Lesson learned…?

During the credit crisis, investment funds utilised a variety of techniques to prevent significant redemptions from causing crystallisation of losses on trades; in some cases managers took aggressive interpretations of fund constitutional documents to prejudice investors. What fund terms will investors likely focus on when investing in new funds to ensure that they are not placed in a similar position?
One evening, not so long ago, I covered my kitchen table with fund documentation I was attempting to review while working at home (OM/PPM, IMA, IAA, Subscription agreement, Custody and Admin Agreements and a side letter or two thrown in for good measure). My wife, a corporate lawyer with an M&A background asked “who actually reads this stuff?” Apart from “me”, I didn’t have much of an answer then, and it would now appear that, at least prior to the recent financial disturbance/crisis/meltdown/apocalypse (dilute to taste), in fact no-one other than my fund lawyer colleagues reads any of it.
That investment managers chose to protect the hedge funds to which they were appointed from mass exodus was not of itself the main source of surprise or consternation from investors but rather it appeared the fact that investment managers had these powers at all which most surprised and concerned investors.
Irrespective of investor’s surprise, however, Cayman hedge funds have for many years contained significant powers in their documentation to allow the directors and/or the investment managers to protect against very large, unanticipated or extraordinary market movements or other factors which might cause a “run” on a fund which, under normal operating conditions, would have been operating in a satisfactory or even exceptional fashion.
Although not by any means an exhaustive list, some of the more popular mechanisms used by managers to protect ‘their’ structures (the use of the term ‘their’ being an argument for another day) included:

  • Gates
  • Suspensions
  • Side pockets (real and synthetic)
  • Redemptions in kind
  • Restructuring

I’ll deal with the first two shortly, the third and fourth can to some degree be dealt with together and I’ll do so below, but the fifth is really a topic for another day. I say this mainly because the wide variety of restructuring scenarios is too difficult to deal with in a short article and also restructurings tended, by their very nature, to require or involve investor consent or participation. As such, although there are numerous exceptions to this, they tended to be less controversial when done properly.
In my experience gates were the most often used mechanism when the fund just needed a quick fix and wasn’t experiencing a complete exodus of investors. The most common version was the ability to ‘gate’ redemptions to a maximum of say 10 per cent of the NAV of the fund, which provision often had no limit as to the number of successive redemption periods for which the gate could be applied.

Although some investors may have been aware, at least in principle, of these provisions, it was often clear that the full implications of these, in circumstances where a large majority of investors were seeking to redeem, were not clear to investors who did not appreciate that, in circumstances where they were a relatively small investor in the fund, the effect of a large investor also seeking to redeem could greatly reduce the amount of liquidity they could obtain during any redemption cycle.
Suspensions appeared most common in cases of mass redemptions. These were often the most controversial power utilised by investment managers and directors as the reasoning, although undoubtedly sound from the investment manager’s perspective, was often unpopular with many investors. The most common form of suspension appeared to be the ability of the directors to suspend the calculation of the net asset value (and therefore as a result suspend subscriptions, redemptions and as a consequence, redemption payments) indefinitely whilst certain conditions described in the offering documents existed. Where the controversy often arose was with the wide discretion given to the directors/investment manager when deciding when to implement a suspension.
However, there were other funds which provided further options within the suspension arsenal which included the ability to suspend only redemptions, or even redemption payments, in the granting of a redemption. Suspension of redemption payments was perhaps the most ‘offensive’ leading to a number of court actions where investors, who considered themselves to have been redeemed from a fund and therefore entitled to receive payment in short order as a de facto creditor, discovered the fund documentation appeared to allow the directors to withhold the payment of proceeds for any varying length of time, or even an indefinite period.

Equally unpalatable for many investors, was the ability granted to some funds by their establishment documentation to suspend redemptions in certain circumstances even where subscriptions were to continue along with the calculation of the net asset value. It must surely have been difficult for such investment managers to answer some investors querying why, as the fund received ready cash assets, the fund was not in a position to return existing investors monies.
Finally, for the purposes of this article, there were side pockets and redemptions in kind. I appreciate they are principally very different mechanisms, but the creation and use of synthetic side-pockets during the recent crisis had the effect of merging the mechanisms. The highly utilised ability to side pocket illiquid investments, which required very specific language to be present in a fund’s offering and constitutional documents received a new twist with a creation by some investment managers of “synthetic side pockets” which allowed investment managers and directors of distressed funds to segregate out troublesome assets and maintain the funds in apparent ‘normal’ operation while avoiding the often stigmatised category of “fund in suspension”.
In many funds, side pockets were not authorised by the fund’s documents but redemption in-kind was. The difficulty was that many illiquid investments couldn’t be redeemed out in kind due to transfer restrictions. The synthetic side pocket was a technique which created the same effect as a side pocket but where a fund’s documents didn’t contain side-pocket provisions.

