Secondary Market Develops in Special Purpose Vehicle Interests as Use of SPVs to Effect Redemptions Becomes More Common

All redemptions from hedge funds holding liquid assets are alike; each redemption from a hedge fund holding illiquid assets is complex in its own way.  At bottom, that complexity arises out of a basic tension: monthly, quarterly or even annual liquidity is, in many cases, irreconcilable with the holding period required to realize value in currently illiquid assets.  Rather than selling illiquid assets at fire sale prices to satisfy redemptions, managers of funds that offer reasonably frequent liquidity have been using various tools to prevent or delay such sales – tools such as gates, lock-ups, suspensions and side pockets.  However, with increasing frequency, managers have also been employing special purpose vehicles (SPVs) in an effort to reconcile investor demands for liquidity with the illiquidity of portfolio assets.  In effect, SPVs offer redeeming investors what might be called a “qualified liquidity”: SPV interests are more liquid than a gate, suspension or hold back, but less liquid than cash.  However, many investors that have submitted redemption requests of late need more than qualified liquidity – they need actual liquidity.  Because of the ubiquity of the credit crisis, many investors are willing to accept – in fact, are demanding – cash today rather than a contingent payment tomorrow, even while recognizing that the cash they receive may be a small fraction of the ultimate realization value of the assets in an SPV.  But managers do not have the cash to give investors – that’s why they put the assets in the SPV in the first place.  What can investors do?  One answer is that they can access a developing secondary market in SPV interests.  We define SPVs and synthetic SPVs, then detail the mechanics of the secondary market in SPV interests, relevant legal considerations (including issues relating to restricted securities, ERISA, AML, KYC and the Bank Holding Company Act), treatment of confidential information, valuation issues, what types of funds would be interested in participating in secondary SPV transactions, the benefits to managers and the potential for use of Dutch auctions.

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