Liquidity management has been a hot topic for hedge fund managers (managers) since the great financial crisis of 2008. Liquidity management will likely receive renewed focus from investors and regulators given the recent arrival of a novel coronavirus disease, COVID-19, that is now sweeping the globe and having a massive impact on world markets. Widely believed to have originated in the city of Wuhan in the Chinese province of Hubei in late 2019, the virus quickly spread to other countries, causing widespread disruption of the financial markets and international trade and commerce. On March 11, the World Health Organization declared the outbreak a global pandemic and urged all countries to do more to control the spread of the respiratory disease. Many countries introduced emergency measures that significantly restricted the activities of their residents and visitors, including social distancing and self-quarantining. Simultaneously, Saudi Arabia and Russia triggered an oil crisis by significantly increasing oil production, thereby placing significant pressure on companies operating in the oil industry that rely on higher-priced oil to service their debts. This has resulted in significant turmoil in the global markets, evidenced by severe volatility, dysfunction in the credit markets and significant declines in stock prices.
All of the foregoing has highlighted for fund managers the need to have a robust liquidity management program in place that allows them to react appropriately to market disruption, including the extreme circumstances currently being experienced worldwide. A mismatch between a hedge fund’s redemption terms and the liquidity of its underlying investments can have serious repercussions for the fund, its investors and the manager’s reputation. It is crucial that each manager develop and implement a liquidity management program that properly squares the redemption terms granted to the investors of a hedge fund with the nature of that fund’s underlying assets. Each manager should review its program on an ongoing basis and consider the impact of changing market conditions, including extreme market conditions. Managers that successfully match a fund’s duration and liquidity as closely as possible to the duration and liquidity of the assets in the fund’s portfolio can mitigate the risk of a disorderly liquidation of the fund’s assets at distressed prices and reduce the likelihood of friction with the fund’s investors.
A broad range of tools is available to managers to help manage liquidity issues that arise from time to time. Prior to launching a fund, a manager must determine a number of key liquidity-related terms, insert the contractual authority to exercise any rights associated with such liquidity terms and disclose those terms in the fund’s offering documents. Liquidity terms encompass a broad range of considerations, including (i) the frequency of redemptions (e.g., quarterly or monthly); (ii) notice periods for redemptions (generally ranging from 30 days to 90 days); (iii) the use of a lockup; (iv) the use of a gate (which may be imposed on either a fundwide basis or an investor-by-investor basis); (v) the suspension of redemptions, subscriptions, the calculation of net asset value and/or the payment of redemption proceeds under certain circumstances; (vi) the use of side pockets or redemptions in kind; and (vii) the ability of the fund or the manager to cause an investor to mandatorily withdraw from the fund under certain circumstances. In connection with the selection of these liquidity management tools, it is essential that managers holistically assess how the duration and liquidity of the fund correspond to the duration and liquidity of the assets in the fund’s portfolio.
Most managers also retain the discretion to enter into side letters allowing 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 redemptions requests ahead of the other investors.
Focus on Disclosed Liquidity Terms
Liquidity management continues to be an area of focus for the Securities and Exchange Commission (the SEC). Managers must ensure that their liquidity management policies and procedures are consistent with the disclosure given to investors regarding such matters. In the Matter of Aria Partners GP, LLC (Aug. 22, 2018), the SEC filed and settled an administrative proceeding alleging that Aria Partners GP, LLC (Aria) violated the Investment Advisers Act of 1940, as amended (the Advisers Act), in a number of ways, including a failure to follow its disclosed redemption procedures. The relevant fund’s limited partnership agreement required 90 days’ written notice for redemptions; however, Aria had an informal policy, which it did not disclose to all investors in the fund, of allowing investors to make partial redemptions with significantly less notice. Aria also allowed some investors to fully redeem from the fund on 60 days’ notice but required other investors to provide the full 90 days’ notice. As a result of the fund losing value in a short period in 2015 and the inconsistent application of its redemption policy, two investors received materially different full redemption amounts. Aria agreed, without admitting or denying the SEC’s allegations, to cease and desist from violating the referenced provisions of the Advisers Act and its rules, accept a censure, and pay a civil penalty of $150,000. In connection with two civil lawsuits filed by the SEC, a manager and its principal admitted in its settlement agreement with the SEC that, among other matters, they granted favorable redemption and liquidity terms to certain large investors and did not disclose certain of these arrangements to the fund’s board of directors and the other fund investors.1
Key Mechanisms for Liquidity Management
If a manager finds itself in a position where there is a mismatch between portfolio liquidity and investor liquidity, it should review the relevant 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 either the form of a specified lockup period during which time either no redemptions are permitted (i.e., a “hard lock”) or the form of a specified lockup period during which redemptions are permitted subject to the imposition of a redemption 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 may allow for the suspension of redemptions, subscriptions, the calculation of net asset value and/or the payment of redemption proceeds under certain prescribed circumstances.
- Secondary Transaction. A manager may assist a redeeming investor locate a third party (which may be an existing investor in the fund) to acquire the redeeming investor’s interest in the hedge fund in exchange for the redeeming investor agreeing to revoke its redemption request.
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 segregate account of the fund from which no redemptions are permitted. If permitted, side pockets are often capped at a specified percentage of the fund’s net asset value (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 identified by the SEC 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 net asset value 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 easily can 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 redeeming investors alternative terms in exchange for the investors’ agreement to retain all or a significant portion of the investors’ 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 revoke all or a portion of its redemption request, the fund may end up having to impose a gate or suspend redemptions or the payment of redemption proceeds.
- Stapled Secondaries. General partner-led secondary transactions have become more common in recent years in the private equity space and are no longer solely a mechanism to dispose of lingering or hard-to-sell assets. They are now commonly used to provide liquidity to limited partners or to maximize the value of a fund’s assets through the extension of the fund’s term. A stapled secondary typically involves an undertaking by a buyer to commit additional capital for follow-on investments by the existing fund or to invest in the manager’s successor fund. They also can involve investors in an existing fund agreeing to “roll over” their investment in the fund to a new fund in connection with a fund restructuring. While they are more common for private equity funds, some hedge funds may also be able to utilize them.
Valuation difficulties and uncertainties are likely to be inherent in any situation where the fund’s portfolio positions become illiquid. At this time, it will be important for managers to review their disclosures to investors, the fund’s governing documents, and the manager’s valuation policies and procedures in order to ensure the valuation process it follows is consistent with these documents. In some cases, managers may determine that there is a need to adjust the valuations assigned to certain assets by a third-party pricing service. Whenever a manager exercises its discretion to adjust the value of an investment, the manager’s valuation process should identify and seek to resolve any conflicts of interest that may be associated with any such valuation by the manager.
Managers should have an appropriate liquidity management program in place. Each manager should audit its liquidity management procedures on a periodic basis to ensure that it is current and appropriate and is being implemented on a consistent basis. In addition, any disclosures to investors regarding the 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.
1See SEC v. Harbinger Capital Partners LLC,12-cv-5028 (PAC) (S.D.N.Y.); SEC v. Philip A. Falcone, et al., 12-cv-5027 (PAC) (S.D.N.Y.).
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