Typically an investor has to give prior notice of their intention to redeem their investment. The period of notice may vary depending on the nature of the fund and the assets that it has invested in. The redemption process is one of the major challenges currently facing the fund industry.
Much has been written about the recent turmoil in the global financial markets, the freeze in the credit markets, lack of liquidity and the corresponding impact on investment funds.
The origins of the current crisis can be found in the earlier collapse of the US sub-prime mortgage industry and the subsequent collapse in the securitization market that was based in part on the value of sub-prime mortgages as underlying assets.
Investment funds are in a wide range of assets. In some cases the investment is direct and the fund buys assets in its own name. In other cases it may invest in other funds as a way if diversifying its risk and hence the reference to “fund of funds” structures.
The basic fund structure is fairly simple. Investors invest into the fund by buying redeemable shares or interests. The fund invests the money in pre-determined types or classes of assets. Investors may or may not have voting control of the fund. The value of the fund will be determined by the value of the assets that it has bought less the value of any liabilities that it has. This is referred to as the fund’s net asset value or NAV.
The value of investors’ shares or interest in the fund is calculated on a regular basis by reference to the fund’s NAV. Some assets that are bought by a fund such as shares in publicly traded companies are easy to value and sell. Others such as interests in securitised assets may be less easy to value and sell and in some cases assets may be highly illiquid and be both hard to value and difficult to sell. A good example if this is the area of private equity or investments in private companies. In many cases, in order for funds to generate high returns for investors, they borrow against the underlying assets that they hold and re-invest the additional funds. This borrowing or leverage may be a number of multiples of the value of the fund’s assets.
One of the key issues for investors is their ability to obtain repayment of their investment. This is a process generally carried out by the fund buying back or redeeming the investors’ shares or interests at a particular NAV per share. Typically an investor has to give prior notice of their intention to redeem their investment. The period of notice may vary depending on the nature of the fund and the assets that it has invested in. The redemption process is one of the major challenges currently facing the fund industry.
In order for an investor to be redeemed, the fund has to be able to raise cash to pay them. This may be easy if the fund has cash available or can easily sell assets to fund the redemption. However when the financial markets are in chaos, this is far more difficult.
When the problem with US sub-prime mortgages arose, investment funds with direct or indirect exposure to the securitisation market suffered losses. These falls in value along with a general loss of confidence in the markets were triggers for investors to start to try and redeem their interests in funds. There were also other factors that influenced whether investors would continue to invest in funds and the financial markets generally or would prefer to hold cash or cash equivalents which were less at risk. This immediately placed further stress on the liquidity of funds and their ability to fund redemptions.
As market conditions became worse, and the value of the underlying assets used as security fell, funds with leverage or borrowings secured against those falling assets started to receive margin calls from their lenders seeking to bolster their security. This in turn exacerbated the liquidity crisis that funds were facing.
Generally, directors of funds have a number of mechanisms by which they can deal with liquidity problems and protect a fund from an inability to meet redemptions or to pay the proceeds of redemptions. If assets become hard to value or difficult to sell, directors can separate them in an accounting sense from the other assets of the fund and create a legal structure called a side pocket, which will segregate these assets from the other assets of the fund. Investors may be issued with a separate class of shares to represent their interest in this segregated asset and the calculation of the NAV for that asset may be suspended. Investors can only realize value from this asset when it becomes possible to value or sell it. This allows the directors to keep the main part of the fund open to redemptions and subscriptions, while allowing them to effectively freeze a portion of each investors holding until market conditions improve. However, if the valuation or marketability problem is more widespread within the fund, then the calculation of the NAV for the whole fund may have to be suspended for a period.
When such problems arise the directors will also have to consider whether they can continue to allow investors to request the redemptions of their investment. If the fund is not going to be able to fund redemptions as they fall due or if paying redemptions would drain a fund of its liquid assets leaving non-redeeming shareholders with an interest only in illiquid assets, directors may decide to suspend redemptions and in some cases may also suspend the payment of the proceeds of redemptions that have already been processed.
It is easy to see how in the current market with the extreme volatility and general decline in asset values, funds have had to take whatever steps that they can to protect themselves.
But what does that really mean and imply? If it is the case that investors generally wish to redeem the investments regardless of the losses that they may suffer, then the fund really has no choice but to abide by the wishes of its stakeholders and wind up its affairs in the best way that it can. If funds are in a situation where redemptions and payment of proceeds of redemptions are suspended until market conditions improve, investors are locked into an investment, which they cannot realise. If the investor is itself a fund with its own investors then the illiquidity of an investment will have a direct impact on its own liquidity and its ability to fund its own redemptions.
Funds are set up and run by investment managers who are looking to attract investors to both provide them with a return on their investment but also to earn performance fees for the investment manager based on the profitability of the fund. Some funds have remained profitable over the last 12-18 months. However for the funds that are in distress, profits are not being earned and investment managers may be receiving no fees at all or fees that are greatly reduced. This may act as an incentive for an investment manger to approach his or her investors with a proposal to close down the fund.
A further problem is that as a result of the structure of funds, investors can have limited rights to challenge decisions of directors in relation to matters such as suspension of redemptions and payment of redemption proceeds. In some cases it can also be difficult for investors to have the right to ask a court to wind up a fund.
The practical effect of all of these issues is that there are a number of funds established in the Cayman Islands and in other financial centres around the world that have either battened down the hatches in an effort to weather the storm in the financial markets, have taken a decision to wind up their affairs in a orderly way or have succumbed to pressure from creditors and investors and been placed into formal bankruptcy or liquidation.
There is also a fall in the number of new funds being set up, which is hardly surprising given the nervousness on the part of investors to get back into the market. However, with interest rates so low and the corresponding returns on cash or cash equivalents being poor, when some stability does return to the markets it is easy to foresee the pace of the establishment of new funds picking up to take advantage of opportunities in the market. This is by no means the end of the offshore funds industry.