Welcome to Sharpe Thoughts, a quarterly newsletter produced by MJ Hudson’s Hedge Fund Team.
“Liquidity”, in the context of traditional hedge funds, is not just the frequency with which investors can get their money back (i.e. “redeem” from the fund) but also, fundamentally, the ability of the fund to be able to satisfy investor redemptions, when necessary.
Historically, at least, investors in hedge funds have tolerated higher levels of opacity in the way hedge funds operated, including with regards to liquidity management. This changed in 2008, when many investors in hedge funds came to realise that, in practice, this lack of transparency meant they had very little control over how and when they could get their capital back, by way of redemption.
Consequently, liquidity (or, perhaps, more appropriately, the risk of a lack of liquidity) has become a hot topic for regulators, hedge fund managers and investors, in the decade since the global financial crisis. At its core, liquidity management is the art of identifying and managing mismatches between the liquidity of hedge fund assets and redemption terms offered by hedge funds to their investors.
Liquidity management tools have always been part of the fund documentation. However, prior to the global financial crisis, they were seldom questioned, much less negotiated. Once the tools were exercised, alarm bells started ringing. When the crisis hit and investors scrambled to redeem their investments, funds likewise scrambled to whatever tools and techniques were available to manage liquidity.
The global financial crisis became a crisis of liquidity for hedge funds.
Hedge funds imposed redemption gates, suspended redemptions, created side pockets and made in-kind distributions of assets, in an effort to manage outflows. Well advised investors, concerned by the restrictions imposed on their ability to access their capital, have since come to demand greater transparency and accountability from hedge funds (and their managers) on these and many other points.
Investors will recognise that, while access to their capital has improved, restrictions can also work in their favour. Such restrictions can protect a viable fund from being crippled by a wave of ‘panic’ redemptions, or relieve pressure if the fund simply cannot liquidate its investments quickly enough to match redemptions. Such mechanisms are, when exercised prudently and in consultation with investors, an essential ingredient in the orderly management and operation of a hedge fund.
Unsurprisingly, regulators have also come to acknowledge that prudent liquidity management plays a vital role in an orderly market and broader financial stability. The International Organization of Securities Commissions (IOSCO) and the European Systemic Risk Board have both recently issued new recommendations and guidance on what they consider to be good practice.
For example, earlier this year, the Chair of ESMA, Steven Maijoor, noted that “liquidity risk in funds, due to the growth in size and importance of the fund sector has been the subject of regulators’ focus and we need to ensure that these risks are adequately managed by funds to ensure financial stability and investor protection.”
Given that liquidity management has not been specifically prescribed by national regulators to date, it remains to be seen whether regulators are the best people to take the lead on the issue. The hedge fund industry is diverse and complex. There is unlikely to be a universal solution that can be captured by a static set of principles. Rather, effective liquidity management is most likely to come from forthright commercial negotiation between investors and fund managers, on a case by case basis.
The days of “one size fits all” fund documentation are well and truly over and any hedge fund manager that thinks that investors are not paying close attention to the terms of the fund documents, especially the liquidity management provisions, may be sadly mistaken.
Some of the tools at the disposal of the hedge fund include:
Lock-ins provide that investors cannot redeem for a certain period, either starting from the date of the fund’s launch or the date the investor entered the fund. This is particularly valuable for new managers and those that have fairly illiquid investments, such as private companies or distressed debt.
Fund managers have become increasingly creative in crafting the terms of lock-ins. It is now common to see redemptions permitted during a lock-in period if a redemption fee is paid, or a cap on the proportion of the investment that can be redeemed in that period. These are often coupled with ‘throttled’ redemptions after the expiry of the lock-in.
The term ‘suspension’ in the context of hedge funds, can mean many things. It can mean the suspension of redemption requests, subscription requests, payment of redemption proceeds or calculating NAV.
It is particularly important that the terms of suspension are carefully drafted; recent Cayman Islands case law has shown that the courts will not expand suspension powers beyond that expressly agreed between the parties.
The circumstances in which directors may suspend have evolved significantly since the global financial crisis. Typically, an inability to calculate value or trade the strategy may be grounds for suspension, as happened during the global financial crisis, although documents may often provide for a broader set of circumstances, including key person events or inability to calculate liabilities.
Gates (or deferred redemptions, as they are often known) limit the amount a shareholder can redeem.
The gate can operate either automatically or at the discretion of the directors. It is typically triggered by receipt of redemption requests over a certain threshold. This threshold is calculated on either a ‘whole fund’ basis (i.e, a proportion of redemptions across the entire fund), ‘class’ basis (i.e, a proportion of redemptions across that particular share class) or ‘investor’ basis (i.e, a proportion of the particular shareholder’s investment being redeemed).
Gates have a variety of profiles. Typically, redeeming shareholders will have the remainder of their requested redemption rolled forward and distributed over subsequent redemption dates.
Only with a genuine alignment of interests and careful coordination of asset liquidity with investor liquidity can we avoid a wide scale repeat of some of the mistakes of the past.
If you would like further advice on this topic, please contact Sean Scott at firstname.lastname@example.org.
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