Since August 2007 the financial landscape has changed. Last year we presented seminars on offshore funds which were sub-titled “Stress-Tested Structures for the Current Market”. In discerning lessons from the credit crunch we focused on drafting changes that were required to insert or improve mechanisms to deal with issues raised by liquidity mismatches and distressed assets. The key legal or mechanical levers were and still are: Side Pockets, Gates, Suspensions and Redemption Payment terms. Offering documents and constitutional documents for offshore funds have evolved quickly and these provisions are now almost universally embedded into the documents. However, the world never stands still, and as a result the following provisions are now also in the spotlight:
- Managed Accounts/Single Investor Funds
- Valuation Committees
- Payments in Kind
- Suspension of Redemption Payments
Below we take a brief look at some structuring developments that we are seeing evolve and share some further drafting refinements that have been necessitated by litigation or fear of litigation.
Managed Accounts/Single Investor Funds
2008 provided many examples of precipitous runs on funds which resulted in the gating or suspension of redemptions. Some funds of funds and strategic investors determined that they would avoid this risk in future by only investing in managed accounts or (their offshore equivalent) single investor funds. Another benefit of this approach is that it avoids the need for a Side Letter and the potential risks inherent in granting preferential terms to a special investor.
There was quite a hubbub on this issue with a number of industry commentators predicting that this would be a major trend as investors sought to protect themselves and avoid being hostage to the fortunes of others. We have set up a number of such funds, but despite predictions, there has not been a flood of such structures. The main reason for this is, in order to make economic sense the investor needs a lot of money to allocate to a portfolio that will be managed in parallel to the fund. We have acted for a number of managers who have set up parallel single investor funds for sovereign wealth fund investors and for some fund of funds and in each case the allocations have ranged from $100m to $500m. Given the gradual removal of gates and suspensions as liquidity returns, it will be interesting to see if certain investors remain wary of commingling their funds with others or if, under pressure on costs, funds of funds continue to invest in multi-investor funds rather than single investor vehicles.
Pricing and valuation of underlying positions has become a huge challenge. Auditors have struggled with accounting standards and funds have faced claims from disgruntled investors who have received NAV statements which provided for valuations at a much higher level than was actually achieved when the investor sought to redeem its shareholding and cash out from the fund.
Much has been made in recent years of the convergence between private equity and hedge funds. As a result of the experiences of many funds in the economic crisis it could be said that a lot of hedge fund investors have, unwittingly, become private equity investors as open-ended funds have mutated into closed ended funds with side pockets, run-off portfolios, suspensions of redemptions and payments in kind.
One area where this convergence has led to the adoption by hedge funds of private equity practices is in the establishment of valuation committees. Funds should consider at the structuring stage whether a valuation committee would be helpful in fixing asset values and assuaging investor fears as to possible self-serving discretionary valuations by the investment manager. Even if not envisaged at the outset, the establishment by a manager of a valuation committee following consultation with investors is a useful investor relations and risk management tool.
Payments in Kind
Long gone are the days when payment in kind provisions were standard boiler plate provisions which no one paid much attention to as they were seldom, if ever, invoked. Legal challenges and volatile markets demand that special care is given to the drafting of such provisions and to the operational execution of a redemption payment in kind. Set out below is an example of an expanded payments in kind provision which we recommend should be considered for all new funds:
“Payment of the Redemption Price to a shareholder on redemption will be made in cash or, in the discretion of the directors (following consultation with the Investment Manager), in securities (which may include short positions, as well as long positions) selected by the directors (following consultation with the Investment Manager), or partly in cash or partly in securities (which may include short positions, as well as long positions) selected by the directors (following consultation with the Investment Manager). In-kind distributions may be made directly to the redeeming shareholder, or alternatively:
- may comprise interest in special purpose vehicles established by the Fund for the purpose of liquidating the securities which are being transferred (either outright or by a participation interest) by the fund; or
- may be distributed into a liquidating trust or account and sold for the benefit of such redeeming shareholder, in either such case (i) payment to such shareholder of that portion of its redemption attributable to such securities will be delayed until such time as such securities can be liquidated and (ii) the amount otherwise due to such shareholder shall be increased or decreased to reflect the performance of such securities through the date on which the liquidation of such securities is effected, and any applicable fees and expenses.”
The underlined terms are additions and clarifications. Key issues to consider providing for are:
- a fuller exposition of the securities which may be transferred. If a fund’s portfolio is comprised of long and short positions then explicitly state that an interest in short posi-tions may be transferred (directly or by way of a participation agreement), otherwise it is likely that the fund will be precluded from transferring a slice of its underlying portfolio to an investor;
- that a payment in kind provision includes not just securities of third party issuers, but also interests in special purpose companies established by the fund;
- inclusion of the right to charge fees on a redemption in kind where the manager will be managing the assets through to their eventual liquidation and conversion into cash.
