In the last three months of 2008, fund managers in many different sectors were forced into gating or suspending redemptions by the turmoil in the financial markets, restrictions on certain investment activities and the Lehman bankruptcy. As funds were forced to suspend or chose to pay redemption proceeds in specie or create side pockets, late December and the early months of 2009 saw fund of funds having liquidity issues, since they relied upon their underlying portfolio funds to give them liquidity. This in turn led to some significant pressure on relatively liquid funds which seem, in some cases, to have been used as ATM machines by their investors who were unable to realise cash elsewhere.
This general illiquidity, coupled with the forced deleveraging and massive rush for cash by investors, caused a large number of funds to suspend redemptions, the calculation of NAV and payment of redemption proceeds. For many funds, the suspension is giving them time to restructure with a view to continuing trading. For others it is part of the process of orderly wind down. Inevitably these suspensions, however made, have led to a number of cases coming before the courts.
Developing Case Law
There have been some interesting case law developments in the major offshore hedge fund jurisdictions, including Strategic Turnaround, where the Cayman Court of Appeal heard a case which dealt with the question of the status of a redeemed investor. In summary, the court worked hard to view a redeemed investor as a type of creditor from the redemption date which, in the light of the new Cayman insolvency regime, potentially gives redeemed investors the ability to wind up the fund, depending on their circumstances and the fund’s constitution. While litigation is rarely good news, these cases do provide some guidance when planning strategies to cope with illiquidity and treating all investors equitably in any plan.
Synthetic Side Pockets
When designing structures for funds to enable them to survive the crisis we have had to be creative and have come up with plans which are allowed under the fund’s constitution but are not expressly contemplated.
A good example is the common provision allowing redemption payments to be made in specie which enables many funds to resume redemption payments earlier than if they waited for the illiquid assets to be realised. However, the fund’s illiquid assets are commonly not easily transferable or a direct holding in which may cause investors legal, regulatory or logistical problems. This is often surmounted by placing the illiquid assets into a SPV and then paying redemption proceeds in specie by transferring the SPV shares to the redeeming shareholders (a “synthetic side pocket”). The shares in the SPV are not redeemable at the option of the holder, but can be structured so that they are redeemed pro rata as and when the SPV receives cash from the underlying assets, thereby allowing the investors to be paid as if they were holding the assets direct. This allows a manager to clean up a fund’s balance sheet.
Prevention is better than Cure
What has become very clear over the last 6 months is that funds which suspend redemptions before they reach a critical redemption date have more chance of avoiding litigation and liquidation than funds which find they have to take emergency steps after the redemption date to limit redemptions.