Hedge Fund Redemptions: A Primer (Part 1 of 2)
Things are good until they arenít.
As last yearís Amaranth debacle illustrated, compliance officers and attorneys at hedge fund managers can face a sudden "rush to the exits" at their fund at any time. Like other business contingency issues, itís a good idea to think about a mass exodus before it happens: Hell hath no fury like an investor who feels that he has been treated unfairly in the redemption process. "In a mass redemption situation, there is special pressure on the manager to ensure that investors are treated fairly and that values are supportable," said Schulte Roth partner Stephanie Breslow. "Otherwise, litigation is a real possibility."
Even routine hedge fund redemptions can raise compliance issues. Based on conversations with a number of leading hedge fund practitioners, here are a few practical guidelines to think about when handling redemptions:
Make sure the price is right. If the prices used to value the investment portfolio and thereby calculate the redemption amount are not accurate, things can quickly go to hell in a handbasket. "Valuation is key," said Eisner partner Nicholas Tsafos. If redeeming investors exit the fund at a too-low value, he explained, "the ramification is that they arenít getting enough money for what their interests are worth." On the flip side, if they come out at a too-high value, the remaining investors in the fund are harmed.
Of course, different types of funds face different types of valuation issues. Funds that invest primarily in publicly-traded, liquid securities will find valuation to be a relatively straightforward matter. On the other hand, noted Alston & Bird partner Lindi Beaudreault, funds that hold a significant amount of illiquid securities may find valuation to be one of their biggest issues.
Breslow reported that valuations are becoming "increasingly challenging" in the hedge fund world because of the trend toward increased complexity in investment instruments and strategies. In an effort to seek out alpha for their investors, she explained, hedge fund managers have been exploring increasingly complex investments. "The less liquid and more complex the instrument," she said, "and the less active the trading, the more subjective the valuation."
Not only can incorrect valuations dilute investorsí interests, they also can hurt the fund manager. Say a fund goes into liquidation mode after a number of limited partners redeem their interests. Following the spate of redemptions, but before the fund is wound up, an auditor is brought in and determines that an illiquid position in the fund, not held in a side pocket, had been grossly overvalued prior to the redemptions. In such a scenario, the early redeemers received a windfall. "All those investors got paid out 100 percent on an NAV that wasnít true," said Tsafos. Assuming the general partner canít get the money back from the redeeming limited partners, "the investors that are left in there are still holding the bag." In such a circumstance, he said, the general partner likely would have to make the remaining investors whole, by making up the difference out of its own pocket.
To avoid such a scenario, most hedge funds include a "holdback" provision in their offering documents. "The reason this is done is in case the auditor comes up with any adjustments that would affect the NAV of the fund," Tsafos explained. A holdback, he said, is a "perfectly allowable practice," provided it is properly disclosed to investors.
"The holdback is the standard," said Bingham McCutchen partner Richard Goldman. "If you want to take out all of your money, generally a hedge fund will distribute most of the withdrawal proceeds to you within 30 days after the liquidity date and hold back a small portion, often five to ten percent, until after the year-end audit." Say an investor pulls out of a fund and his redemption is processed using a June 30 NAV, resulting in a $1 million distribution. Pursuant to a five percent holdback provision, however, only $950,000 would initially be distributed to the investor. The remaining $50,000 would typically be held by the fund and delivered following the completion of the audit. If, as a result of the audit, the fund retroactively reduces the fundís NAV as a whole as of the redemption date, a reduced portion of the holdback will be delivered.
What should the fund do with the holdback while it is being held back? In Tsafosís experience, the holdback is typically put in an interest-bearing account. "Thatís the most fair way to do it," he said. "I would not put it at risk in the market." Goldman concurred. "More funds than not are putting the money into the interest-bearing account," he said. But, he added, "some firms donít have that."
The holdback serves an additional purpose: If the redemptions occur in a liquidation situation, the holdback provision allows the fund to establish a reserve to pay for the expenses involved in liquidating the fund.
Make sure that you have enough liquidity in the fund to meet redemptions. Redemptions happen. Can your fund raise cash to meet them?
"Have some sort of liquidity strategy available to meet redemption needs," advised Tsafos. Unlike mutual funds, which are redeemable on a daily basis and therefore maintain a regular cash balance, hedge funds typically offer only quarterly liquidity dates and do not maintain a regular cash cushion to meet redemptions. But from a portfolio management perspective, explained Tsafos, funds should not box themselves into a situation where they have to sell off a position at an inopportune time in order to raise cash. To address this, some funds arrange liquidity by establishing a line of credit with a bank. Other funds may use proceeds from certain types of transactions, such as short sales, swaps, and repurchase agreements. Talk to your favorite hedge fund lawyer about whether such strategies actually work in practice, create undue leverage, are appropriate for the fund, and have been appropriately disclosed.
Do what you say you are going to do. Follow the redemption procedures outlined in your fundsí limited partnership agreements and private offering memoranda. In a 2003 enforcement proceeding against hedge fund managers Wilfred Meckel and Robert Littell, the SEC asserted that the managers failed to comply with the distribution procedures established by their fundsí administrator and disclosed in their fundsí partnership agreements. The fundsí documents provided that net profits or losses would be allocated to the fundsí limited partners in proportion to their capital accounts. However, the SEC alleged that the managers allowed several investors to withdraw their interests at an inflated value, i.e., before losses had been allocated. Two investors, said the SEC, received approximately $6.8 million in excess of their investment values in one of the funds at the time of their redemptions. "As a result, those partners who remained invested [after the redemptions] suffered both from the large devaluation of their assets due to trading losses and the dilution of their remaining assets resulting from the improper distributions," asserted the SEC.
