Early indications are that investors believe that the COVID-19 crisis feels different to the 2008/2009 financial crisis, during which there were largescale redemptions from hedge funds that triggered the widespread use of liquidity management arrangements (e.g. gates and side pockets). Indeed, there is evidence that investors are currently increasing their allocation to hedge funds.
Firstly, and most importantly, we hope that our clients and contacts are well and coping in these unprecedented times.
In the UK, we are just starting to get used to lockdown. We are in the early days of this crisis. Some hedge funds and strategies are flourishing; others are making big losses.
We hope that the liquidity crisis of 2008/2009 does not repeat itself. In any event, however, we thought that it would be timely to explore the use of liquidity management arrangements and to ask how far we have come since the last crisis (during which our partners gave extensive advice to managers) and what managers, investors and fund directors have learnt in the intervening period.
During the financial crisis, and in the years that followed, the reputation of hedge funds was tarnished as the use by some managers of liquidity management arrangements were felt to have been used to protect the manager and not the fund, to have been caused by style drift by the manager into more illiquid assets, to have been forced on investors (or, at least, to have been implemented without the requisite, or a sufficiently robust, governance procedure being followed), or imposed in a way that did not do enough to balance the interests of investors vs the manager (particularly with respect to ongoing fees).
Investors were seemingly not without blame as several more liquid funds felt as if they were being used as ATMs during the period.
Special liquidity arrangements, such as side pockets, in kind redemptions, suspensions, gates etc., however, are better recognised by investors and regulators as important and able to be in the best interests of the fund.
This was aligned with investor sentiment (see, for example, the AIMA paper "A Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures")
"If structured properly, the hedge fund should provide an investor with sufficient flexibility to render its own determination of the continued viability of the investment vehicle on an ongoing basis. However, it is important that a hedge fund’s investors do not have the ability to compromise the hedge fund manager’s business or other clients’ capital by having too much latitude in forcing liquidity. Hedge fund managers should not be placed in a situation, which has occurred in the past, when they feel compelled to focus on raising cash for the next redemption period rather than maximising risk-adjusted returns."
The AIFMD, in particular, permits the use of tools and special arrangements to manage liquidity and specifically refers to the use of side pockets and gates.
AIFMs should therefore review their written policies and procedures to see if they need to be updated in light of the crisis. These may become far more important.
The liquidity management system and procedures shall, amongst other things, ensure that:
"…the AIFM considers and puts into effect the tools and arrangements, including 'special arrangements', necessary to manage the liquidity risk of each AIF under its management. The AIFM shall identify the types of circumstances where these tools and arrangements may be used in both normal and exceptional circumstances, taking into account the fair treatment of all AIF investors in relation to each AIF under management. The AIFM may use such tools and arrangements only in these circumstances and if appropriate disclosures have been made in accordance with Article 108 (the AIFMD Level 2 Regulations).
"The recitals provide: 'The use of tools and special arrangements to manage liquidity should be made dependent on concrete circumstances…' ".
"Special arrangement" means "an arrangement that arises as a direct consequence of the illiquid nature of the assets of an AIF which impacts the specific redemption rights of investors in a type of units or shares of the AIF and which is a bespoke or separate arrangement from the general redemption rights of investors".
The definition is not particularly useful as special arrangements may be implemented for reasons other than the illiquidity of underlying assets. We note that the recitals refer to liquidity management arrangements allowing AIFMs to cope "with illiquid assets and related valuation problems in order to respond to redemption requests". In any event, read as a whole, the AIFMD's liquidity management provisions are intended to achieve a clear outcome.
Interestingly, the AIFMD specifically states that the "suspension of an AIF should not be considered as a special arrangement as this applies to all of the AIF’s assets and all of the AIF's investors". This will largely not make a difference, however, as suspensions are usually (but not always) mentioned alongside "special arrangements".
More permanent borrowing arrangements to manage liquidity are "more likely" to be a special arrangement for the purpose of managing illiquid assets.
The industry should be in a better place during this crisis with liquidity management being subject to a number of specific regulatory requirements, with provisions having been battle-tested and refined, with initial investor lock-ups appearing more frequently, with a greater level of understanding, and with a higher level of diligence being performed by investors but only time will tell if the balance is right.
Managers considering the use of liquidity management arrangements must:
(a) look in detail at the relevant provisions of the fund documents;
(b) consider the potential consequences of implementing the provisions (will they make things worse?);
(c) have the right motive;
(d) follow the necessary governance processes;
(e) aim to be fair; and
(f) be mindful of relevant regulatory requirements.
Managers should have an exit in mind when they impose special liquidity management arrangements. Investors will be strongly opposed to being locked-up indefinitely.
Managers should also consider their reputations. Some very big manager names never recovered from the consequences of actions they took in 2008/2009.
(A) Gates
Redemption gates put a limit on investor withdrawals.
