After a challenging year for the hedge fund industry, Mark Lewis identifies the various techniques that can be applied to help the funds through this current storm.
As hedge fund managers grapple with volatile and falling markets and an upward spike in redemption requests, the variety of practical techniques that can be employed to help funds weather the storm have dominated attention in the sector. The Cayman Islands are home to approximately 80 per cent of the world's offshore hedge funds, so the solutions and strategies being adopted in Cayman to deal with illiquidity represent the industry's leading efforts in what has been its biggest test to date.
Funds that planned for the worst at the outset already have mechanisms to adequately deal with redemption issues enshrined in their constitutive documents and have certainly seen the benefit of foresight. The value of being able to act quickly to implement 'gates' to slow down redemptions, or 'side pockets' to isolate underperforming assets, without having to obtain shareholder approval, cannot be overstated and can sometimes mean the difference between survival and failure for a fund.
A gate, which places a limit on the number and/or aggregate net asset value of investments that can be redeemed on a redemption date, is an important component in a fund manager’s toolbox when a fund is faced with illiquidity and numerous investors attempt to withdraw at the same time. Getting the gate in place before the next redemption date is a much more realistic task when the fund's Articles of Association already contain a power allowing the directors to impose a gate, spelling out to investors exactly how it will operate. Otherwise, securing investor approval for such a mechanism in volatile market conditions is far from easy as shareholders have to essentially co-operate and agree to what is, in effect, a reduction in their redemption rights.
‘Side pocketing’ of underperforming or illiquid assets presents another option managers are considering in the current environment. Side pockets provide a useful solution in a situation where an asset is not capable of being valued or a fund cannot access assets which might be locked up due to the insolvency of its prime broker or custodian. Once an underperforming asset is side pocketed, the manager can continue to trade and strike a regular net asset value for the fund’s remaining assets. He or she can then deal with the side-pocketed asset when market conditions improve or a valuation can be achieved without loss of the eventual value of the asset to investors.
In the current market turmoil where assets are difficult, if not impossible, to value, attorneys in Cayman are seeing a marked increase in instructions from funds seeking to introduce gate and side pockets provisions to allow them to effectively manage volatility.
Where a fund does not have, or is unable to introduce, provisions to implement a side pocket, there has been a need for more innovative solutions, particularly the creation of sub-funds or the incorporation of wholly-owned special purpose vehicles (SPVs) to which the illiquid assets are transferred. Shares in an SPV can be distributed to investors in a number of ways, either through a compulsory redemption or an in-kind distribution on a redemption of fund shares.
The state of change that the hedge fund industry has experienced is clearly evident in the evolution of hedge fund offering documents, which have developed significantly in recent years. The differences between current offering documents and offering documents produced more than five years ago can be very pronounced.
Evolution has taken place over time to meet constantly changing market conditions and the challenges managers face today such as dealing with redemptions, valuations, and use of side pockets, which were simply not contemplated even five years ago.
In this new evolving era for hedge funds, there has also emerged a greater understanding on the part of investors of the issues that managers deal with and how the value of an investment portfolio can best be preserved.
Where investment managers have little alternative other than to suspend redemptions, investors now appear more willing to co-operate in order to preserve value, rather than going on the offensive as they have in the past. In some instances, the introduction of a lock-up or gate to give volatile markets a chance to settle down can have a calming effect on investors, without the devastating impact on goodwill that it might have had as little as a year or two ago. Investors are all too aware that with major stock indices moving 4 per cent to 5 per cent on a daily basis, the exact time at which a valuation has to be made can have a significant bearing on net asset valuation, making temporary lock-ups more attractive.
The Lehman Brothers’ bankruptcy and the unprecedented upheavals in the banking sector also presented a new round of problems to the hedge fund industry. In addition to tipping some previously performing portfolios over the edge, the bankruptcy has highlighted the changing nature of the relationships between funds and their prime brokers. Funds now need to be protected from the potential bankruptcy of their prime broker and the days of having just one institution fulfilling this function are probably over, with the norm now likely to be three or four prime brokers per fund, with risk prudently spread among them.
Even for a fund that is not currently in a distressed state, it might only take two heavyweight investors seeking redemption to make the fund's future very uncertain. Some investors actually argue for lock-ups to be implemented to prevent other investors from rushing for the exit, leaving behind them a destabilised fund with only illiquid assets and little chance of recovery.
Part of the current survival strategy for funds, which aren't necessarily distressed, involves the management or rebalancing of a fund’s investor base, so as to remove dependence on one or two large investors.
If provisions that enable the fund to deal with illiquidity issues are not in place, managers with good communication skills are getting on the phone with investors to explain the reasons behind the actions they intend to take, rather than writing letters of apology. As long as investors understand that good and solid principles are being applied, they tend to react positively, compared with the alternative of selling now at fire-sale prices. However, often the ability to sell a change in strategy will come down to the reputation of the manager.
Though 2008 may look like it will be the worst year on record for hedge funds, in general they have outperformed the stock market in relative terms.
After the third-quarter redemption date passed with many investors and managers left in a holding pattern, uncertainty still prevails. Fourth-quarter redemption requests, the majority of which fall due in the middle of November and the end of December 2008, are likely to provide a greater indication of what is in store for the markets over the short and medium term.
At the time of writing, actual fund terminations have remained relatively low and during the peak of the crisis in September 2008 there were still more than three times as many new funds registered in Cayman than the 46 that were terminated. What has been seen is an increase in the number of funds notifying the Cayman Islands Monetary Authority that they are suspending redemptions or imposing gates, although in most cases funds are doing all they can to avoid suspending redemptions and net value asset (NAV) calculations. In some instances funds are employing a two-pronged strategy: suspension to solve the issues of redemptions, and a side pocket or SPV to deal with illiquidity.
What has not been seen in the Cayman Islands is a significant number of hedge fund liquidations. The winding up and dissolution of a fund makes maximising the benefit to investors that much harder, with a statutory regime imposed on the realisation and distribution of assets. Rather than a formal liquidation, the trend has been for the directors and investors to try and work out some type of arrangement that satisfies investors while imposing some form of moratorium upon the fund until market conditions improve.
As managers gear up for a potential surge in redemption requests by converting assets to cash, they face weak and volatile markets and widespread selling pressure from fund of funds which threatens to cast a major shadow over global equities.
The impact of the credit crunch is also being played out as investment managers find it increasingly difficult to borrow money from their prime broker to satisfy redemption requests. This increases the drive to cash as managers are forced to liquidate securities to realise cash. While cash is normally the last place an investment manager wants to be, it is perhaps now a sign of the times and indicative of the bewilderment of many in the investment community about exactly what their next move should be.
As the global economy teeters on the edge of recession and the focus turns to a probable new wave of regulation both in the US and internationally, the Cayman Islands’ hedge fund industry is again demonstrating its resilience and remains poised to service the next wave of capital – most likely from the Middle and Far East – to be invested back into the US equity markets.
While many funds will no doubt fail as a result of the current market crisis, a broad array of potential solutions and a greater degree of understanding from investors give more funds a greater chance of avoiding a formal liquidation process.
Mark Lewis Managing Partner- Clients
Sandie Corbett Bankruptcy and Insolvency Partner
Walkers Bermuda, British Virgin Islands, Cayman Islands, Dubai, Guernsey, Hong Kong, Ireland, Jersey, London and Singapore.