How Can Hedge Fund Managers Prevent or Mitigate Revocations of Redemption Requests?
Hedge Fund Law Report
In the scramble for liquidity starting in summer 2007 and persisting, in varying degrees, through today, the perception and use of redemption requests has evolved. Traditionally, hedge fund managers and investors understood redemption requests as irrevocable; and the constituent documents of most hedge funds reflect that understanding, requiring the manager to process any redemption request properly received from an investor. However, fund documents also generally grant the manager – in its discretion and consistent with its fiduciary duty to the fund and all of its investors – discretion to grant a request by an investor to revoke its redemption request. During the credit crisis, some investors have been taking advantage of such provisions in fund documents by submitting “preemptive” redemption requests. That is, they have been submitting requests for full or partial redemptions for each redemption period, then withdrawing those redemption requests before the redemption is effectuated. The specific purpose of such preemptive redemption requests is to avoid getting caught in a gate, or to submit redemption requests before the manager suspends redemptions. The general goal of such requests is to maximize a claim on liquidity in a time of illiquidity and market dislocation. However, while the ability to submit such requests is good for the investor that reserves the right to redeem, it is bad for the manager and other investors. In effect, the ability to submit preemptive redemption requests gives the requester an option on redemption. But like any option, this one has a cost. In this case, the cost is borne not by requester, but by the other fund investors. And that cost has at least three components: (1) reduced liquidity for other investors (who may be caught by a gate if total redemption requests in any period exceed a certain threshold of net asset value, usually around 15 percent); (2) costs in connection with preparing to meet the redemption, such as administrative and valuation fees, brokerage commissions, etc.; and (3) opportunity costs, which consist of the manager selling at inopportune times to raise the cash required to pay redemptions, or missing good investment opportunities while sitting on that cash. In economic parlance, investors submitting preemptive redemption requests are internalizing the liquidity benefits of such requests while externalizing the various costs of such requests to other fund investors. Since fund managers have a legal fiduciary duty to act in the best interests of the fund and all of its investors, and a practical duty to avoid, to the extent possible, operational structures that inhibit their ability to manage their funds, managers have been looking for credible ways to prevent or mitigate revocations of redemption requests. We detail four specific strategies that managers are using to discourage revocation of redemption requests, and another approach to redemptions that may render all of those techniques unnecessary.