The hedge fund industry has been severely affected by the recent turmoil in the financial markets. The dramatic fall of market prices, pressure to de-leverage, short selling bans and the increased costs of borrowing have all negatively impacted hedge funds. Statistics released by the Cayman Islands Monetary Authority confirm the impact of the global financial crisis on funds regulated by CIMA. In 2008, the number of new funds processed by CIMA declined by 18 per cent, and fund terminations increased by 29 per cent, as compared to the previous year. Neal Lomax, partner and head of office at Mourant du Feu & Jeune, Cayman Islands discusses in this first in a two-part series.
In the last six months, hedge funds faced with substantial redemption requests have struggled to meet liquidity needs. Many have been forced to sell assets at distressed prices, which in turn has led to a fall in net asset values, triggering more redemptions. The fundamental issue is timing. If hedge funds had the ability to hold investments for longer periods, they would have greater flexibility to value their investments other than on a potentially forced realisation basis. For this reason, hedge funds have resorted to a range of techniques, some traditional and others newly minted, to reduce the pressure to liquidate the fund’s portfolio at an inopportune time.
Techniques employed to control liquidity
The options available to control liquidity are dictated by the provisions of the fund’s governing documents, any side letters and the quantity of redemption requests in a given period. The following are some of the techniques which have been employed:
• Lock-ups: A lock-up refers to the initial amount of time an investor is required to keep its money in a fund before redeeming. The governing documents of hedge funds often include provisions that subject investors to an initial lock-up of one to three years following subscription. Redemptions may be permitted within the lock-up period subject to an early redemption fee.
•Side Pockets: A side pocket is a segregated account created to hold portfolio assets that the manager deems illiquid. When a side pocket is created a corresponding portion of the investors’ interests are generally converted into a new class of non-redeemable interests, representing the fund’s investment in the illiquid asset. Affected investors participate in the profits, or take the losses, on the asset only when it is realised or deemed realised.
•Spin outs: Some funds lacking side pocket provisions in their governing documents have created special purpose vehicles to achieve much the same effect. The SPV either acquires the illiquid assets directly or (if the illiquid assets are non-transferable) enters into a participation agreement with the fund and acquires future proceeds from the illiquid assets. In each case, the fund receives shares in the SPV which are transferable and may be distributed in kind on a redemption.
• Gates: A redemption gate is a limit on the percentage of fund capital that can be redeemed on any redemption date. Where a fund has a stacked gate any unpaid redemptions from a given redemption date are rolled forward and assume priority on the next redemption date. Some funds have adopted investor-level gates which limit the percentage of each individual investor’s investment that can be redeemed on any redemption date. These may assist in eliminating the “rush to the exit” problem faced by funds with a stacked gate.
• Redemptions-in-kind: The governing documents of most hedge funds permit the fund to make distributions-in-kind of securities to satisfy investors’ redemption requests. Assuming that the illiquid investments are divisible, a hedge fund can make a proportionate distribution-in-kind to each of its redeeming investors. By returning a combination of cash and a pro rata share of the less liquid investments in the fund’s portfolio to redeeming investors, the fund is able to ensure that those investors choosing to remain in the fund are not left with a higher concentration of less liquid investments.
•Suspension of redemptions: The governing documents of hedge funds generally incorporate provisions, which allow a fund to suspend redemptions during, among other times, the existence of any state of affairs which makes the disposition of the hedge fund’s investments, or the determination of their value, impractical or prejudicial to investors. Whilst a suspension of redemptions has in the past been considered as effectively signaling the imminent demise of the fund, it no longer has the same funereal connotations.
•Restructuring: A fund may be restructured into a liquidating entity (to hold and dispose of illiquid investments) or as an ongoing entity (in which the manager continues to manage the portfolio on behalf of investors who elect to remain invested). Alternatively, a fund may be converted into a listed closed-ended vehicle. Investors in such a vehicle might benefit from greater certainty on pricing, transparency and the ability to exit the fund by selling in the market.