In the current climate, there are growing concerns about hedge funds. Ingrid Pierce examines ways to breathe new life into struggling funds

When the happy couple is getting ready to walk down the aisle, any suggestion by one party that the other should sign a pre-nuptial agreement is usually enough to pour cold water on the romance and derail any hope of holy matrimony. Just as the unsuspecting bride and groom are unlikely to spend much time mulling over the potential pitfalls of their union, little thought tends to be given to the possibility of future problems with a fund when it is launched.

The start of a fund's life, however, is the most appropriate time for these delicate subjects to be broached. The fallout from the credit crisis and its impact on certain hedge funds has underlined the importance of ensuring that funds are appropriately structured in order to improve their position in the event of a liquidity crisis.

The simultaneous withdrawal of only a few investors with large holdings in a particular hedge fund can quickly cause it to go into distress. Add into the mix the inability of the fund to sell assets at a reasonable price, and the resultant run on redemptions could threaten the fund's very existence. The variety of potential liquidity problems has been compounded by funds' inability to borrow at rates previously anticipated, leaving the usual strategies for survival in shreds. Investors are short of cash and, as greater numbers seek to redeem, there are some tough options on the table.

A favoured starting point for funds with concerns over liquidity or redemption requests is the imposition of a gate. By placing some restrictions on the redemption rights of investors, it is possible to provide some breathing space for the fund and allow investors to be paid a pro-rata portion of their redemption proceeds over time. The mechanics of the gate should be clearly set out in the fund's documents and carefully followed on implementation.

Other funds have created and used side pockets, in which hard-to-value assets are placed until such time as they have a realisable market value (the determination of which is usually at the fund manager's discretion). Alternative steps are to delay the payment of redemption proceeds for an extended period (if permitted by the fund documents) or to opt for a complete suspension of redemptions, during which the fund will attempt to liquidate certain positions with a view to lifting the suspension and continuing to trade. However, the harsh reality is that many funds find it impossible to recover from a full suspension of redemptions, which is often the final act before a formal winding up process is initiated.

New challenges

The current banking crisis presents a new set of challenges for the fund industry. The ramifications of an insolvent prime broker or custodian have shot some previously performing portfolios into distress. What are the options if the custodian is now in liquidation and no longer able to discharge its obligations, or its projected performance of the terms of its contract is now seriously in doubt? For the affected funds, a very large percentage of assets housed with certain brokers or custodians may now be regarded as 'tainted'.

Funds structured to permit the creation of side pockets for special investments will be in a much stronger position to deal with these events, subject to two important caveats. First, the fund's documents must be sufficiently flexible to permit the fund to classify the tainted asset as a 'special investment'. Second, investors must have consented – expressly or by implication – to the issue of special shares in exchange for participation in the special investment.

The fund's ability to classify the relevant asset as a special investment will depend on how such investments have been defined in its documents. Side pockets traditionally have been used for hard-to-value investments acquired by the fund as an initial investment or a follow-on investment. Realisation usually occurs when the asset is sold or when it can be said to have a recognised market value.

In current market conditions, valuing the so-called 'tainted' asset may not be the problem, rather the fund could face issues readily accessing the security – particularly if its assets are held by a custodian in administration (or other insolvency proceedings) where the assets are subject to a statutory moratorium or court order restraining the commencement of any proceedings against the custodian. In these circumstances, the fund still needs immediate access to the underlying assets, but is unable to take any meaningful steps to obtain them. Is this situation sufficient for the fund to determine that the asset may be placed into a side pocket? Some funds have taken an aggressive line on this point, arguing that even wholly liquid assets can properly be side-pocketed until the happening of a particular event. However, this sort of treatment may well be outside the contemplation of the fund's documents.

Investors' consent to restrictions on their ability to redeem typically is obtained at the time of the fund's launch, by express provision in the fund's articles and/or in the subscription contract. The absence of such consent is a real issue: in light of recent market conditions, funds need to react quickly and authoritatively. In most cases, there simply isn't sufficient time to convene a shareholder meeting or even to solicit individual consent from investors. Any attempt to impose restrictions on an investor's right to redeem may be open to challenge on the basis that such restrictions have an adverse effect on the rights attached to the shares and/or will constitute a breach of contract between the fund and the relevant investor.

Many funds faced with this dilemma are being forced to take a commercial view of the matter, weighing the benefit of the new restrictions against the risk of action by investors whose consent has not been obtained.

Other options

An alternative solution is for the fund to establish a wholly-owned special purpose vehicle. Investors in the fund who wish to redeem may be issued shares in the vehicle by way of redemption in kind. Although nowhere near as good as a cash distribution, the shares should reflect the value of the underlying asset which, in due course, can be sold in the open market or repurchased by the vehicle.

Specific advice – on tax, in particular – must be taken to determine whether an in specie distribution is possible and if it will in fact be beneficial to investors.

Whichever route is adopted, investor communication is paramount. It is crucial to keeping investors informed, involved in the process and aware of their options. In times of illiquidity and stress, both sides should see the benefit of putting the thorny issue of who gets paid what and when on the table before they actually tie the knot.

Ingrid Pierce is a partner in the corporate and international finance department at Walkers in the Cayman Islands. She is head of the commercial trusts group and specialises in all types of investment funds.