Valuation and liquidity management have been hot topics for hedge fund managers (“managers”) since the financial crisis. Recent market conditions, including volatility in the high-yield market, have again highlighted the need for managers to develop and implement robust liquidity management procedures.
In particular, the low interest rate environment has resulted in a greater demand for fixed income securities in the search for yield. This search for yield, coupled with the changing role of banks since the financial crisis, has resulted in increased investment in riskier and less-liquid instruments. In December 2015, a number of hedge funds suspended redemptions due to illiquidity in the market. Often, this problem was due, in part, to a mismatch of the redemption terms offered to the investors and the liquidity of the underlying investments. In addition to having a liquidity mismatch, some managers may also find themselves in a position where they are unable to accurately value certain assets in a portfolio or where the value assigned to one or more underlying investments is challenged.
Focus on Valuation
Management fees and performance-based compensation are typically calculated on the basis of the fund’s net asset value (“NAV”). NAV is typically determined using a valuation policy that has been developed by a manager and disclosed to the fund’s investors. Often a manager or an affiliate will have some involvement in valuing certain assets. This creates an inherent conflict of interest, because it is in the manager’s interest to value assets at the highest possible level in order to maximize compensation.
Over recent years, the Securities and Exchange Commission (“SEC”) has brought a number of valuation-related enforcement actions against investment advisers, particularly in the following three areas:
(i) Failure to adequately supervise.
In the Matter of Oppenheimer Asset Management Inc. (March 11, 2013), the SEC filed and settled an administrative proceeding alleging that a portfolio manager shifted the valuation method used to value an underlying investment in order to increase its valuation. The adviser and an affiliate had in place written policies that required the compliance department to review and approve marketing materials. However, the policies did not require the review of the portfolio manager valuations and “... were not reasonably designed to ensure that valuations were determined in a manner consistent with written representations to investors.”
In In re J. Kenneth Alderman et al. (Dec. 10, 2012), the SEC filed and settled an administrative proceeding alleging that the directors failed to satisfy their pricing responsibilities by delegating their fair valuation responsibility to a valuation committee without providing adequate guidance on how fair valuation determinations should be made and making no meaningful effort to understand how the fair value of investments was being determined. The SEC found that the valuation committee did not utilize reasonable procedures and often allowed portfolio managers to arbitrarily set values, resulting in the funds' overstating the value of their securities.
(ii) Failure to abide by valuation procedures.
In the Matter of Lynn Tilton et al. (March 30, 2015), the SEC filed an administrative proceeding alleging that a portfolio manager elected to substitute her own independent discretion when valuing investments rather than following the valuation process disclosed to investors.
In SEC vs. Yorkville Advisors, LLC (Oct. 17, 2012), the SEC alleged that Yorkville Advisors adjusted its valuation methodology so that losses in convertible securities would not be taken into account and indicated that “the methodologies Yorkville actually applied to value its convertibles in 2008 and 2009 did not comport with Yorkville’s valuation policies either as written or as described to investors.”
(iii) Failure to reflect all material factors.
In the Matter of KCAP Financial Inc. (Nov. 28, 2012), the SEC filed and settled an administrative proceeding alleging that executives from KCAP Financial Inc. overstated certain investments held by a fund by electing not to take into account trade data from market transactions in the fall of 2008 and opting instead to use an income-based approach to valuation as opposed to their disclosed “enterprise value” methodology. This resulted in a higher valuation for their investments.
In the Matter of Evergreen Investment Management Co. (June 8, 2009), the SEC filed and settled an administrative proceeding alleging that, among other violations, the adviser ignored readily available information relating to certain securities when making valuation recommendations to the fund’s valuation committee. In addition, a third-party pricing service that was pricing a significant number of positions had not been properly diligenced.
Most of the enforcement and other actions in recent years have stemmed from valuation issues arising during the financial crisis in 2008, a time of great market distress and volatility. These cases are a reminder that managers must have clear policies and procedures in place for valuing assets and should regularly review them and update them when necessary.
Recent Regulatory Focus on Liquidity Management
The SEC recently proposed a set of comprehensive reforms for mutual funds and exchange-traded funds that would provide for (i) liquidity risk management standards that address issues arising from modern portfolio construction; (ii) a new pricing method that, if funds choose to use it, could better allocate costs to shareholders entering or exiting funds; and (iii) fuller disclosure of information regarding the liquidity of fund portfolios and how funds manage liquidity risk and redemption obligations (“Proposal”).
In addition, the Financial Conduct Authority (“FCA”) in the U.K. recently announced that it has been working with the Bank of England, at the request of the Financial Policy Committee, to assess risks posed by open-ended investment funds investing in the fixed income sector. The FCA has highlighted three areas of focus for firms to evaluate when assessing their liquidity management: (i) tools, processes and underlying assumptions; (ii) operational preparedness; and (iii) disclosure
Although the Proposal focuses on the retail fund space, which generally offers daily liquidity, and the SEC expressly noted in the Proposal that “…investor expectations of private funds’ redemption rights differ from the redemption expectations of typical retail investors in open-end funds,” liquidity management has always been a key consideration for hedge fund managers, including those operating in the fixed income space. A mismatch between a fund’s redemption terms and the liquidity of its underlying investments can have devastating repercussions for the fund, its investors and the manager’s reputation. It is crucial that each hedge fund manager develop and implement a robust liquidity management program, with appropriate deviations for any fund that has different liquidity features. It should review the program on an ongoing basis and consider the impact of changing market conditions, including extreme market conditions.
