Shaun Folpp, Ogier,
Jess Shakespeare, Kinetic Partners
The future looks bright for turnaround and insolvency professionals in the hedge fund space in the Caribbean, most notably in the Cayman Islands and the BVI, the jurisdictions of choice for offshore hedge funds.
With only an estimated 3 per cent, or $60 billion of $2 trillion-plus hedge fund assets still gated following the economic crash, there is cause for celebration in the world of hedge fund investors. Indeed that figure will continue to fall as liquidity becomes available and managers and general partners continue to wind down their illiquid portfolios.
At the onset of the crisis in 2008, and in an effort to facilitate the stable liquidations of portfolios, many funds implemented gates, suspended redemptions or otherwise locked in investors, many with the objective to pay out within two or three years.
That time has now come and gone for many funds and their managers who have not met those objectives. It is unlikely that investors will be willing to give managers further time without outside assistance or a definitive plan.
Often these illiquid investments or illiquid portfolios have been separated from the fund by way of, for example, a side-pocket or a liquidating trust. In the case of funds of funds, these illiquid investments are most commonly in similarly positioned illiquid funds or even in funds of funds themselves. In many cases, managers have agreed to reduce management fees from the typical 2 per cent as a concession to investors. Due to the illiquid nature of the funds, reporting has often been minimalised, albeit consensually.
With markets now bouncing back, liquidity becoming more available, and new funds launching, it is understandable that in some instances these portfolios are no longer the primary focus of their managers.
Hedge fund managers are expected to concentrate their efforts on making money, attracting new investors, launching new funds and generally ensuring the graph points continuously upwards. Indeed it is not uncommon for an investor to receive his annual side-pocket performance report together with details of the manager’s latest subscription opportunity.
It should come as no surprise then that in the first two quarters of 2011, a number of investors have begun focusing on pursuing these unsatisfied redemptions requests and are seeking advice on how best way to accomplish this. Looking forward to the remainder of 2011 and into 2012, one expect an increasing trend in investors looking to scale up their efforts to retrieve their redeemed investments. In addition, many managers of these illiquid portfolios are also concluding that realisation efforts must be revamped, including through the use of turnaround and insolvency professionals with workout experience in the hedge fund space. The involvement of these professionals brings an additional layer of independent and and arms-length oversight to creditors and investors and adds transparency to the wind-down process.
For managers, the process can provide some much needed respite from the burden of winding down funds or portfolios which have reached the end of their lives and also from pressures they might be facing from investors. In fact, a turnaround and insolvency professional may have a network of secondary market buyers willing to purchase troublesome illiquid portfolios and positions, and brokers who can match buyers to sellers. The secondary market developed in the late 1990s as a result of an influx of capital being put into too few hedge funds managed by too few managers at the time.
Before equalisation of this imbalance occurred, investors were willing to pay premium over net asset value for access to their preferred strategies and managers. Several years and several thousand managers and new strategies later, the secondary market post-crash now typically serves more on the distressed market side and trades often at cents on the dollar. Still, investors are often willing to accept the sacrifice when they look at the opportunity cost of not participating in a resurging market.
With regard to the costs for these services by turnaround and insolvency professionals, some have found that traditional rates and hourly-type remuneration are not often acceptable to managers or investors and have adjusted their compensation packages accordingly. These days investors expect their professionals to align their interests with them by having some “skin in the game” and therefore share in the risks and the rewards. Thus, a fee structure incorporating hourly rates, a percentage of recoveries, a percentage of assets under management, or a combination of these approaches is often more acceptable.
Immediate and substantial cost savings, so called “quick wins”, also often can be made to reduce the amount of cash going out of the door so quickly. These may involve the renegotiation of service provider’s contracts on the theory that less work is required with regard to an illiquid portfolio. This may be particularly true of the Administrator, but it also may apply to other service providers as well.
In contentious situations, a turnaround or insolvency professional can take the lead on both offensive and defensive legal actions, thereby acting as a shield between third parties and the fund/ manager. He or she can also make independent and objective decisions regarding legal actions where other business relationships may prevent incumbent managers or GPs from doing so.
As a result, busy times are expected for turnaround and insolvency professionals in the hedge fund domiciles of the Cayman Islands and the BVI.
Recent case law
Depending on the jurisdiction of a fund in question, recent case law has emerged that offers two differing views on both what constitutes a member with the right to file a winding-up petition and what constitutes a fund’s loss of substratum. Much has been written on these topics in recent months, so only a recap is provided here, with a focus on what these might mean for the jurisdictions in question.
In the context of entitlement to petition to wind up a fund, the UK Privy Council in the well-known 2010 Strategic Turnaround appeal from the Cayman Islands Court of Appeal, determined that, depending on the specific terms of the articles of the fund, a redeeming member becomes a creditor on the redemption day; accordingly, such a member is entitled to petition to wind up the fund as a creditor.
Many believed that the BVI would adopt the same approach. But insolvency legislation of the BVI that is not mirrored in Cayman legislation blocks an unpaid redeeming shareholder from petitioning to wind up a fund as a creditor. Under BVI legislation, the definition of “creditor” for the purposes of presenting a petition excludes claims made by a member in his or her character as member.
BVI Courts had determined that a redeeming member was nevertheless a creditor and entitled to present a winding up petition as a creditor. However, on appeal to the Court of Appeal from one of those matters (Westford Special Situations Fund), that decision was overturned, and it is now clear under BVI law that unpaid redeeming members cannot present a petition to wind up the fund as a creditor.
This is not the case in Cayman. Creditors‘ petitions are usually simpler to bring than members’ petitions, and to the extent Cayman fund investors will have a remedy not available to BVI fund investors.
in the context of a petition for the winding up of the fund on the just and equitable grounds, the much-discussed apparent divergence of approach between the courts of the Cayman Islands and the BVI as to what constitutes a loss of substratum of an investment fund is probably more apparent than real and more a difference in approach than in practice. Both Courts seek to ensure an orderly wind down in funds in run off for the protection and benefit of investors.
The Cayman Court has gone further than the BVI Courts in statements of principle, asserting that once a fund ceases to operate as a trading investment entity, then it should ordinarily be wound up by the Court. In practice, however, if a management wind-down is operating fairly and properly, and not at excessive expense to the fund – in particular, in fees paid to service providers at a level inappropriate in a wind down – the Cayman Court ordinarily will stay or adjourn the petition to allow the wind-down process to be completed on terms, if appropriate, laid down by the Court.
The Courts of the BVI have taken a different approach in principle and do not regard as appropriate ordering the winding up of a fund merely because it is run off. However, given the Cayman Court’s practice of staying or adjourning petitions in appropriate cases to allow a management wind-down to be completed, the difference between the courts, with one favouring investors and the other favouring funds, is likely to be illusory in practice.
“This article first appeared in the September 2011 issue of The Journal of Corporate Renewal, published by Turnaround Management Association. It is reprinted with permission.”