Side Pockets

Enhancing returns

Piers Alexander, Conyers Dill & Pearman

A problem often encountered by hedge funds is their investors' desire for regular exit routes, with the accompanying need for funds to maintain liquid positions. In order to meet this requirement, many hedge funds are structured as open-ended investment vehicles, providing investors with the option to require the redemption of their shares at regular monthly, quarterly or annual intervals. This means that a fund is expected to maintain a cash or near-cash reserve in order to facilitate redemption requests. However, cash or near-cash is unlikely to produce the attractive returns demanded by hedge fund investors and as desired by hedge fund managers.

Lock-up

Hedge funds can balance the need to take longer-term investment positions and the investor desire for liquidity in a number of ways. For example, the fund may impose a lock-up period of, usually, anywhere between six months to two years, during which shares may not be redeemed. The lock-up will run for the requisite period from the last day of the initial offer ("Closing Date") in respect of shares subscribed by an investor on or before the Closing Date and, in respect of shares subscribed subsequent to the Closing Date, for the requisite period from the day on which the investor subscribed for the shares. In the event of a redemption request for shares which were subscribed for at different times, the shares and the lock-up period will usually be determined on a "first in, first out" basis.

The advantage of the lock-up period is that it gives investors the comfort that their investment is not tied up indefinitely; that they have an exit route other than simply on the liquidation the fund. Likewise, for the fund manager, the lock-up period means that it has the ability to make longer-term, strategic investments decisions, secure in the knowledge that the investment strategy of the fund can be pursued without the potentially destabilising effects of investor redemptions during the early months or years of the fund's operations.

Redemption request limitation

Another common method is for the fund to impose a limit on the amount of redemption requests which will be accepted on any given redemption day. Typically, such a limit takes effect when the redemption requests would result in aggregate redemption proceeds being payable in an amount which exceeds a fixed percentage (usually 10%) of the total number of shares in issue on the relevant redemption day. If the limit is exceeded, the amount of all redemption requests received will be reduced pro rata, so that the aggregate redemption proceeds payable do not exceed the fixed percentage of the total number of shares in issue. In this way, all investors wishing to redeem shares on the relevant redemption day will redeem the same proportion of shares. The balance of the redemption requests, in excess of the fixed percentage limit, which were not redeemed, will be carried forward to the next following redemption day, together with all redemption requests subsequently received, to be redeemed at the redemption price applicable on that redemption day.

However, the balance of redemption requests carried forward, together with all redemption requests subsequently received in respect of the next following redemption day, will also be subject to the fixed percentage limit. Of course, a redeeming investor does not have control over redemptions by other investors in the fund and the disadvantage of the above redemption request limitation is that it could lead to the balance of an investor's redemption request being rolled over time and again. Accordingly, it is important to ensure that any balance carried forward is given priority over subsequent redemption requests received by the fund, according to the length of time for which such balance has been carried forward.

Special situation investments:

1. Limiting the liquidity requirement

The increasing difficulty in finding mis-priced assets in liquid public markets has seen some funds move towards more illiquid, but potentially highly profitable, real estate, private equity or emerging market investments. Alternatively, some funds are investing in "Special Situation Investments", such as bankruptcies, re-organisations, liquidations, tender offers and spin-offs, as a bolt-on to their traditional portfolios.

Many of these investments may need to be held for long periods by the fund and, whilst the lock-up period and the redemption request limitation does provide some breathing space in order to allow the fund's investments to grow, an open-ended fund will always need to keep a weather-eye on the possibility of investor redemption requests forcing the disposal of investments, potentially at an earlier stage than the fund may have desired.

2. Dealing with difficulties

Added to the pressure of maintaining the necessary amount of cash or near-cash reserves in order to meet redemption requests, there are other problems for any fund which seeks to enhance its traditional portfolio focus with Special Situation Investments. For example:
 

  • Special Situation Investments are, by their very nature, difficult to price accurately until the occurrence of a liquidity event (e.g. a public offer, takeover, liquidation, or sale). If a Special Situation Investment is included in the general portfolio of a fund, it can only be valued at the base acquisition cost or at that assessed by the fund manager, rather than at a quoted market price. This will distort the calculation of the fund's net asset value.
  • If some investors redeem their investments in a fund which includes a Special Situation Investment in its general portfolio, the remaining investors will hold a disproportionately large interest in the illiquid, non-marketable investments owned by the fund. In addition, even though a fund as a whole may be compliant with its investment restriction, expressed as a percentage of the fund's net assets, on the holding of non-marketable investments, redemption monies will be taken from the liquid portion of the fund's portfolio, with the effect that the non-redeeming investors' exposure to the non-marketable investments held by the fund may, individually, exceed such a percentage level.
  • Until the occurrence of a liquidity event, any performance fee charged on a Special Situation Investment will not be calculated by reference to a net asset value based on a quoted market price.

