10 November 2008
Stresses from the subprime meltdown and other recent events in the banking sector have had an adverse impact on certain hedge funds, taking some portfolios into a distressed state. In the Cayman Islands, this fallout has thrown greater prominence on the variety of techniques that distressed funds can use to ride out the storm.
A lack of liquidity is usually the first sign of potential trouble for a fund, whether it is holding securities that are difficult to price independently or when trading at current prices would result in substantial losses. Higher short-term borrowing costs and a rise in redemption requests from investors, who are also short of cash, have compounded the problem. The combination of market uncertainty and the expectation of investor redemption requests have seen funds convert large swathes of their investments into cash, adding to the selling pressure and the skittish investment markets.
It could take only a few large investors to seek to redeem their investment at the same time to cause a fund to struggle to meet its redemptions in full, even if liquidity was not previously an issue for the fund.
As a matter of survival, affected funds require some method of reducing the redemptions that investors can make and the imposition of a gate is a popular method of first aid. By placing a limitation on the number or aggregate net asset value of fund securities that may be redeemed on a particular date or during a particular period, it is possible for funds to slow the bleeding, but it is important to act fast and get the gate in place before the next redemption date. This objective is much more achievable if the fund’s constitutive documents are initially drafted to contain a power for the directors to impose a gate. In the absence of such express authority, the fund will need to obtain investor consent to amend its constitutive documents to enable this mechanism – and that consent is unlikely to be forthcoming.
Where securities have become distressed or hard to value, funds may opt to place them in a side pocket until value is restored and the investment can be realised. This approach has the additional advantage of presenting a cleaner net asset value going forward as the troubled assets are hived off.
While many funds were still dealing with the fallout of the subprime market collapse, September’s crisis in the banking sector, including the unprecedented $600bn (£387.42bn) bankruptcy of Lehman Brothers, presented another round of tough questions. Specifically, how should funds deal with a default by or the insolvency of their prime broker or custodian? Issues arising are not limited to a fund being a creditor of such an institution, but extend to funds facing their assets being locked up in prime broker accounts for some time due to insolvency proceedings, making assets inaccessible and therefore impossible to value.
To treat all investors equitably, the creation of a side pocket is the obvious solution. Funds that were established with provisions in their constitutive documents detailing how side pockets may be created are certainly seeing their value now. Keeping the distressed assets and side pocketing them avoids the need to obtain investor consent to transfer the assets in specie.
Funds that do not have the ability to side pocket illiquid securities will either need to put such measures in place, which will require investor consent, or look for a more creative solution. This might involve the transfer of securities to a wholly-owned special purpose vehicle (SPV) and the transfer of shares in the SPV to investors in some way. For example, a compulsory redemption or an in-kind distribution on a redemption of fund shares could serve as a transfer mechanism.
Many funds established during more upbeat years eschewed side pockets, as managers felt that mentioning the possibility of underperforming assets could be interpreted as a lack of confidence in the investment strategy. As recent developments show, it is vital for funds to be in control of redemption issues from the beginning to avoid problems later on. The investor consent that is required to introduce illiquidity management measures such as the imposition of a gate, extended lock-up periods or the creation of side pockets may be difficult to obtain when markets are volatile and uncertain.
The wide range of techniques and strategies to deal with distressed funds to keep them afloat reflects the activity that has been seen in Cayman in the past 18 months. Interestingly, there has not been a significant number of hedge fund liquidations. Forcing the winding up and dissolution of a fund makes it much harder to maximise the benefit to investors, with a statutory regime being imposed on the realisation and distribution of assets. The volatile markets and widespread markdown continue to provide opportunities for investment funds, with new vehicles focusing on distressed strategies continuing to be formed in Cayman.
For now, attention will switch to fourth-quarter redemption requests and the implications for international stock markets. While uncertainty in the market prompts redemptions, funds may be forced to sell more assets to meet these requests. Greater selling pressure and an impending vicious downward cycle could mean an even greater reliance on the innovative solutions funds are employing to manage distressed situations.
Sandie Corbett is managing partner of the insolvency and corporate recovery group at Walkers and Caroline Williams is a partner specialising in hedge funds and private equity