Liquidating Funds: You’ve Been PIK’d

 

In this Update, we will focus on the ability of the investment managers of hedge funds to make payments in kind (“PIK”) as a way to fulfill an investor’s redemption request. This concept is distinct from the ability of investment managers to (1) form side pockets, the assets of which are not eligible for redemption; (2) suspend redemptions outright; or (3) impose fund or investor level redemption gates. Having the ability to PIK investors upon redemption is appealing in certain cases where the assets are so illiquid that the only way to sell them is at a severely reduced price. This approach may be less appropriate when an investment manager intends to invest in liquid, exchange traded assets.

 

When an investment manager has an illiquid portfolio, little cash (and wants to conserve what little it has for the benefit of the remaining investors in the fund) and is faced with substantial redemptions, it may opt to pay redemptions in kind (or partly in cash and partly in kind). The Investment Manager must then choose which assets to pay to redeeming investors. One option would be to be distribute a pro rata portion of all the assets (or at least the illiquid assets) in the portfolio. This portion of assets would likely include short positions. This approach is at least equitable in that all investors (those that are redeeming and those that are remaining) will receive their pro rata portion of the selected assets. The pro rata approach may require modification if it will result in odd lots (price penalty) or a fractional interest in an asset that is difficult to sell in pieces. It may be prudent for an investment manager to hire an independent third party or the board of directors to oversee this asset selection process to ensure that it is fair and equitable.

 

Liquidating Funds

 

One concern with PIK redemptions is that the substantial majority of hedge fund investors are not organized to, and probably do not want to, manage these illiquid assets to realization. Consequently, many funds provide for the investment manager to take these selected assets (pro rata or otherwise) and place them in a liquidating fund or trust. The redeeming investors would then receive their pro rata ownership interest in the liquidating fund.

 

The next threshold issues when dealing with liquidating funds are (a) how long will it take to liquidate these assets, and (b) what kind of fees should an investment manager be paid for doing so? Given that assets in a liquidating fund are no longer being managed for performance, industry participants have differing opinions on whether an investment manager should continue to receive a performance fee for these assets. Further, some industry participants would argue that an investment manager shouldn’t receive a management fee on the assets of the liquidating fund so that the investment manager will have the proper incentive to wind the liquidating fund up as soon as possible. Some investors would argue that a management fee that declines significantly over time would provide the proper incentive to an investment manager to liquidate the assets and pay cash to redeeming investors.

 

Another consideration in this regard is to determine where the funds will come from to pay any management and or performance fees? One approach may be to include sufficient cash in the liquidating fund to cover the fees for the expected life of the fund. Another approach would be to accrue these fees and pay them to the investment manager when the assets have been monetized with appropriate modifications to the fee accruals based on the actual sale price.

 

A related issue to consider is whether a fund’s counterparties would be willing to contract with or provide services to a liquidating fund. Consequently, the fund from which the liquidating fund assets came from (or some other viable vehicle with ISDA Agreements in place (the “Sponsor”)) will be required to face the “Street”, post collateral, provide hedges, etc. One way to deal with this issue is for the Sponsor to enter into a credit facility with the liquidating fund which should have a market rate of interest negotiated on an arm’s length basis. The Fund should consider the size and financial strength of the Sponsor to ensure that that entity is strong enough to shoulder the financial responsibility of providing financing to the liquidating fund.

 

The goal of this exercise is to be as fair as possible to both the redeeming investors and the remaining investors in the fund. In the midst of a financial crisis such as 2008, trying to pay substantial redemptions in cash could jeopardize the ability of a fund to continue its operations.

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