Most hedge funds hold a portfolio of securities and other financial instruments with a range of liquidity characteristics: some positions may be highly liquid, while others may be difficult or impossible to trade currently. The liquidity characteristics of a typical hedge fund can vary significantly over time as portfolio assets are sold and proceeds used to establish new trading positions. Fund managers are often rewarded by holding well-selected illiquid assets, because that is where some of the best arbitrage opportunities exist. However, being illiquid at the wrong time can prove disastrous, as the 2008 financial crisis demonstrated for many managers.
Against this background, it is interesting to read redemption payment language in the governing documents of hedge funds. Most governing documents that we review include language allowing the fund manager to pay redemption proceeds either in cash or on an in-kind basis (i.e., in securities or other financial instruments held by the fund).
Most often, the manager retains complete discretion regarding when to make an in-kind redemption payment to a particular fund investor, as well as the composition of that in-kind payment. For example, in most hedge fund documents we review, the fund manager retains the right to make an in-kind redemption payment in highly liquid securities, thinly-traded securities, illiquid instruments, or any combination of these alternatives. The manager’s discretion applies regardless of the actual composition of the fund at the time of the redemption. The manager also typically retains the right to establish reserves or holdbacks that reduce the redemption price paid to the redeeming investor, even though these reductions may represent a discount applied due to manager uncertainty over the value of the portfolio.
What is the Driver?
Why is it the norm that an institutional investor who pays all cash when it invests in a hedge fund does not insist on all cash when it redeems from the fund? One answer might be that hedge fund investors want the hedge fund’s portfolio to be as fully devoted to alpha-generating activities as possible. The argument goes that the right to make an in-kind redemption payment provides the manager the necessary comfort to hold a greater portion of the portfolio in more opportunistic (and possibly less liquid) trading positions and less in cash reserves to fund potential redemption requests.
But if that is the reason, what exactly is the purpose of other redemption control mechanisms that are often more tailored to the liquidity characteristics of the portfolio—for example, lock-ups, gates and suspension provisions? It would seem that those types of restrictions could more appropriately spread and segregate the contingent liability represented by the investors’ redemption rights to better match the liquidity characteristics of the fund’s portfolio.
Another answer could be that the in-kind redemption right is viewed as boilerplate language that investors expect will not be invoked except in “end of the world” scenarios in which they might have bigger problems than receiving an in-kind redemption payment from a hedge fund. After all, many, if not most, mutual funds retain the right to make redemption payments in kind, and no one expects that they would invoke that option except in dire circumstances. But if that is the motivation, why is the manager’s in-kind redemption discretion typically so broad? Why not limit it to situations in which there are massive redemption requests, or the manager elects to dissolve the fund?
Unfortunately, over the years we have seen more than one situation in which a hedge fund manager opted to make an in-kind redemption payment in the form of illiquid securities to an investor not because of general economic turmoil, but because of portfolio issues unique to the fund. What’s more, we have sometimes seen managers discriminate against an institutional investor with large holdings in the fund by adopting a policy that all redemptions over a certain dollar amount will receive in-kind redemption proceeds.
Perhaps it is not as important for an institutional investor to solve this riddle as it is for the investor to make sure the manager treats the investor equitably in considering whether to make an in-kind redemption payment. One way for an investor to begin to protect itself is to understand the manager’s side pocket policy. Side pocketing an investment takes the in-kind redemption issue off the table with regard to that investment—under the typical side-pocket language, all existing fund investors will be liquidated at the same time and pay the same fees with regard to the side pocket, regardless of when they redeem from the fund’s main portfolio.
Merely looking at a fund’s legal documents is not enough, because these documents typically allow the manager wide latitude in whether to side pocket. In other words, the fund is legally entitled to hold a significant portion of its portfolio in illiquid assets without designating any of those positions as side pocket investments. Instead, understanding the fund’s side pocket policy and history—which may be much more investor-friendly than the legal documents—may give the investor insight about whether the side-pocketed assets are truly reflective of all the fund’s illiquid holdings.
Another approach is for an investor to negotiate for limits on the portion of its redemption proceeds that can be paid in illiquid securities. Recently, we reviewed a fund that used this concept in its fund documents. The fund documents generally limited in-kind redemption payments to marketable securities. However, if redemption requests exceeded a threshold percentage of the fund’s total NAV, the manager could elect to pay an equal portion of each pending redemption request in illiquid securities, up to a maximum percentage cap (one that insured the bulk of proceeds would still be paid in cash). All illiquids distributed to redeeming investors were placed in a liquidating trust that essentially worked as a side pocket, with all redeeming investors being treated the same.
One additional idea is to negotiate a “most favored nations” clause on the subject. For example, the investor might ask the manager to confirm in writing that if the manager elects to pay the investor redemption proceeds in the form of illiquid securities, that the percentage that the in-kind payment represents of the investor’s total redemption proceeds will not exceed that of any other investor in the six months preceding or following the redemption. For the post-redemption date covenant, again a liquidating trust or similar vehicle works best, so that the investor doesn’t accept title to any illiquids until the percentage of cash it is entitled to receive is finally resolved.
A final possibility is a general clause in the side letter that the investor will be treated “equitably and proportionately” to other investors with respect to any in-kind redemption payment of illiquid securities by the fund. Alternatively, the side letter language could read that “the investor will not receive a materially disproportionate payment of redemption proceeds in the form of illiquid securities, based on the portion of the fund’s overall portfolio that is illiquid.” This approach tends to lead to a negotiation between the parties at the time of the redemption based on the fund’s current portfolio composition and recent redemption practices. In all of these cases, the investor should obtain a right to inspect the fund’s books and records regarding historic and future redemptions so that the investor can assess whether the fund is living up to its side letter commitment.
The typical hedge fund language granting the manager unlimited discretion to make in-kind redemption payments deserves more thoughtful reflection by the industry. Hopefully, institutional investors will lead in developing a new standard that trades some of the current discretion reserved to hedge fund managers in making in-kind redemption payments for greater assurances that investors will be treated fairly when a manager considers the in-kind payment option.
Luis F. Ruiz