Generally, funds have a fund-level gate (i.e. a limit on the amount that all investors in a fund are permitted to redeem at a given point in time) and/or an investor-level gate (i.e. a limit on the amount that an individual investor may redeem).
Fund level gates have dramatically fallen out of favour since the crisis and statistics show that the vast majority of new hedge funds do not have a fund level gate.
Many fund level gate provisions were not limited by time and were drafted so that earlier redeemers got priority at every redemption opportunity until their original redemption request was settled. Provisions also tended to roll over redemption requests to the next redemption opportunity. This drafting actually motivated investors to rush for the exit when the gate was implemented. A provision that was intended to help actually made things worse.
Investor level gates are more common but their appearance has also fallen significantly since the crisis.
We do wonder, however, how many managers and investors will wish that the fund documents did contain gating provisions in the coming months.
(B) Side pockets
Side pocket arrangements segregate illiquid or hard-to-value positions from the main pool of assets in a fund until such time as they are realised or are no longer difficult to price. When used correctly, side pockets can be useful liquidity management tool.
Side pocket provisions are still common in fund documents and we expect these provisions to be triggered over the next few weeks or months. Quite often, however, the provisions leave much of the detail to be determined by the governing body and a number of issues will need to be considered.
(C) Suspensions
The devil here is truly in the detail. Fund directors will need to carefully consider the exercise of any suspension (be it a suspension of redemptions and/or NAV calculations) and what changes may need to be made during any period of suspension (e.g. whether the manager's fees should be lowered).
(D) In-kind redemptions
Again, the detail of the wording of the provisions will be extremely important and managers and fund directors should consider the consequences very carefully.
The utmost care should be taken with any proposal to create a liquidation SPV and to satisfy redemption requests with an in-kind distribution of shares in the SPV. This use of Liquidation SPVs is a good example of the more creative and/or aggressive interpretations of fund document provisions in 08/09 that created much of the ill will between investors and managers.
Firstly, and most importantly, we hope that our clients and contacts are well and coping in these unprecedented times.
In the UK, we are just starting to get used to lockdown. We are in the early days of this crisis. Some hedge funds and strategies are flourishing; others are making big losses.
We hope that the liquidity crisis of 2008/2009 does not repeat itself. In any event, however, we thought that it would be timely to explore the use of liquidity management arrangements and to ask how far we have come since the last crisis (during which our partners gave extensive advice to managers) and what managers, investors and fund directors have learnt in the intervening period.
During the financial crisis, and in the years that followed, the reputation of hedge funds was tarnished as the use by some managers of liquidity management arrangements were felt to have been used to protect the manager and not the fund, to have been caused by style drift by the manager into more illiquid assets, to have been forced on investors (or, at least, to have been implemented without the requisite, or a sufficiently robust, governance procedure being followed), or imposed in a way that did not do enough to balance the interests of investors vs the manager (particularly with respect to ongoing fees).
Investors were seemingly not without blame as several more liquid funds felt as if they were being used as ATMs during the period.
Special liquidity arrangements, such as side pockets, in kind redemptions, suspensions, gates etc., however, are better recognised by investors and regulators as important and able to be in the best interests of the fund.
The AIFMD requirements (applicable to full-scope EEA AIFMs)
The AIFMD, which came into force after the financial crisis, imposed a duty on EEA AIFMs to ensure that, for each AIF that they manage, the investment strategy, the liquidity profile and the redemption policy are consistent.This was aligned with investor sentiment (see, for example, the AIMA paper "A Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures")
"If structured properly, the hedge fund should provide an investor with sufficient flexibility to render its own determination of the continued viability of the investment vehicle on an ongoing basis. However, it is important that a hedge fund’s investors do not have the ability to compromise the hedge fund manager’s business or other clients’ capital by having too much latitude in forcing liquidity. Hedge fund managers should not be placed in a situation, which has occurred in the past, when they feel compelled to focus on raising cash for the next redemption period rather than maximising risk-adjusted returns."
The AIFMD, in particular, permits the use of tools and special arrangements to manage liquidity and specifically refers to the use of side pockets and gates.
Liquidity management policies and procedures
AIFMs need to have in place an appropriate liquidity management system and effective procedures. AIFMs need to document their liquidity management policies and procedures, review them on at least an annual basis and update them for any changes or new arrangements. AIFMs shall include appropriate escalation measures in their liquidity management system and procedures to address anticipated or actual liquidity shortages or other distressed situations of the AIF.AIFMs should therefore review their written policies and procedures to see if they need to be updated in light of the crisis. These may become far more important.
The liquidity management system and procedures shall, amongst other things, ensure that:
"…the AIFM considers and puts into effect the tools and arrangements, including 'special arrangements', necessary to manage the liquidity risk of each AIF under its management. The AIFM shall identify the types of circumstances where these tools and arrangements may be used in both normal and exceptional circumstances, taking into account the fair treatment of all AIF investors in relation to each AIF under management. The AIFM may use such tools and arrangements only in these circumstances and if appropriate disclosures have been made in accordance with Article 108 (the AIFMD Level 2 Regulations).