Side pocket solutions

In order to achieve both fairness amongst investors and accurate net asset value and performance fee calculations, funds will separate their Special Situation Investments from the general portfolios. This can be achieved through "side pockets".

The way a side pocket operates is that only those investors who are invested at the time of the original purchase of a particular Special Situation Investment (or, if an existing holding of the fund, at the time such holding is characterised as a Special Situation Investment) may participate in the profits or gains arising from that Special Situation Investment. Accordingly, any person investing in the fund subsequent to the fund's purchase of, or characterisation of an existing holding as a Special Situation Investment, will not have an interest in that Special Situation Investment.

In practice, upon the fund's purchase of, or characterisation of an existing holding as a Special Situation Investment, a portion of every investor's holding in the liquid portfolio of the fund ("Liquid Shares") is exchanged for a newly issued class of shares representing the fund's investment in the Special Situation Investment ("Special Situation Shares").

This exchange is effected by: first, a redemption of the relevant number of Liquid Shares held by an investor equal in value to the amount required by the fund to be subscribed by that investor in the Special Situation Investment, pro rata to all the other investors invested in the Fund at the relevant time; and then an immediate subscription by the investor of an equivalent value of Special Situation Shares.

No redemption of Special Situation Shares is permitted. However, investors may continue to redeem their interests in the liquid portion of the fund's portfolio.

Upon the occurrence of a liquidity event, each investor will have its Special Situation Shares redeemed. As a price for the Special Situation Investment can now be obtained, it is at this stage that the performance fee in respect of the Special Situation Shares will be calculated and payable. With the redemption monies payable in respect of the Special Situation Shares, the investor will then subscribe for an equivalent value of Liquid Shares.

Pitfalls and remedies

As a Special Situation Investment cannot be valued until the liquidity event, investors are tied to an investment in which they have no way of determining, during the time it is held by the fund, how successfully it is performing.

An investor may redeem his holding, but only from the liquid portion of the fund. The investor is, therefore, forced to retain an interest in the Special Situation Shares, unable to exit fully from the fund for what could be several years.

Whilst any investment bears the risk that it may not be successful, there is an increased risk inherent in the nature of a security of the type characterised as a Special Situation Investment (i.e. often involving financially troubled companies) – such security may result in a distribution of cash or a new security the value of which will be less than the base acquisition cost of the Special Situation Investment. Similarly, if an anticipated transaction does not occur, the fund may be required to sell its Special Situation Investment at a loss.

To counter the risk-potential of Special Situation Investments, the fund will normally restrict its holdings in Special Situation Investments to a percentage of the fund's net assets, measured at the time of investment, applicable both in respect of a single Special Situation Investment and in respect of all Special Situation Investments in aggregate made by the fund. Such allocation restrictions are commonly between 10 and 20% for single, and up to 40% in aggregate, Special Situation Investments.

No fund will want to dispose of an investment at a loss in order to meet redemption requests, and the prohibition on the redemption of Special Situation Shares could seem an attractive proposition by which a fund may counter the need to meet redemption requests. A fund would, by using its power to characterise an existing holding as a Special Situation Investment, be able, at least in part, to prevent redemptions from its liquid portfolio. However, by ensuring that the scope of what constitutes a Special Situation Investment is clearly defined in the fund's documentation, it will be difficult for a fund to misuse its power by designating an existing holding as a Special Situation Investment if that holding does not bear the appropriate characteristics.

Conclusion

Some of the advantages of side pockets for investors is that their interests in a Special Situation Investment are not diluted when additional investors subscribe to the fund, nor will they be left with a disproportionately large interest in illiquid investments if other investors decide to redeem out of the fund. In addition, the net asset value of the fund and the performance fee payable to the fund manager will not be based on unrealised gains on investments valued other than at a quoted market price.

Piers Alexander is an attorney in the Hong Kong office of Conyers Dill & Pearman. He specialises in the establishment of investment funds in Bermuda, the British Virgin Islands and the Cayman Islands. He holds memberships with the Law Society of England and Wales (non-practising) and the Bermuda Bar Association, and is a Registered Foreign Lawyer with the Law Society of Hong Kong.