A broad range of options are available to hedge fund managers to help manage liquidity issues that arise from time to time. Therefore, prior to launching a fund, a hedge fund manager must determine a number of key liquidity terms, insert the contractual authority to exercise any rights associated with such liquidity terms and disclose these terms in the fund’s offering documents. Liquidity terms encompass a wide range of considerations, including the frequency of withdrawals (e.g., quarterly or less frequent liquidity is most common), notice periods for withdrawals (generally ranging from 30 days to 90 days), the use of a lockup, the use of a gate (which may be imposed either on a fundwide basis or on an investor-by-investor basis), the suspension of withdrawals and subscriptions, the calculation of NAV and/or the payment of withdrawal proceeds under certain circumstances, the use of side pockets or redemptions in-kind, and the ability of the fund or the manager to cause an investor to mandatorily withdraw from the fund under certain circumstances. If a manager would like to maintain the flexibility to implement any of those tools in connection with a hedge fund product, it must clearly disclose this in its offering documents in addition to building the contractual authority to do so in the fund’s governing documents. Most managers also retain the discretion to enter into side letters allowing for a deviation from the specified terms of the fund for certain investors. Providing some, but not all, investors with additional portfolio information, particularly if this is coupled with more-favorable redemption terms, can be problematic if it allows those investors to foresee a liquidity problem with the underlying portfolio and submit redemption requests ahead of the other investors.
Key Mechanisms for Liquidity Management
If a fund manager finds itself in a position where there is a mismatch between portfolio liquidity and investor liquidity, it should review the fund’s offering materials and governing documentation to determine what avenues are available to it in dealing with the issue. The following is a summary of some of the typical mechanisms that managers rely upon in such circumstances:
- Lockup. Hedge funds may require investors to commit their capital for a certain period of time in the form of a lockup period, which can take the form of either a specified lockup period during which time either no withdrawals are permitted (i.e., a “hard lock”) or a specified lockup period during which withdrawals are permitted subject to the imposition of a withdrawal fee (i.e., a “soft lock”).
- Gate. This is a mechanism that allows a manager to limit, either on an investor-by-investor basis or on a fund-level basis, the percentage of the fund’s net assets that can be redeemed on any redemption date. Investor-level gates are more common than fundwide gates, as they give investors more certainty with respect to their ability to redeem.
- Suspensions. Fund documentation will often allow for the suspension of withdrawals, the calculation of NAV and/or the payment of withdrawal proceeds under certain prescribed circumstances.
In the event that a manager is facing a liquidity mismatch, whereby it will not be able to honor redemptions fully in cash, and the options above are either inappropriate or unavailable or have already been exhausted, the manager can, if permitted to do so by the terms of the relevant fund’s documents, utilize one or more of the following techniques:
- Side Pockets. Managers often retain the flexibility to designate certain illiquid or hard-to-value securities and “side pocket” them in a segregated account of the fund from which no redemptions are permitted. If permitted, side pockets are often limited to a specified percentage of the fund’s NAV (e.g., 15%). Side-pocketed investments are typically left in the side pocket until such time as they are realized or the circumstances giving rise to their illiquidity or valuation difficulties have been resolved. One of the concerns the SEC has cited with respect to the use of side pockets is that a manager may use them to remove illiquid or poorly performing assets from the fund’s NAV and calculation of any performance-based compensation, thereby artificially inflating the fund’s performance.
- In-Kind Redemptions. In-kind redemptions can be effected by a direct transfer of illiquid or other assets to redeeming investors. However, underlying investments may be subject to transfer restrictions or may not be of a nature that can easily be divided and transferred to investors, thus making a direct transfer unworkable. Alternatively, a manager can establish a special purpose vehicle (“SPV”) and transfer the illiquid assets to the SPV, either as a direct transfer or indirectly through the use of an economic participation right, and distribute interests in the SPV to the redeeming investors. The redeeming investors typically receive periodic distributions from the SPV.
- Exchange Offer. If a manager determines that side pockets or in-kind redemptions are either not permitted or not appropriate under the circumstances, it can offer withdrawing investors alternative terms in exchange for the investors' agreement to retain all or a significant portion of their investment in the fund. For example, a redeeming investor could agree to exchange a portion of the interests being redeemed for interests of a new class that are subject to a specified lockup but lower fees. The benefit to an investor of agreeing to an exchange offer could be the fact that if it does not withdraw all or a portion of its redemption request, the fund may end up having to impose a gate or suspend withdrawals or the payment of withdrawal proceeds.
Recent market turmoil has once again highlighted the importance of ensuring that funds have a comprehensive valuation policy and an appropriate liquidity management program in place. Each manager should audit its valuation and liquidity management procedures on a periodic basis to ensure that they are current and appropriate and are being implemented correctly. This audit should seek to identify and address any conflicts of interest in the valuation process and should involve initial and periodic due diligence of pricing sources.
In addition, any disclosures to investors regarding valuation policies and procedures, tools for liquidity management, and risk factors related to the potential lack of liquidity in offering documents should be clear and accurate. To the extent a fund has received a significant number of redemptions, the manager should ensure that (i) its disclosures and compliance policies are complied with in connection with such redemption requests and (ii) it honors the redemption requests in a manner that seeks to balance the needs of the existing investors with the needs of the redeeming investors through the use of the liquidity management tools described above.