"The recitals provide: 'The use of tools and special arrangements to manage liquidity should be made dependent on concrete circumstances…' ".
"Special arrangement" means "an arrangement that arises as a direct consequence of the illiquid nature of the assets of an AIF which impacts the specific redemption rights of investors in a type of units or shares of the AIF and which is a bespoke or separate arrangement from the general redemption rights of investors".
The definition is not particularly useful as special arrangements may be implemented for reasons other than the illiquidity of underlying assets. We note that the recitals refer to liquidity management arrangements allowing AIFMs to cope "with illiquid assets and related valuation problems in order to respond to redemption requests". In any event, read as a whole, the AIFMD's liquidity management provisions are intended to achieve a clear outcome.
Interestingly, the AIFMD specifically states that the "suspension of an AIF should not be considered as a special arrangement as this applies to all of the AIF’s assets and all of the AIF's investors". This will largely not make a difference, however, as suspensions are usually (but not always) mentioned alongside "special arrangements".
More permanent borrowing arrangements to manage liquidity are "more likely" to be a special arrangement for the purpose of managing illiquid assets.
Periodic disclosure to investors (Article 108)
AIFMs must:- notify to investors whenever they make changes to the liquidity management systems and procedures which are "material" .
- immediately notify investors where they activate gates, side pockets or similar special arrangements or where they decide to suspend redemptions;
- provide an overview of the changes to arrangements concerning liquidity, whether or not these are "special arrangements". Where relevant, the terms under which redemption is permitted and circumstances determining when management discretion applies shall be included. Also any voting or other restrictions exercisable, the length of any lock-up or any provision concerning ‘first in line’ or ‘pro-rating’ on gates and suspensions shall be included.
Liquidity management arrangements considered
We have considered the most common types of liquidity management arrangements below.Concluding thoughts
Investors are very wise to liquidity management provisions in fund documents and these have no doubt been closely looked at as part of the operational due diligence so there should be no nasty surprises this time around if the arrangements were to be implemented in the expected manner.The industry should be in a better place during this crisis with liquidity management being subject to a number of specific regulatory requirements, with provisions having been battle-tested and refined, with initial investor lock-ups appearing more frequently, with a greater level of understanding, and with a higher level of diligence being performed by investors but only time will tell if the balance is right.
Managers considering the use of liquidity management arrangements must:
(a) look in detail at the relevant provisions of the fund documents;
(b) consider the potential consequences of implementing the provisions (will they make things worse?);
(c) have the right motive;
(d) follow the necessary governance processes;
(e) aim to be fair; and
(f) be mindful of relevant regulatory requirements.
Managers should have an exit in mind when they impose special liquidity management arrangements. Investors will be strongly opposed to being locked-up indefinitely.
Managers should also consider their reputations. Some very big manager names never recovered from the consequences of actions they took in 2008/2009.
(A) Gates
Redemption gates put a limit on investor withdrawals.
Generally, funds have a fund-level gate (i.e. a limit on the amount that all investors in a fund are permitted to redeem at a given point in time) and/or an investor-level gate (i.e. a limit on the amount that an individual investor may redeem).
Fund level gates have dramatically fallen out of favour since the crisis and statistics show that the vast majority of new hedge funds do not have a fund level gate.
Many fund level gate provisions were not limited by time and were drafted so that earlier redeemers got priority at every redemption opportunity until their original redemption request was settled. Provisions also tended to roll over redemption requests to the next redemption opportunity. This drafting actually motivated investors to rush for the exit when the gate was implemented. A provision that was intended to help actually made things worse.
Investor level gates are more common but their appearance has also fallen significantly since the crisis.
We do wonder, however, how many managers and investors will wish that the fund documents did contain gating provisions in the coming months.
(B) Side pockets
Side pocket arrangements segregate illiquid or hard-to-value positions from the main pool of assets in a fund until such time as they are realised or are no longer difficult to price. When used correctly, side pockets can be useful liquidity management tool.
Side pocket provisions are still common in fund documents and we expect these provisions to be triggered over the next few weeks or months. Quite often, however, the provisions leave much of the detail to be determined by the governing body and a number of issues will need to be considered.
(C) Suspensions
The devil here is truly in the detail. Fund directors will need to carefully consider the exercise of any suspension (be it a suspension of redemptions and/or NAV calculations) and what changes may need to be made during any period of suspension (e.g. whether the manager's fees should be lowered).
(D) In-kind redemptions
Again, the detail of the wording of the provisions will be extremely important and managers and fund directors should consider the consequences very carefully.
The utmost care should be taken with any proposal to create a liquidation SPV and to satisfy redemption requests with an in-kind distribution of shares in the SPV. This use of Liquidation SPVs is a good example of the more creative and/or aggressive interpretations of fund document provisions in 08/09 that created much of the ill will between investors and managers.