Packaging illiquid assets
Michael Wode and Stewart Bent consider the practical implications of the side arrangements fund managers employ in dealing with illiquid assets
In their perennial quest for performance, alternative fund managers are increasingly turning to illiquid assets such as private equity, real estate and emerging market investments to supplement the more traditional asset classes. The mix alone is not controversial, however complications arise when a material amount of illiquid assets are mixed with liquid assets in an open-ended fund.
Firstly, illiquid assets are by their nature difficult to value and are often held at cost until liquidated. This means that the true value is not reflected in the fund's net asset value and subscription and redemption prices, causing inequity among transacting investors. Incoming investors will get a bargain and exiting investors will get a haircut.
The manager also suffers some detriment in so far as the management fee is calculated by reference to a lower NAV, and the performance fee is deferred until after liquidation. In fact the timing of the liquidation could also be exploited by the manager to manipulate performance.
Secondly, the mix could cause complications with respect to liquidity, as managers seek to avoid prematurely liquidating illiquid assets to fund redemptions, or inflicting a higher proportion of illiquid assets on remaining investors as liquid assets are used to fund redemptions.
And thirdly, the mix also presents complications with respect to the management of the portfolio, possibly requiring balancing around the illiquid assets, in order to comply with investment restrictions.
Not to be deterred by these complications, managers have sought to address investor equity and management flexibility by employing ‘side -pockets' within the fund, to ring-fence the illiquid assets from the liquid pool of assets.
A side-pocket is effectively a special locked-up class of shares or units within the fund, specifically created to hold the illiquid asset.
On creating a side-pocket, the fund is effectively divided into a liquid class containing the liquid portfolio and the side-pocket holding the illiquid assets, with investors obtaining shares in each class. The mechanism works like this: The side-pocket is created on the acquisition of the illiquid asset. The existing investors in the liquid class are compulsorily redeemed out of the liquid class (crystalising any performance fee) and subscribed into the illiquid class (side-pocket) on a proportionate basis.
The side-pocket is then closed until the illiquid asset is liquidated. While investors can redeem out of the liquid class under usual rules they cannot redeem out of the side-pocket. This means that there will invariably be a different mix of investors in the side-pocket and the liquid class over time. On liquidation of the asset, any performance fee is calculated for the side-pocket and paid to the manager. The side-pocket is closed by compulsory redemption of the investors by either cash payment or subscription for new shares in the liquid class.
Simple example: A fund has two investors:
Shareholder 1 has an investment of $800,000 (€543,000) (80,000 shares) and shareholder 2 has an investment of $200,000 (20,000 shares) The
NAV/share is $100. The total NAV is $1,000,000. The fund purchases an illiquid asset valued at $200,000.
The fund compulsorily redeems 2,000 shares (2,000 x 100) equal to $200,000 pro-rated between shareholder A and B.
Shareholder 1 has 1600 shares redeemed and shareholder 2 has 400 shares redeemed in accordance with their 8/2 split.
The fund then issues $200,000 worth of shares in the illiquid side-pocket (class B) on a pro-rated basis to shareholder 1 and 2.
At a subscription price of $100, shareholder 1 receives 1600 B shares and shareholder 2 receives 400 B shares.
Shareholder 1 retains its total investment of $800,000 and shareholder 2 retains its investment of $200,000.
By housing an illiquid asset in a side-pocket, the manager avoids the inequity and management burden that would otherwise occur by mixing liquid and illiquid assets.
The obvious danger is that a manager could use the side-pocket to exile poor performing assets so as to manipulate returns. From an operational perspective, there are a number of matters which should be considered.
Firstly, the constituent document should give the fund the power to compulsorily redeem investors out of the liquid class and compulsorily subscribe them into the side-pocket and administer the side-pocket as contemplated.
Secondly, as the side-pocket investment will be illiquid, thought should be given to how fees will be payable for the illiquid class. Either sufficient additional cash could be transferred to the side-pocket along with the illiquid asset to pay on-going fees for the expected duration of the side-pocket or fees could be deferred until the asset is disposed of. However because of the potential different investor base, fees for the side-pocket should not be payable from the liquid class.
Any performance fee payable on the liquidation of the asset should be determined on a standalone basis. That is, it is not appropriate to consolidate performance with the liquid class in determining the fee payable. Redemption from the side-pocket should be restricted until the asset is disposed of. Redemption can be effected by cash payment of by compulsory subscription for additional shares in the liquid class so that monies are retained in the fund. The above mechanics should be clearly disclosed in the offer document.
The alternative funds industry's predilection for all things fast, can be more fully identified in the employment of ‘side-cars'. There are various types of side-cars, including vehicles used for reinsurance, but for present purposes we are referring to co-investment vehicles used for over-allocation of private equity deals.
At its simplest, a side-car is a vehicle set up by a general partner alongside the principal fund as a source of additional capital for larger private equity deals. The invitation to participate in the side-car is often limited to the existing limited partners in order to avoid dilution of the ultimate investment. The limited partners of the principal fund are invited but not obliged to invest in the
A side-car benefits both the manager and the investors. The manager is able to easily access additional capital from the same source reducing fund-raising and know-your-client costs and time; source larger transactions; address funding shortfalls of the principal fund; and avoid the time, cost and uncertainty of a consortium or club deal involving lengthy negotiations and due diligence of each investor.
Investors also benefit through access to co-investment opportunities; reduced time and cost associated with investing in a mirror image investment structure; and reduced establishment costs of the side-car.
However the convenient packaging of co-investments into a side-car is not without its disadvantages vis-à-vis direct co-investment.
