What can funds do to protect themselves from liquidation?

While it may seem simple to say “pick the right investments”, it is not that straightforward. Determining if the fund is a viable concern can be a tricky process, particularly when taking into account the rights of shareholders (who may also be creditors). What most believe is key to any situation, including potential liquidation, is frequent and clear communication with investors.

Henry Bregstein at Katten Muchin Rosenman in New York believes a key concern is redemption terms. “Make sure that redemption terms match portfolio liquidity and provide transparent gate and suspension of redemption provisions that benefit investors as opposed to merely trapping assets,” he advises.

“I have to believe that material mismatches in portfolio liquidity and redemption terms and the misuse of gates and suspension provisions will be a focus of investor litigation,” cautions Bregstein.

According to Steven Nadel at Seward & Kissel, funds should monitor their book and counterparty exposure carefully and be careful with leverage.

Mitch Nichter, partner at Paul Hastings, says funds can protect themselves by clearly communicating to investors, both initially and throughout the investment term, the primary attributes of the product they are purchasing such as liquidity, volatility and other risk/return characteristics.

He also thinks they should structure the fund and the management company to manage these attributes. “In our experience many crisis situations, including those that resulted in fund liquidations, could have been minimised or avoided by ongoing effective communication with investors.

“Avoiding the perception of unfair surprise avoids crisis,” notes Nichter.

Using accurate and descriptive private placement memoranda and gate provisions limiting withdrawals by percentages is the advice from Hannah Terhune at Capital Management Services Group. “Avoid fraudulent practices. Communicate proactively with your existing investors,” she says.

Sonya Van de Graaff at Brown Rudnick in London thinks funds should protect liquidity by including gates, side pockets, lock-ups and suspensions of redemptions in the investors’ agreements.

She also advises clearly defining the boundaries to financial covenants and margin calls in prime brokerage and other funding documentation and limiting the scope of discretions of the financier to refuse drawdowns and make margin calls.

“Don’t be afraid of negotiating prime brokerage documentation,” she declares.

The main challenge is to continue good investment performance, say Brian McDermott and Siobhán Moloney at A&L Goodbody. The use of investment strategies, effective selection of service provider counterparties, maintaining good investor relations, working within a jurisdiction which offers an effective regulatory regime that protects and is attractive to investors can all assist in protecting funds from liquidation, they advise.

Omar Zerafa at Aequitas Legal in Malta believes law firms have their limitations in helping a fund avoid or survive a crisis “since most of the time a crisis is the result of a conglomerate of external forces which are very often unpredictable.”

He does concede that law firms can help strengthen the fund and prepare it for times of crisis. “Careful drafting of fund documents and foresight of possible risks can mitigate the effect of turbulence on the fund,” he says.

Daniel Mackelden at Isle of Man law firm Cains thinks properly structuring the fund on set-up is the first step. It is important, he says, to ensure it contains the necessary protections and flexibility to match the fund’s investment aims and investor expectations.

“There is also an ongoing need to keep the fund up to speed on the latest developments in structuring and make consequential changes,” he says.

“Have cash!” is the snappy answer from Gray Smith at Appleby in Cayman Islands.

“Liquidation happens when you can’t pay your debts when they fall due, so make sure wherever possible that you have the liquidity needed (easier said than done) and have documents which allow you to postpone payments (rather easier),” he advises.

Tania Dons and Richard Finlay in the Cayman office of Conyers Dill & Pearman have a different answer.

They agree with others that it is key to ensure the fund’s documents are sufficiently flexible and clear to enable it to manage its way through a crisis. Fund managers are now more aware of the pitfalls and want to include tools in the documentation to provide for possible future contingencies, they note.

Robert Briant in the British Virgin Islands office thinks the question really should be: how can funds protect themselves from being in crisis?

“The short answer to the question is a fund can avoid insolvent liquidation by ensuring it remains solvent. Otherwise liquidation is a necessary part of a fund’s life and takes place when that life comes to an end,” he says.

“Otherwise a fund will avoid liquidation if it has sufficient assets and remains solvent. A fund will have sufficient assets if it has good returns and the support of investors.

“Having said this, even a strong fund may be under pressure in a crisis when investors are looking to redeem investments, irrespective of the return. It is here where gates and the temporary suspension of redemptions may be appropriate,” Briant concludes.

In the Bermuda office Dawn Griffiths says clients need to ensure careful management of investor expectations and “seek restructuring solutions that are in the best interests of the funds. Close consultation with legal counsel on the drafting of the fund’s constitutional documents is essential.”

Because some issues have been tested in the courts of certain offshore jurisdictions, funds should ensure they review their own documentation to leverage off the lessons learnt over the past year, she advises.

Ingrid Pierce at Walkers thinks in certain cases it is “simply impossible to avoid liquidation”. She notes that the directors may be under a fiduciary duty to consider liquidating the fund.

“However, the emphasis must be on pre-emptive action, keeping investors informed, seeking their views and if necessary, their consent to a proposed course of action. Otherwise, the fund is at risk of winding up proceedings from investors as well as outside creditors,” she concludes.

Michael Richardson in the Cayman office of Maples and Calder says funds fail and are no longer a viable entity for a number of reasons, including sudden large unexpected market pricing dislocation and illiquidity in asset classes, leverage and funding mismatches, loss of investor confidence, fraud, inability to meet margin calls and an investor liquidity crunch.

“Early identification of problems and development of solutions is vital. Funds need to involve legal counsel as soon as possible where there are concerns that any cause for the fund failing may arise.

“Good and open dialogue with the fund’s investors, lenders and other counterparties as to the reasons for the fund’s problems and the development of a credible business plan to deal with the fund’s predicament might enable the fund to weather the storm,” advises Richardson.

Together with legal counsel the fund needs to analyse its documents or counterparty documents as applicable and assess the flexibility available in order to develop a strategy of defence, he notes.

“Gating or suspending redemptions of shares may be required to take the pressure off the fund and reduce the need for the fund to make fire sales of assets in illiquid markets.

“Negotiations with lenders or leverage providers to deal with margin calls or other potential loan default situations may also be necessary,” concludes Richardson.

The importance of clear and open investor communication is also highlighted by Simon Schilder at Ogier in the British Virgin Islands.

“If a hedge fund in a crisis can manage to retain the confidence of its investors, then it will already be beginning to win the battle to avoid liquidation,” he says.