Several practitioners noted that fund documents typically provide the general partner with some wiggle room in handling redemptions. "The general partner has some flexibility," said Goldman. "Most documents will permit the general partner to have some discretion or to waive certain terms." Breslow agreed. "Typically, there is a fair amount of flexibility" in fund documents, she said. For example, she noted, funds may be able to redeem an investor in cash, in kind, or in a combination of the two.
What if the terms of your limited partnership agreement and private offering memorandum conflict? "You truly would hope that there would be consistency between the two," said Goldman. "If push came to shove, the limited partnership agreement is the contract that the investor signs. At some level, that would control, but the investor may have a good argument to rely on the PPM." However, he noted that in the case of offshore funds, "usually the articles are fairly generic and the offering memo becomes the controlling document."
Be fair. While the general partner may have some flexibility to waive or change terms, those waivers and changes should be "fairly consistent across investors," said Goldman. "What we wouldnít want to see is for some investors, a holdback, for others, no holdback," he said. "We like to see consistency."
Tsafos also identified holdbacks as an area where hedge fund managers may face fairness issues. Some funds, he said, may "decide to hold back different amounts for different investors." For example, if the investor is a relative, the fund manager might be tempted to hold back less than if the investor was an ordinary investor. However, he said, managers should avoid such practices. "You really canít be picking and choosing how much you are going to hold back," he said.
Beaudreault urged CCOs to fully recognize the importance of the fairness issue. While a CCO may theoretically understand that a fund cannot give undisclosed preference to one group of investors over another, "if you havenít had the government actually come in and scrutinize your books," the CCO may not appreciate how important this issue is to the SEC. "The SEC really does care about these issues and really does scrutinize them when they come in during the exam process," said Beaudreault. CCOs should "take it seriously," she said. "The biggest concern, and what could really get you in trouble from a regulatory perspective, is if the fund is going down and in that context some people get to get out sooner than others," she noted. "Regulators have a general distaste for preferential liquidity, and particularly undisclosed preferential liquidity." If you secretly let some people get out sooner than others, she said, "you are really at risk of getting yourself sued."
How can you tell if something is fair? Hereís a helpful rule of thumb, courtesy of Breslow: "Whenever you waive one of the terms you have the right to insist on, kick the tires" and ask "would you do that for any other investor similarly situated?" If the answer is not "this is something I would be happy to do for anyone," rethink what you are doing.
Be careful with side letters. Side letters are, at their heart, a vehicle for providing certain investors with preferential treatment.
In her May 2006 testimony before the Senate Securities subcommittee, Susan Wyderko, then-director of the SECís Division of Investment Management, stated that some side letter provisions may be "troubling" and "involve material conflicts of interest that can harm the interests of other investors." Chief among those, she said, were side letter agreements "that give certain investors liquidity preferences or provide them with more access to portfolio information." She said that SEC examiners are reviewing side letter agreements and evaluating whether appropriate disclosure of the side letters and relevant conflicts has been made to other investors.
For compliance officers, side letters can present a real conundrum. "People request them," said Breslow, "and if the effect of the letters is to give some investors an undisclosed advantage over others, this is where the SEC quite legitimately is concerned." Breslow, for one, said that she advises her clients against granting preferential liquidity rights in side letters and warns them that if preferential liquidity is granted, it must be adequately disclosed.
Goldman noted that some side letter provisions are more problematic than others. For example, he said that he was not very concerned about side letters that provide for reduced fees. However, if a side letter states that an investor is not subject to a redemption gate and other investors are, that could be more troubling.
If you havenít already, round up all of your fundsí side letters and take a look. In particular, look for examples of preferential liquidity, such as:
Early redemption rights;
Reduced notice provisions (i.e., 15 daysí notice instead of 45 days);
Ability to redeem in the event of a catastrophe;
Ability to redeem if a "key man" departs;
Ability to redeem in the event of a market downturn;
Waivers of redemption fees; and
Waivers of applicable redemption gates.
The key, said Goldman, is for compliance officers to know what their fundsí side letters have promised.
How much detail is required in disclosure about side letters? The U.K. Alternative Investment Management Association, a trade group representing the U.K. hedge fund industry, recently issued guidance on the level of suggested disclosure.
For us Yanks, however, things are bit more fuzzy. "I donít think we totally know yet what the SEC wants us to do on this," said Breslow. "I donít think we really have clarity on how much disclosure is adequate disclosure. We certainly write about the possibility of there being side letters and warn of the types of preferential rights they may provide, but it is unclear, for example, whether it is necessary to disclose the portion of the investor base that has these preferential rights or the specifics of the rights granted." U.S. funds typically have not specified details such as the percentage of the fundís investments that may be subject to a side letter agreement, she said.
In any event, Breslow suggested that when negotiating side letters, hedge fund managers bring a lawyer into the process sooner rather than later. "It is amazing how often we donít get to see side letters before they are signed or substantially negotiated," she said. If they arenít sent to counsel for review early enough in the process, she said, "we donít get to fix them." For example, she said that sometimes side letters are written broadly, to cover all the funds that the manager runs. This, she noted, can sometimes be problematic. "There may be things you may be able to give them in one fund that you shouldnít give them in the other," she said. For example, a fund of funds investor may invest in a managerís domestic as well as offshore funds. In the domestic fund, there may be reasons why investors cannot transfer or redeem their interests with too great a frequency, she said. In the offshore fund, however, that may not be an issue.
Next week: Side pockets, redemption gates, distribution of proceeds, and more!