Operationally, experience has shown that in order to avoid, or at least minimise, the risk of claims from investors, the following steps should be taken when a fund proposes to satisfy redemptions by payments in kind:
- provide notice to redeeming investors prior to the redemption date (and allow withdrawals of requests);
- explain why the redemption in kind is being invoked and offer an option to investors to take custody of assets (where possible) or to participate in a liquidating vehicle or trust managed by the manager;
- ensure any fees attached to management of a liquidating vehicle incentivise the manager to dispose of assets as quickly as prudent (i.e., not a surrogate management fee);
- effect the legal transfer of assets to the redeeming investor or to the liquidating vehicle or trust immediately following the redemption day. Although the documents will provide that risk transfers to the redeemed investor on the redemption day it is likely to be problematic if on the redemption day NAV per share is $100, but by the time the assets transferred to meet that price are received by the investor, their value has diminished so that they are only worth $50 when actually paid to the investor.
Suspensions of Redemption Payments
Most funds have provisions that enable them to suspend redemptions in certain extreme circumstances. Such funds typically also include provisions which enable them to defer payment of a portion of the redemption proceeds (especially for funds of funds) attributable to unrealisable positions and to retain holdbacks from the redemption price to meet adjustments following the finalisation of the redemption price after the audit.
A suspension of redemptions clause, in order to be effective, must be invoked prior to a redemption date. However, it is possible for a fund to include a provision that allows it to suspend the payout of redemption proceeds, so that if the circumstances that would have caused it to invoke a suspension occur after a redemption date, but prior to the redemption payment date (typically 30 days after the redemption date) it can suspend payment.
The efficacy of such a provision has been upheld by the Cayman Court of Appeal in the recent case of In the Matter of Strategic Turnaround Master Partnership Limited. In its judgement the Court of Appeal analysed the procedure and effect of a redemption of shares in a corporate fund and made some significant points, which need to be taken into account from a legal drafting perspective and also operationally by the administrators of funds:
- redemption is not a single event, but a process beginning with the submission of the redemption request and ending with the payment in full of the redemption price;
- upon the redemption date, the redeeming shareholder becomes a creditor of the fund in respect of the redemption price, notwithstanding that that price has not yet been calculated;
- as a creditor, on a winding up of the fund, a redeeming shareholder ranks behind unsecured third party creditors but ahead of shareholders who have not yet redeemed their shares; and
- notwithstanding that it has become such a creditor, the redeeming shareholder remains a member of the fund at least until its name has been removed from the register of members.
The court’s view of when a redeeming shareholder ceases to be a member of a fund is not clear as it appears to contemplate that a shareholder could continue to be a shareholder until the redemption price had been paid in full, notwithstanding that its name had previously been removed from the register of members. The Court of Appeal’s decision was based on its interpretation of the contractual documents of a particular fund. To avoid any uncertainty we have amended our articles of association to include the following explicit provision:
“Upon the Redemption Day on which a share is redeemed, the holder shall cease to be a Member in respect of such share and shall not be entitled to any rights in respect thereof (and accordingly his name shall be forthwith removed from the Register with respect thereto and the share shall be cancelled and available for immediate reissue. Notwithstanding the preceding sentence a person whose share or shares have been redeemed, shall, in respect of such share or shares:
- have the right to receive as a creditor (1) the Redemption Price… and (2) any dividend which had been declared in respect thereof before such Redemption Day; and
- continue to be bound by the provisions of these Articles regulating the payment of the Redemption Price including the right of suspension of such payment hereunder.”
The point at which a redeeming shareholder ceases to be a member is important, because, as a member, the shareholder continues to be bound by the articles of association including any provisions empowering the fund to suspend payment of the redemption price. Certainty on this issue is in the interests of the fund and the redeeming members. The anomaly of a redeemed shareholder remaining as a member as well as a creditor will have a number of unwelcome results, such as:
- a shareholder who had redeemed all its shares and could continue to be locked into the fund for up to 18 months where the fund’s documents provide for a partial holdback or redemption price pending completion of the audit. During this period, the redeemed shareholder would remain entitled to exercise its rights as a shareholder, and those rights would need to be taken into account in any proposed shareholder actions, including voting at any general meetings of the company.
- two members of the fund existing in respect of the same shares. Redeemed shares are required to be cancelled and become available for re-issue when the redeeming shareholder has been removed from the register. If the redeemed shares were issued to a new investor, then there would be two members of the fund in respect of the same shares.
So, in addition to adopting our new language in the articles of association for new funds, which provide that a redeemed member ceases to have all the rights of a shareholder and that its name be removed from the register of members on the relevant redemption day, we suggest that funds liaise with their administrators to ensure that they are removing the names of redeeming investors on the relevant redemption day.