Hedge Fund Restructuring
Restructuring in a Challenging Environmentilliquidity of assets, poor performance, and historic market volatility. All of these factors may cause an ordinarily positive-minded advisor to want to stay in bed each morning. So what is a hedge fund and fund managers to do? Action can be broken into two parts; triage and planning for the future.
Triage. Most funds regardless of strategy have experienced redemptions, some representing a significant portion of fund assets. Redemptions, whether they be attributable to performance, leverage providers no longer providing forbearance, or investors using the more liquid strategy funds as ATM’s, forces managers to focus on one thing - creating liquidity. The reality is that unless the fund was invested in a liquid strategy, it has most likely instituted gates and/or suspended redemptions and NAV’s.
Absent the ability to raise new capital, managers must find other ways to deal with the significant amount of redemptions. The credit environment has made it nearly impossible to sell assets. Previously under-read Limited Partnership Agreements, Bylaws, and Articles and Memorandum of Association are being scoured to find creative alternatives to deal with the redemptions. Themes are emerging including creating some type of side-pocket or liquidating entity to hold illiquid assets. As these assets mature or liquidate, proceeds are paid to redeemed investors. In some circumstances, fund managers are creating funds within funds by establishing redemptive share classes. In varying scenarios, redemptive investors are allocated their proportionate share of investments which interests are then transferred into Special Purpose Vehicles (SPV’s) or held at the fund level. As the assets liquidate, investors receive their proceeds. Certain funds have informed investors that this liquidation could take several years or longer. In conjunction with creating a redemptive share class, a new share class is created to accept new subscriptions and allow the fund to put on new trades. This ensures that new capital will not be used to fund redemptions. Some funds are simply choosing to close and start over. Some skeptics believe this is to avoid the high-water-mark issues created during the past year.
Managers are reaching out for help beyond the usual fund advisors. Investment banks and advisors are becoming a good source of capital and exit strategies. There is money in the market looking to invest in both illiquid and distressed assets. In addition, new investments are bringing the expected higher yields with better quality collateral as one would expect in a tight credit environment. Matching willing buyers and sellers requires fund managers to think outside the box.
The Future. So who has survived so far? Funds with no leverage that generally provided complete transparency and put down good relative or absolute returns received fewer redemptions. Funds with fewer fund-of hedge funds as investors fared better if only due to the fact that the majority of FOF’s were levered and were forced to redeem to pay off their leverage. These funds, while shaken, are well positioned for growth. Many have lost significant AUM and are seeking alternatives for new capital or mergers with other fund advisors. The market has seen an increased number of parties interested in purchasing funds and their advisors. Many fund advisors are sorting through the emotions of selling the firm and what the future would hold for them under such an environment. Some are faced with the difficult decision of taking additional seed capital in exchange for a portion of their business. In all these situations, advisors should seek advice on valuing their business and the alternatives available to them. For those managers whose funds have closed, seeking strategic partnerships may be an alternative to begin the process of rebuilding your business. For fund managers that want to start anew, understanding the new structures that investors are seeking, including hybrid closed-end funds with callable periods and tails, is essential. And throughout, better transparency will be a requirement, as well as dealing with any additional regulation that will be imposed on investment managers as a result of current and pending legislation.
The hard lesson of 2008 for alternative asset managers was how to create liquidity –quickly, and sufficiently – to satisfy investors on demand. To prevent the fire-sale of assets at distressed prices to satisfy these demands, many funds raised gates or suspended redemptions. While these strategies proved somewhat successful in the short-term at preventing those distressed sales, those same funds now must address the stigma associated with employing such tactics. The obvious worry is that as capital returns to the alternative asset management space, those once locked-out investors will look for funds that orderly handled the onslaught of redemptions versus simply throwing up gates or indiscriminately suspending redemptions.
Many funds that performed well in 2008 (relative to the overall markets) were still struck by these mass redemptions. Investors were driven to look for liquidity wherever they could find it and most managers did not have the systems in place to effectively address these redemptions in an organized manner. These managers were forced to look for help from outside parties – in many instances remedial steps were taken to address the funds’ lack of liquidity. Some managers, however, being proactive are taking steps to prepare in advance for any worsening of the current financial crisis.
The best way to address current concerns as well as help insulate against any future liquidity concerns is to consider having an external independent firm evaluate strategic alternatives for the Advisor and the Funds. This analysis is individualized for each fund as to address the liquidity issues the fund is currently facing, its future liquidity risks, and explores several alternatives for the advisor and funds, that may include (non-exhaustive):
1.) Creation of a side pocket(s) or a liquidating entity;
2.) Creation of a redemption share class and a new share class;
3.) Wind-down of the Funds and creation of a new fund(s);
4.) Financing for the Funds, including bank syndications and/or participations;
5.) Limited auction-bid process for redemptions;
6.) Sale or partial sale of the Advisor or the Funds;
7.) Seed capital for a new fund(s) or capital infusion in the Funds;
8.) Evaluating strategies for the Advisor and the Funds; and
9.) Do nothing / Status-quo.
These strategies are to help accelerate the redemption or repurchase of interests in the funds by investors who sought, or may in the future seek, redemption of their interests in one or more of the funds. The reward these managers will receive for their planning and preparedness is investors’ confidence by way of investors’ capital.
About the Author
Karl D'Cunha is a Senior Managing Director at Houlihan Smith where his primary responsibilities as part the firm’s financial advisory practice include providing financial opinions including valuations, fairness opinions, and structured finance advisory. He is co-head of the firm’s Hedge Fund Advisory services group and a team leader of the firm’s Technical Standards Committee. Mr. D’Cunha has over 12 years experience in the alternative investments industry, including working with some the largest hedge funds globally on valuation, accounting and compliance issues.
Mr. D’Cunha has been actively involved in investment company related services since 1997 and has prepared, supervised, or consulted upon assignments covering most facets of valuation and accounting relating to US and International private equity, venture capital and hedge funds, investment advisors, mutual funds and other entities. Mr. D'Cunha was previously an audit manager at Ernst & Young, LLP and PricewaterhouseCoopers, LLP with 8 years experience in the Investment Management industry group.
Mr. D'Cunha holds a B.A. in Finance and Economics from University of Western Ontario and a Graduate Diploma in Accounting from McGill University. Mr. D'Cunha is a Chartered Accountant, a level III candidate in the Chartered Financial Analyst program. Mr. D’Cunha is a member of the following organizations: New York Hedge Fund Roundtable, Hedge Fund Association, Canadian Institute of Chartered Accountants, CFA Society of Chicago, CFA Institute, Association of Chartered Accountants in the United States, Appraisal Issues Task Force, Association of Latino Professionals in Finance and Accounting (ALPFA), Arts and Business Council and American MENSA, Ltd.
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