Hedge Fund Redemptions: A Primer (Part 2 of 2)
One note about holdbacks. As noted in last weekís article, many hedge funds have a holdback provision, pursuant to which a portion of an investorís redemption request will be held back to allow for subsequent valuation adjustments or to cover liquidation expenses. Typically, the held-back amount is placed in a special interest-bearing account that is not exposed to market risk.
Adviser Compliance Associates partner Jeff Morton pointed out that some funds do not disclose whether the interest accruing on the held-back amount will accrue to the investor or to the fund. In Mortonís experience, funds handle it both ways. "Itís kind of 50/50," he said. Some funds "will say ĎWe believe itís the fundís money, any interest earned accrues to the fund.í" Other funds "tell you that for the amount that is held back, the interest will accrue to the investor." Either way, he said, "itís a disclosure issue."
Watch your side pockets. If your fund utilizes a side pocket, there are several issues to keep in mind.
First, look at your disclosures. Have your investors been told up front that they will not be able to redeem their interest in the side-pocketed assets? "Thatís a clause that should be in the partnership agreement and clearly disclosed in the offering memorandum," said Bingham McCutchen partner Richard Goldman.
If a fund has not told its investors about the side pocket, the fund may find itself with no side pocket at all. And that could have dire consequences for the fund. If a fund has to liquidate positions to meet redemptions, the remaining investors will be left with a larger piece of the illiquid investments that were supposed to have been placed in the side pocket. Ultimately, the fund manager may be forced to prematurely liquidate the illiquid investments in order to meet investor redemptions.
If a fund manager persists in treating assets as side-pocketed, even where no disclosure has been made, expect SEC scrutiny. "If thereís no disclosure, I think the SEC would have a serious problem with that," said Morton. And, he added, "I would presume investors would have some right of action."
Keep in mind that the SEC already is aware of the issue. In a June 2006 speech, Commissioner Roel Campos cautioned that "some hedge funds require leaving some of the investment in side pockets as a condition for redemption, even though the condition was not disclosed in the investment agreement."
Assuming the side pocket has been disclosed, check to see whether the provision was drafted so that the percentage limit on the amount of assets placed in the side pocket applies at the time the investment is initially placed in the side pocket. Not only does this eliminate the need to monitor the percentage of assets in the side pocket on an ongoing basis, it eliminates the potential for limited partner withdrawals to cause the fund to hit its side pocket limit. Even then, consider disclosing that subsequent limited partner withdrawals or an increase in the value of the fundís side-pocketed or non-side-pocketed investments may cause the relative amount in the side pocket to fluctuate.
Compliance officers also should test to confirm that the manager has not been selectively allowing certain investors to redeem their side-pocketed assets, i.e, allowing certain investors to withdraw their entire investment from the fund despite the presence of the side pocket. Such a practice raises a host of issues: Not only might it violate the fundís stated redemption provisions, it raises fairness and conflict of interest issues (why are certain investors given preferential treatment?). In addition, the practice may raise valuation issues, because the value of unrealized side-pocketed investments typically would not have been tested in the market.
Compliance officers also should consider how side pocketed investments have been valued. While there seem to be varying views out there, the general consensus of practitioners is that assets in the side pocket should be fair-valued over time (both upwards and downwards) and not simply held at cost. Also, keep in mind that if the fund is subject to a GAAP audit, GAAP requires fair valuation.
Lastly, compliance officers should keep an eye on the timing of assets being placed in and out of side pockets, out of concern that the manager may be attempting to manipulate fees. For example, say the manager knows that a position has incurred a loss. Recognizing that loss would pull the value of the fund down, thereby decreasing the managerís fees. So, to avoid recognizing the loss, a manager may be tempted to treat the position as illiquid and move it at its current value into the side pocket, under the theory that it will sit out of sight, perhaps with less frequent valuation adjustments, and with no particular time frame for pulling it back in to the main portion of the fund. To avoid such a scenario, compliance officers should give heightened scrutiny to situations where an existing investment has been placed in a side pocket subsequent to being purchased.
Of course, it may very well be the case that the investment was perfectly liquid when purchased and later become illiquid. In such a situation, the compliance officer should confirm that the previously-held investment was truly illiquid when it was moved to the side pocket, confirm that the firm properly valued the investment at the time the investment was moved over, and document how the firm reached those conclusions.
Again, the SEC is aware of this issue. In his June 2006 remarks, Campos warned that hedge funds may hide poor-performing assets in side pockets to exclude the assets from the fundís valuation for purposes of calculating performance fees. And the SEC staff undoubtedly has read the Wall Street Journal articles about Ritchie Capital, the mid-sized Geneva, Illinois hedge fund that last year came under attack from investors for shifting certain assets, but not others, into side pockets.
