Hedge Fund Managers Using Special Purpose Vehicles to Minimize Adverse Effects of Redemptions on Long-Term Investors
Hedge Fund Law Report
When a hedge fund is invested in illiquid assets, redemptions from that fund can adversely affect various constituencies, including non-redeeming investors, redeeming investors, the manager and even those who have day-to-day dealings with the assets. Managers have various tools available to them for preventing or delaying redemptions, or mitigating the adverse outcomes that can flow from them. Such tools include fund-level gates, investor-level gates, hard and soft lock-ups, rolling redemption periods, holdbacks, redemption suspensions and side pockets. In addition, pension funds and other institutional investors are increasingly demanding access to hedge fund strategies via separate accounts, in an effort to minimize the mismatch between the time horizons of different investors in commingled vehicles. With growing frequency, however, managers are employing a different strategy to effectuate redemptions – at least, redemptions of a sort – while avoiding many of the adverse outcomes normally associated with redemptions. That strategy involves the use of special purpose vehicles (SPVs) – essentially, separate entities to which a fund can transfer illiquid assets, or economic exposure to illiquid assets, and which can issue interests that are transferred to redeeming investors in lieu of cash or the assets themselves. In effect, managers formerly had been limited to three options when faced with redemptions: give nothing (i.e., impose a suspension, gate or holdback); give cash; or give in kind. The use of SPVs introduces a fourth option: give interests in a new entity organized solely to house illiquid assets – if you will, a sort of “bad bank” for illiquid hedge fund assets. More than anything, SPVs offer managers a way to control the timing of the disposition of currently illiquid assets, and to avoid forced sales into distressed markets. We provide a comprehensive analysis of the use of SPVs in the redemption context, including a discussion of what SPVs are and how they work, what synthetic SPVs are and the contexts in which they can be used, a comparison with side pockets, recent examples, fee considerations and more.