This was done by creating a new subsidiary of the fund and using the power to pay redemption proceeds in-kind to indirectly convey the illiquid assets to the investors. The creative use of some of these synthetic side pockets to work around documentation which had not been created with such side pockets in mind proved a further concern to many investors, already irked by the ‘protectionism’ being applied throughout the industry.
So what have investors learned from all of this? Although investors may now be more aware of these provisions, in some cases acutely so, fund documentation being produced today, at least, from this commentators perspective, where no cornerstone investor exists, does not differ significantly in terms of restricting investment managers and directors from that produced prior to the financial crisis. If anything, documentation which was found by investment managers and directors to be restrictive and which made it difficult for them to protect the fund or otherwise restructure, now appears to contain more flexibility than it did previously.
Having said the above, many commentators at the recent GAIM Ops Cayman Conference made numerous references to the dissatisfaction of investors, particularly large institutional investors, with some of the mechanisms employed by the funds in which they were invested during difficult times.
In fact, commentators on one of the panels made it very clear that investment managers who had employed gating mechanisms were now off the list for future allocations. It would appear that the creative use by some investment managers of the powers provided in the fund documentation as well as some of the ‘damned if you do damned if you don’t’ options employed in order to protect funds were seen by many investors as a blatant attempt on the part of the investment manager to protect their own interests rather than those of investors.
Whether that’s true or whether investment managers were genuinely trying to do the job for which they were originally employed, protect their investors capital and value, would seem to be somewhat of a moot point and the feelings coming from some of the discussion panels seem to very much indicate that there is an element of mis-trust that now needs to be addressed.
That is why all of the above therefore makes it all the more extraordinary that gates, side pockets, suspensions and payments in kind all remain very firmly on the agenda for new fund establishments.
Some investors certainly seem to be more aware of these mechanisms, and all indications are that side letters and other assurances would be sought before an investment would be made, but it seems rare that investors would go so far as to demand removal of these powers from the arsenal of an investment manager and/or directors of a fund altogether.
So what investors would appear to have learned therefore is that whilst these mechanisms should remain in the fund in order to protect assets and value generally, such can also be employed against you so you should make sure, to the extent possible, that whilst other investors may suffer from the implementation of the above mechanisms, your arrangement should ensure preferential treatment for your investment. Where that is impossible or unpalatable for the fund, investors can insist at the very least on some fine tuning of gating and other mechanisms.
As the market continues to recover and new fund establishments continue to grow I think it is safe to assume that we can expect to see an increase in the number of ‘seed investor classes’, preferential liquidity and other terms, an increase in the number of side letters focusing specifically on excluding investors from side pocket and gating provisions as well as excluding them from the effects of suspensions.
Investment managers who imposed gates contrary to the wishes of their major investors may find such investors unwilling to again take the leap of faith required to allocate funds to that manager. Indeed, what investors seem to have learned is not that funds should never have these mechanisms at their disposal but rather that investment managers and directors must be relied upon to use these mechanisms properly and in the interests of the investors.

Where they are deemed not to have done so in the past, such managers and indeed directors may find it very difficult to continue to attract investment to the structures by whom they are employed. What investors have learned is not that these powers are unreasonable but rather they must ensure, and indeed insist on, the responsible use of same.

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Ian Dillon
Ian is a partner in William Fry’s Asset Management & Investment Funds Department specialising in Alternative Investments with a focus on Hedge Fund formation, Alternative Investment Management regulation and corporate governance as well as providing advices on on-going matters affecting the alternative investment management industry in Ireland.  Ian is a recommended lawyer in Legal 500, Cayman Islands and Chambers Global 2013 guide notes : Ian Dillon has established a strong reputation in the investment funds arena and focuses primarily on hedge fund-related work. Clients note that he is "always reachable, pragmatic, very helpful and is there to hold your hand through the process."
Ian Dillon
William Fry
Fitzwilton House
Wilton Place
Dublin 2, Ireland

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