeds to be paid within 30 calendar days of the redemption day, with the remaining 5% to be paid following completion of the fund’s audit subject to any adjustment in the redemption price resulting from that audit). Typically, the obligation to pay out redemption proceeds within a period will not be absolute, meaning that proceeds may be paid out over a longer period.
These rights are not, however, absolute in the vast majority of funds:
Some funds, particularly those which have a relatively illiquid underlying portfolio, will impose a ‘hard lock-up’ on investors. In legal terms this ‘lock-up’ is achieved by issuing the shares on the condition that there is no right to redeem them until they have been held by the relevant investor for a minimum period (commonly, one year). Most funds with a hard lock-up will contain provisions that allow the directors of the relevant fund discretion to waive this restriction.
However, in exercising this discretion, the directors are always obliged to act in the best interests of fund as a whole. The directors are able to waive these restrictions and comply with their duties in circumstances where the relevant investor is procuring re-investment of an equivalent amount by another investor (as is often the case where funds of the funds are managing the portfolios of the various funds that they manage). It is much more difficult for directors to ascertain that they are acting in the best interests of the fund as a whole in circumstances where the restrictions are being waived simply to accommodate the relevant investor.
The commercial reasons for imposing a ‘hard lock-up’ do vary. In some funds, the imposition of the lock is intended to provide an additional means of managing liquidity issues arising out of the nature of the fund’s portfolio. In other circumstances, a successful fund may undertake a second or third round of fund raising imposing a ‘hard lock-up’ as a means of trying to promote stability in the invested capital in the fund (thereby achieving some stability in the management fees payable to it).
As an alternative to the ‘hard lock-up’ mechanism, some funds will adopt a ‘soft lock-up’ mechanism (often in combination with a gate mechanism, discussed further below).
This soft lock-up on capital is achieved by imposing a redemption fee on any investor who seeks to redeem their investment during a prescribed period. These fees tend to be 2% and 3% of the net asset value of the investment being redeemed and, again, are typically subject to a directors discretion to waive them. It is, generally, easier for the directors to determine that waiving such a fee is not incompatible with their duties, than it is in relation to waiver of a ‘hard lock-up’. The proceeds of the fees payable upon the imposition of a ‘soft lock-up’ will typically be paid to the fund, rather than the investment manager, meaning that all investors benefit from the fee.
Many funds operating a soft lock-up will also impose a ‘gate’ on redemptions. A gate works by limiting the amount of investment which may be redeemed from the fund on any one redemption day. Typically, if total redemption requests received for a redemption day exceed a specified threshold (usually expressed as a percentage of the net asset value of the fund as a whole) redemptions will only be permitted up to that threshold on that redemption day. The remaining redemption requests that will not be honoured on that redemption day will then be rolled over to the following redemption day, where they will be given priority over ‘subsequent’ redemption requests. Gates operate on a pro-rated basis, so that all investors seeking to redeem shares on any given redemption day are equally subject to the deferral.
The rationale behind a gate is to provide some semblance of equality for shareholders in the event redemption of a substantial proportion of the fund is contemplated. By imposing a gate, the fund is able to mitigate the risk that those shareholders who remain in the fund are in some way prejudiced by a material redemption. This would be the case, for example, if all of the fund’s liquid assets were used to fund a substantial redemption, leaving the portfolio comprised of relatively illiquid assets, the short term realisation value of which may be minimal.
Again the decision to exercise a gating right will typically be subject to a discretion on the part of directors. In practice, gates are rarely exercised (not least because the exercise of such rights can often be subject to commitments in side letters, stating that the fund will not exercise them).
Funds may from time to time enter into side letters with substantial investors, the terms of which may relate to the mechanisms discussed above. Typically, such investors will be seeking comfort under the side letters in relation to how, if at all, various restrictions and penalties referred to above will be imposed in relation to their investment.
Such arrangements give rise to a number of issues. Directors entering into such arrangements may find themselves in a difficult position if they have failed to negotiate terms with the relevant investor that make it clear that the assurances in the side letter are subject their duties to act in the best interests of the fund as a whole. The other side letter issue on redemption rights which can sometimes be overlooked is the impact of ‘most favoured nations’ clauses. When assessing the impact of side letter terms on redemption rights, it can easily be forgotten that such clauses may give investors rights in relation to preferential redemption terms in addition to those they have directly negotiated.
The tools that we have discussed so far are intended to provide the fund with means for managing redemptions on a day to day, month to month and quarter to quarter basis. These tools alone are not necessarily sufficient for the fund to manage requests to withdraw money in circumstances where there is an event that impacts on the fund’s portfolio substantially (as was the case for a number of hedge funds during the ‘credit crunch’ this summer). In such situations there are other tools that funds may have to fall back on where the ‘standard armoury’ is not sufficient to protect the interests of shareholders as a whole.
In some cases, the fund may need only to temporarily reduce the capacity of investors to redeem shares. This might be necessary, for example, because the fund has a relatively concentrated portfolio of illiquid investments and realisation of one of those investments to fund a redemption might be to the detriment of all remaining shareholders.
In such circumstances the most straightforward thing for the fund to do would be to agree with a redeeming investor individually how the redemption would be managed. This might involve the investor voluntarily withdrawing their redemption request once they are better appraised of a potential return on the investment that is not necessarily visible to them at the time they put the redemption request in. Failing that, the fund might wish to effect the redemption in the manner contemplated in the prospectus and then have the directors use their discretion to lengthen the period for settlement of redemption proceeds.
If the relevant event impacting on the portfolio is more profound the fund may seek to effect a temporary suspension of the redemption of shares generally. This is usually achieved by the fund declaring a temporary suspension on the calculation of net asset value if one of the conditions for temporary suspension is met. This serves the purpose of not only preventing redemptions (as no net asset value can be ascertained for the relevant redemption day) but also preventing inflows of further monies until such time as the fund’s portfolio can again be accurately valued.
A less commonly pursued alternative is for the fund to seek to engage with its shareholder base as a whole and to agree a restructuring proposal with all investors, the effect of which is to restrict substantially all shareholders rights to redeem. This would typically be done by seeking to amend fund’s constitutional documents to limit redemption rights further.
As was the case for a number of high profile funds during the course of the summer, difficulties in the fund’s portfolio can become sufficiently dramatic that the fund takes the view that it will not be possible for it to recover losses sustained. Such circumstances then give rise to question marks about how investors will be able to exit from the fund. Most funds that reach this position are likely to look at placing the fund into liquidation and then effecting an orderly distribution of assets amongst remaining investors once all of the fund’s creditors have been paid off. In most jurisdictions this would be effected by the appointment of third party administrator or liquidator who will then manage the ‘run off’ of the fund’s portfolio and the distribution of assets.
The significant point to note in relation to redemptions and the appointment of a liquidator is that in most jurisdictions, immediately upon appointment of a liquidator, outstanding redemption requests will be void and no further redemptions of shares will be permitted other than with the consent of the liquidator. This consent is unlikely to be forthcoming unless it is in the best interests of all shareholders and, in all likelihood, all shareholders will be required to wait to participate pro rata in any distribution of assets resulting from the liquidation. This can be an unfortunate consequence particularly for investors who have either put in notice of their intention to redeem shares on a long notice period or who have had their redemption requests deferred as the consequence of the operation of a gate mechanism.
It will still be some time before any industry-wide picture of the impact of the events of summer 2007 on redemption rights will be known and how market terms might change to address these issues. What is clear, however, is that a great number of investors are likely to be more sensitive to the issue and to take such steps as they can to assure themselves that, wherever possible, they will be able to realise their investment in all circumstances.