As the hedge fund industry grapples with an unprecedented volume of redemption requests, hedge fund sponsors are struggling to satisfy these requests while still complying with their fund documents and fiduciary duties, and preserve enough of their assets and investor capital to remain a viable presence in the industry. Below we note some issues that have arisen with respect to hedge fund redemptions. (Readers should be aware that this is a succinct summary of an article that Bloomberg Law Reports™ will be publishing in the near future. )
Gates and Suspensions
Gates and suspension provisions are two standard features of a hedge fund that enable the investment manager to preserve the value of the fund and prevent a sudden exodus of capital when faced with mass redemptions. A gate enables the fund to limit redemptions as of any date, while a suspension provision precludes redemptions altogether as of such date. Each plays a different role in a fund's strategy with respect to handling redemptions and the exact language of their drafting can lead to very different consequences.
Payments in Kind (PIKs) and Special Purpose Vehicles (SPVs)
Many funds have the ability to satisfy a redemption through a PIK - distributing an investment held by the fund to the investor. However, there are many practical obstacles a fund faces when making a PIK, as well as potential obstacles posed by Delaware’s Revised Uniform Limited Partnership Act and some thorny fiduciary duty considerations. The exact partnership agreement language with respect to PIKs will be critical in defining the full extent of a fund's flexibility to make PIKs.
One form of PIK that was widely implemented during the period of 2008 year-end redemptions was a PIK made through a newly organized SPV. An SPV may be used to isolate and manage down assets to be liquidated in connection with satisfying redemptions of redeeming investors. The redeeming investors then receive a PIK in the form of an interest in the SPV in satisfaction of their redemption requests. Although an attractive mechanism that may enable a fund to avoid a fire sale of assets, many fund sponsors discovered that there are numerous potential pitfalls associated with such SPVs, ranging from compliance with fund redemption provisions, fiduciary issues, conflicts of interest and valuation issues. Some of these issues have been the subject of litigation in the United States and Bermuda.
Impact of Recent Redemptions on Hedge Fund Terms
As a result of the recent wave of redemptions, fund sponsors are keenly aware of the importance of matching the redemption terms of their fund documents to the liquidity of the assets held by the fund. Many have also had occasion to revisit and clarify partnership agreement provisions affecting redemptions, which may have been either ambiguous or did not provide the full range of flexibility that the fund sponsor would have liked.
Although every fund sponsor undoubtedly hopes that it will never again have to face such a period of volatility and massive redemptions, investors can expect that fund sponsors that survive this crisis will fine-tune their fund documents to incorporate features enabling them to handle mass redemptions without being forced to liquidate assets at depressed prices. These features may include explicit provisions in the partnership agreement to use SPVs, as well as individual investor-level gates. An investor that is subject only to an individual investor-level gate will not have its own liquidity dependent to the same extent on other investors' redemptions and thus may not be motivated to submit a redemption request solely to secure its place in the redemption line. However, these investor-level gates can obviously limit the ability of an investor to withdraw a large percentage of its capital at any one time and will necessarily impact an investor's liquidity management and initial decision to invest.
Because many investors have been uncomfortable having their liquidity rights affected so dramatically by the redemption decisions of other investors, investors will likely continue to show a growing interest in “separately managed accounts.”