Keep an eye on redemption gates. A redemption gate allows a fund to impose a limit on total fund-wide withdrawals if total redemptions due to be effected at one redemption date are more than a certain percentage of the total amount of the fund. In other words, if everyone is rushing to the door, the door is narrowed and people are told to wait, allowing the fund manager to sell off positions in an orderly manner. "If everyone is trying to get through the door at the same time," explained Morton, it could affect "what everyone is going to get back." Typically, redemption gates range from 20 to 25 percent of the fund, and redemption requests thwarted by the gate are given priority at the next liquidity event.
Here, compliance officers should test to confirm that individual investors have not been allowed to "slip under" the gate. It may be hard to resist, but funds should not give certain investors preferential treatment, particularly if the preferential treatment has not been disclosed to other investors. "What happens if your biggest investor starts whining and complaining and wants to get all of their investment back at once?" asked Morton. If a fund has let some investors through the gate in the past, "what kind of precedent does that set for any potential gate issues going forward?"
Oversee processing of redemptions. The mechanical aspects of processing redemptions also present challenges. For starters, compliance officers should have a firm grasp of the chronology of events: How often does your fund offer liquidity events? On a quarterly basis? Monthly? How much notice are investors required to provide? Are certain investors allowed to provide shorter notice?
Typically, redemption requests are processed by the fundís administrator or prime broker, and are approved by the fund manager. The compliance officer "is not necessarily involved in it day-to-day," said Morton.
Still, the managerís compliance officer should oversee the processing of redemption requests. For example, the compliance officer may want to request and review copies of the administratorís procedures for processing redemptions. "Even do a site visit," he added.
What should the procedures cover? Eisner partner Nicholas Tsafos suggested that the administrator monitor withdrawal notices and make follow-up phone calls (or send a follow-up notice) to a redeeming investor, to confirm the redemption instruction. In addition, the administrator could compare the redemption instruction to the original investment letter that the investor had signed, to make sure that the account that the money is going to being wired to is the same account that the money originally came from, or an otherwise valid account. Moreover, the administratorís procedures should cover confirmation of authorization, particularly if the investor is an organization or institution. Here, explained Goldman, "you want to make sure that the redemption request is sent by an authorized signer of the investor." For example, if a fund has an account for a husband and wife, and a redemption request for that account bears only the husbandís signature, the fund should obtain the wifeís signature as well.
The key, explained Tsafos, is that the person handling redemptions "take the extra step" and not just "take something in from the mail." He noted that hedge funds and their investors have been defrauded in instances where an unauthorized person submitted a redemption request and the fund honored it. In the past, he said, some funds have inadvertently wired proceeds "to an account that nobody knew about."
What about lost redemption requests, where an investor claims to have submitted a redemption request that was not received by the administrator or the fund? Schulte Roth partner Stephanie Breslow analogized this to the situation where a customer shows up at a busy restaurant and claims to have a reservation: "Nobody can prove he didnít call." Similarly, when an investor claims to have submitted a redemption request that has "gone missing," it may be impossible to determine whether or not the redemption was actually sent by the investor. To address this issue, she said, some funds are building protections into their documents by specifying that written instructions are not validly received unless followed up by a phone call.
What if the request truly was lost, either by the fund or its administrator? "If the position has moved against you in the meantime," said Breslow, the fund manager may have an error situation on its hands. As would be the case in any other error situation involving the administrator, managers should look at the liability and indemnification provisions in the fundís agreement with their administrator. In the event of simple negligence (transposing two digits on a fax number, for example), the administrator may not be liable and, depending on the liability provisions in the fundís offering documents, the error may come out of the fund as a whole.
Tsafos noted that proper treatment of redemptions is critical from the accounting perspective. He pointed to a FASB pronouncement that, in essence, states that if a fund receives notice that an investor wants to withdraw capital as of a specific date, the fund needs to reclassify the redemption amount from partnersí capital to a liability. If a fund has net assets of $100 million, but has pending redemptions of $5 million, he explained, "they really have net assets of $95 million."
Lastly, check to see whether your fund permits redemptions in kind, as well as or in connection with cash redemptions. "Managers generally pay out redemptions in cash where possible, but may use the right to pay out in kind in some situations, including through participations in illiquid assets," explained Breslow. Such an approach may or may not make sense, depending on the circumstances involved. For example, she said, if a fund group is being restructured and investors are being transferred to a new fund vehicle, redemptions in kind may be a good, tax-free way to accomplish the restructuring. For other types of funds, redemptions in kind may not be practical. If the fund in question is a distressed fund, the average investor "is in no position to deal with trade claims," she noted. And, added Breslow, redemptions in kind in the liquidation scenario can raise thorny valuation issues. So, before proceeding with a redemption in kind, talk with your favorite lawyer.