What are the main issues affecting practices such as side pockets, synthetic side pockets, gates and suspension of redemptions?

According to Nora Bullock and Simon Atiyah at Lovells, side pockets and the imposition of gates have led to many legal disputes over the last two years. They expect more to follow once these positions are unwound and money is returned to investors. Many see these mechanisms as a way for a manager to hold onto assets (and therefore fees) when investors want to get out, they say.

Investors that require valuations or liquidity can be more disadvantaged than investors who do not, note the pair. They point out that assets can often be disposed of but the manager and maybe some investors believe the timing is not right, while other investors just want the cash no matter what the potential value of the assets might be if they waited.

“Make sure that the fund’s constitutional documents contain the necessary powers to permit the creation of side pockets without the need for a shareholder vote,” advises Simon Firth at Kaye Scholer. For gates and suspension of redemptions his advice is to be precise about the terms of the gate and particularly about who comes where in the order or exit. 

At Withers, partner John Langan looks at the issue from a different perspective.

He thinks managers, faced with a difficult time in raising new funds, may need to bow to investor pressure and modify certain terms of their proposed funds. “Regulators may focus on certain practices or contractual features of funds that might previously have been accepted as standard,” he notes.

In New York, Steven Nadel at Seward & Kissel says managers must balance investment liquidity against investor concerns for ease of liquidity. “On the investment side, if assets are hard to trade or value, the safest and fairest approach would be to side-pocket them,” he advises. “From the investor perspective, given what happened at the end of 2008, they prefer not to have the uncertainty associated with part of their money held in a side pocket with a term that cannot be defined clearly,” he says.

The basic issue, according to Mitch Nichter at legal firm Paul Hastings, is that a fund needs to be structured to accommodate both the liquidity needs of the chosen investment strategy and the liquidity requirements and expectations of fund investors. “All of these practices and others are simply liquidity/redemption regulation mechanisms that can be useful if clearly understood by investors and used fairly and consistently by managers,” he says. 

In the last year the Irish Financial Regulator gave guidance to the industry as to its thinking on measures being used to alleviate liquidity difficulties for Irish funds in current market conditions, explain Brian McDermott and Siobhán Moloney at A&L Goodbody.

The regulator took the practical approach that each fund affected by liquidity issues must consider the position in its own context, taking into account the fair treatment of incoming, existing and outgoing investors. To the extent that fund documentation needs to be amended, the flexible regulatory position permits this being done quickly without additional delays waiting for individual shareholder consent, note McDermott and Moloney. 

At the Cayman Islands office of Walkers, partner Ingrid Pierce believes it is “pivotal to find the appropriate mechanism with which to manage liquidity and to ensure that such methods are permitted by the constitutive documents of the fund.”

She gives the example that if the fund is proposing to impose a gate or to suspend redemptions, it is critical to manage the timing to avoid redemptions crystallising. “The fund must also ensure that it acts in the best interests of investors as a whole. The valuation of underlying assets held by the fund is also a hugely important issue, whether or not the assets are formally designated as side-pocket investments,” she says.

For Gray Smith at Appleby in Cayman these mechanisms are part of the tension between investors and managers. He thinks managers to varying degrees will use these tools. “The communication between managers and investors must improve,” he advises. “Investors also need to be more sophisticated and probably increase the use of advisors and lawyers when making investments.”

However, he cautions that some strategies will inevitably see a greater use of these and resulting lower liquidity. Investors must work out exactly what they are looking for before choosing.

Recent case law needs to be taken into account when considering any options that may impact on the ability of an investor to redeem its interests in a fund, says Nicholas Butcher in the Cayman practice of Maples and Calder. “One effect of the liquidity problems faced by many funds has been a significant refining of techniques to combat crisis. At the same time defensive strategies have been under the microscope as investors have a much greater awareness of how they can be affected,” says Butcher.

As investors become more alive to liquidity tools, he says there will be a need for more dialogue between investors and managers. “Investors want to know what is available in the fund’s arsenal of defences and in what circumstances the defences will be used,” notes Butcher.

Tight, accurate and consistent drafting of constitutional and offering documentation is essential, advises Butcher. This, he says, can help avoid “expectation mismatches in a crisis scenario”.

The use of side pockets has not yet been rigorously tested in the offshore courts, note Tania Dons and Richard Finlay at Conyers Dill & Pearman in Cayman. They expect to see the use of gates and the suspension of redemptions as well as others continue to be challenged by disgruntled investors in offshore jurisdictions. 

Some guidance on the suspension of redemptions and the status of investors following the redemption date has been given in recent decisions of courts in the Cayman Islands, the British Virgin Islands  (BVI) and Bermuda. These matters, note Dons and Finlay, are likely to continue to be the subject of other court cases in offshore jurisdictions and will be further debated and refined over the coming months.

Simon Schilder at Ogier in the BVI agrees. He expects stress-testing of many of the traditional liquidity control mechanics used by hedge funds over the last 18 months will demonstrate the importance of properly providing for some or all of these types of mechanics in fund documents.

“The lessons learnt from the experiences of the financial crisis have necessitated drafting changes to fund documents so as to enhance the workings of these mechanics in practice,” he says. He points to the fact that provisions in fund documents have been tested in court and the legal interpretations will mean change to fund documents in future. Hedge fund practices have also necessitated particular refinements to the drafting of some of the mechanisms in fund documents.

“An interesting question for hedge funds in the future will be how investor tolerance for some of the liquidity control mechanics which hedge funds are now seeking to employ will then play out going forward, particularly whether current themes and practices for liquidity control mechanics continue or evolve yet further as financial markets stabilise and investment performance returns,” says Schilder.