Investments side pocketed? Redemptions or net asset value calculation suspended? Nicholas Holland, partner at law firm Bircham Dyson Bell, offers a few tips for curing illiquidity in your investment portfolio.

Investments side pocketed? Redemptions or net asset value calculation suspended?  Nicholas Holland, partner at law firm Bircham Dyson Bell, offers a few tips for curing illiquidity in your investment portfolio.

During the financial crisis many hedge funds faced by redemption requests from investors responded by suspending redemptions (refusing to pay investors back their money), suspending the calculation of the fund’s net asset value (refusing to value the fund, which prevents payments to anyone, including investors, whose interest in the fund is determined by reference to its NAV) and by side-pocketing investments (pooling illiquid assets classes into separate sub-funds and offering redemption in the form of shares in the new illiquid fund).  Many funds remain tied up in this manner though there has been increased impetus very recently to place them into liquidation.  Some of these devices were unlawful under the funds’ terms or failed to capture some of the investors they intended to prevent redeeming their investments.  Here is a brief overview of these developments and the remedies that may be available to investors.

In terms of structure, hedge funds may be divided into funds which are (1) essentially corporate in nature and (2) unit trusts.  The corporate fund is typically comprised of two kinds of feeder funds into which the investors place their funds: one for investors captured by the US tax regime and one for those that are not US taxpayers.  These feeder funds then invest into a master fund through which the actual investments are made.  

With respect to the non-US taxpayer feeder fund, the investors own non-voting shares in a corporation and the voting shares are either owned by the investment manager or by a trustee pursuant to an offshore trust deed which provides that these non-voting shares are owned not for the benefit of any person but for the purpose of voting in accordance with an investment plan.  The feeder fund does nothing but invest funds in the master fund in exchange for non-voting shares in a corporate vehicle of the master fund.  The voting shares of the master fund are again held by the investment manager who decides where the funds are invested. 

In a unit trust structure, typically, the investors place their funds in trust with a bank trustee.  The investors are given “units” or allotments in the trust property.  The value of these shares in the feeder fund or the “units” in these trusts are determined by the administrator of the fund who determines the NAV of the investments per unit.

Different structures, different remedies

The decision to opt for one or the other of these structures or another is general tax driven.  However, the decision has large implications for the remedies available to investors in these funds.  The largest of these implications is that insolvency proceedings may be available to address corporate fund structures typically on the grounds that the company cannot meet its liabilities or on the basis that a liquidation order should be made on the basis that such an order is otherwise “just and equitable”. 

However, no such proceedings are available in connection with a unit trust.  In connection with an unwilling trustee of a unit trust an application would have to made to the court for the replacement of the existing trustee with one more disposed to winding up the trust; however, a note of caution must be sounded here as many offshore unit trusts the power to commence such proceedings may be restricted to a protector or enforcer who may be unwilling to make such an application.

Theory becomes practice

These implications were of course largely theoretical until the collapse of the financial markets in 2008. At which point, funds found themselves in a dilemma, a dilemma arising from the very nature of hedge funds, irrespective of their structure.  Hedge funds have a serious flaw caused by the means by which investors are permitted to redeem their investments.  In order to “cash out” one’s investment in a hedge fund, one submits a redemption request which provides that on a certain date one is entitled to be paid the “net asset value” (as determined by the fund’s administrator) of one’s investment.  In a severely declining market, this creates a vicious incentive by favouring those investors who redeem early.   As stock prices collapse, many of the investments in the portfolio become illiquid as there are few if any buyers.  As redemptions are paid out the proportion of illiquid assets remaining increases; ultimately the last to redeem may not be paid out as there are no liquid assets remaining.  The realisation of this possibility may and often did cause a run on redemptions thus collapsing the fund.

Faced with this dilemma, fund managers looked for ways to either fairly distribute the liquid assets in the funds to investors or simply to prevent their funds from being liquidated.  Some froze redemptions, some suspended NAV calculations and others side-pocketed some (very occasionally virtually all) of the funds assets.  Freezing redemptions was the most direct response to redemption requests; however, many companies were not permitted to freeze redemptions under the offering documents and memorandum and articles (although some tried to do it anyway). 

The less direct tactic of suspending NAV indirectly had the same effect on redemptions:  in the absence of a NAV, the administrators could not process redemptions.  Of course in the absence of NAV, many of the service providers including the fund manager (who are compensated by a proportion of the NAV) were no longer entitled to remuneration from the fund.  

Finally, side pocketing was a device whereby illiquid assets were transferred to a sub-fund in exchange for units in the side pocket.  Redemption requests would then be satisfied with a combination of cash and units in the side pocket.

What rarely, but sometimes, happened was that fund managers voluntarily placed their funds into liquidation.  Initially efforts by investors to force funds into liquidation were unsuccessful until the landmark Privy Council decision in Culross Global SPC  vs. Strategic Turnaround Master Partnerships in which the investors were finally granted standing to appoint a liquidator and in which instances this would be permitted was greatly clarified.  Whether the investors have such standing will be determined henceforth on a case-by-case analysis of the fund documents. 

Investors have remedies available to them to put some liquidity back in to these dormant investments. They are starting to pursue them.