For example, an investor will continue to be a passive investor, and pay incentive fees for the privilege in contrast to direct investment where the investor has greater control and does not pay fees. The fee itself can be justified by the separate and exclusive management and fiduciary obligations attending the side-car. Additionally, investors in a side-car do not incur the significant cost and effort that is involved in a direct co-investment.
Again from an operational perspective there are a number of matters which should be considered in designing a side-car.
Firstly, fees are of primary importance to existing limited partners invited to participate in a side-car. While it is common for the general partner to
charge both management and incentive fees at the side-car level, a discount to the rates applicable at the principal fund level may be considered appropriate. For example, the management fee may be calculated by reference to paid-up capital rather than committed capital and the carry may be charged at a reduced rate.
While investors may wish to have fees charged on their combined holding, such an approach is administratively complicated and unlikely to be appropriate, given the current practice of charging carry on each co-investment rather the entire portfolio.
Allocation of deals as between the principal fund and the side-pocket also warrants the parties' special attention. While the practice is for the deal to be allocated first to the principal fund up to the fund's limit and then to the side-car, some flexibility is recommended so as to avoid any de minimal or uncommercial allocation.
For example, if the principal fund with committed capital of $200m has a limit on any deal equal to 20% and is contemplating a deal of $42m, the parties could retain some flexibility to allocation as between the principal fund and side-car rather than strictly observe the $40m vs $2m allocation to the principal fund and side-car respectively. The principles of allocation should be governed by priority for the principal fund and commercial soundness.
Other issues concern governance as the entities are legally distinct and should be managed so as to ensure their separateness, there is obviously a commonality which should not be ignored. For example, it makes sense for the side-car to take advantage of the advisory committee to the principal fund rather than establish its own. Secondly the side-car should have regard to the decisions taken at the principal fund level to ensure management cohesion and to avoid a divergent approach by vehicles which house common investors.
Moving to the third side dish, alternative fund managers have long employed side-letters in the management and organisation of investors. Side-letters are commonly used to provide an investor with terms more favourable than those described in the fund's offer document.
Such terms may include the waiver, reduction or rebate of fees, the provision of additional information or reports and more favourable liquidity rights (including additional redemption dates or reduced notice periods).
The use of side-letters has attracted increasing regulatory attention for the potential prejudicial treatment to investors who are not parties to the side-letter.
Accordingly care must be taken to ensure that the provision of any side-letter does not contravene the fund's constituent document, rendering it unenforceable or in breach of the fund's duty to act fairly as between investors.
Not all side-letters are problematic, though. For example, the waiver or reduction of management fees is permissible because it is the manager's prerogative to deal with its fee as it sees fit. Further, certain preferences are permitted if created within a separate class of shares or units and available to all members of that class.
In many cases, it is a fine line and care should be taken to ensure that any side-letter is enforceable.
By way of guidance, the Alternative Investment Management Association (AIMA) recently issued its industry guidance on side-letters that confer preferential rights on an investor with respect to (i) the right to redeem or (ii) information which would give the investor some preference in determining whether to redeem.
This would include an agreement to accept a shorter notice period for redemptions, ‘key man' provisions, redemption ‘gate' waivers and portfolio transparency rights.
AIMA guidance requires disclosure to investors of both the existence of side-letters which contain material terms and the nature of such terms, although the identity of the parties may be kept confidential.
The authors suggest the following practical approach to the use of side-letters:
1. New business
For any new fund, the fund should first consider whether side-letters will be used and if so, discuss their intentions with their fund lawyers. The discussion will invariably consider disclosure in the fund's offer document along the following lines:
"As a general principle, the directors will run the fund with the same terms for all investors of the same class. However, the directors may in certain circumstances reserve the right, to enter into side-letter arrangements with certain investors that provide for terms of investment that are more favourable to the terms described in this offer document."
Inclusion of such a provision per se may not address issues as to unenforceability, but at least it highlights to investors the potential difference in treatment that may be offered.
2. Service provider as a party to the side-letter
A service provider other than a trustee, should not need to counter-sign any side-letter which reflects a private arrangement between the fund and the investor. Where however the terms of a side-letter are disclosed to the service provider, the provider will ordinarily raise any legitimate concerns it has as to consistency with the terms of the constituent document or unfairness as between investors, to ensure enforceability. Understandably, a professional service provider will be reluctant to participant in any unacceptable conduct.
For trusts, it is usual that the trustee will be asked to sign a side-letter and acknowledge its terms. Usually the trustee would do so only after considering the terms against the trust deed and its fiduciary duties, and on the condition that the manager jointly signs. It may be necessary to obtain independent legal advice.
3. On-going disclosure of material terms
In keeping with the AIMA guidance, the authors recommend disclosure to investors of side-letters containing material terms (affording preferred exit opportunities) and on-going disclosure. Disclosure may be made by way of notice, addendum, or included in the fund's monthly, quarterly or half-yearly investor reports/newsletters. It is not expected that the number of side-letters, the dates on which they were entered into or the parties to them be disclosed.
Finally, for administrative ease it is recommended that the manager maintains a register of all side-letters signed by or on behalf of the fund including information as to name of the parties and the terms so as to best manage obligations and avoid conflicts.
To finish, sometimes things go a little sideways for managers. Take the recent activities of two hedge fund managers literally engaged in turf warfare in the Hamptons.
Quite ironically, the clash relates to a row of hedges running down the side of a property owned by a hedge fund star manager, which was flattened by a senior executive at, to widen a path to the beach. This is not your average neighbour dispute and is more akin to the dispute over the East China Sea.
From an operational perspective, the authors recommend watching from the side, well clear of these titans at war and their earth moving equipment.
Stewart Bent is head of business development, Asia ex-Japan, for Fortis Prime Fund Solutions (Asia). Michael Wode is business development manager, Australasia, for Fortis Prime Solutions (Asia)