By Mark Barnicutt on October 14, 2010
In recent weeks, we’ve had the opportunity with some new clients to review some existing/legacy hedge fund security holdings….many of which were purchased over the past decade, typically pre-2008.
Many investors were shocked to learn about certain of the redemption provisions – or clauses – that were in original offering memoranda for these investment products…especially in the 2008/09 period when they were seeking to redeem their assets in the face of the global financial crisis.
As a result, I’ve provided a list below of some of the key redemption clauses that can be included in hedge/alternative investment products — especially ones in which some/all of the underlying securities are illiquid – such as many of the hedge funds that were sold to investors pre-2008.
Funds can range from fully open to fully closed (typically for a maximum term) with respect to redemptions. The degree of closure is typically correlated with the degree of liquidity of the underlying securities in the fund. In other words, the greater the degree of illiquidity, the greater the bias towards closed status. As few investors like to have their investments fully locked-up for a long period of time, the following Redemption Provision structures can be utilized with respect to funds that contain assets with less liquid securities:
Penalties: A percentage charge against amounts redeemed typically during the early days of initial investments (ie: 90 days to 1 year).
Lockups: Investors cannot redeem for a certain period after making their investment (ie: typically in the 90 day – 2 year range with the latter for the less liquid asset type of fund)
Gates: Restricts the amount of redemptions that can occur at any given permissible redemption period (ie: x% of NAV — typically in the 10% – 25% range)
Redemption Notices: Requires investors to provide the manager with advances warning of pending redemptions. (ie: typically 90 – 120 days)
Side Pockets: Not a direct redemption control tool but an indirect one. If a liquid security becomes less liquid (and difficult to price assets), the manager has the ability (subject to restrictions in the Offering Document) to transfer the illiquid securities into a side pocket, which is akin to a sub-fund structure within the main fund. From a manager’s perspective, it’s a protective mechanism to avoid the forced liquidation (at unattractive pricing) of generally illiquid securities.
Redemption Suspension Powers: Manager has the power (defined typically for specific triggering events) to suspend (either partially or wholly) fund redemptions
Sweetened Terms: Not specifically a Redemption Provision but Managers, when faced with large redemption requests, will typically put a “sweetened terms” offer out to investors such as lower management and performance fees and/or the reset of high watermarks.
These redemption provisions are not intended to be an extensive list of all types of such provisions but to provide an overview of the core conditions which are often found in hedge/alternative investment fund offering documents whose underlying investment securities are generally not fully liquid.
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