Mandatory redemption provisions are provisions in hedge fund documents that generally permit a manager to eject an investor from the fund, in whole or in part, in the manager’s sole discretion, and against the investor’s will. At first blush, such provisions would appear to have utility only in the best of times, when the demand for hedge fund capacity exceeds the supply. But as discussed more fully below, a hedge fund manager has a continuous obligation, regardless of the marketing or investment climate, to control the composition of its investor base. This is because the types of investors in the hedge fund – regardless of investment strategy or outcome – can have a material effect on the fund and the manager. On the fund side, the types of investors in the fund can affect the fund’s regulatory status (in particular under the Employee Retirement Income Security Act of 1974 (ERISA) and the Investment Company Act) and costs. And on the manager side, the types of investors in the fund can affect the manager’s time, reputation and flexibility in portfolio management. A mandatory redemption provision provides a contractual basis for acting on the conclusion that the burdens to the fund or manager (regulatory, cost, reputational, etc.) of keeping an investor outweigh the benefits (fees, relationships, etc.) of keeping that investor. In effect, mandatory redemption provisions are to a hedge fund investor base as a standard investment management agreement is to a hedge fund investment portfolio: both give a hedge fund manager considerable discretion to act in the best interests of the fund, even where those interests diverge from the interests of one investor. We recognize that capital raising remains a paramount challenge and an urgent imperative for hedge fund managers – especially for startup managers, but even for established ones. See “Why Does Capital Raising for Distressed Debt Hedge Funds Remain Particularly Challenging Despite the Recent and Anticipated Positive Performance of the Strategy?
,” Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009); “How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?
,” Hedge Fund Law Report, Vol. 2, No. 50 (Oct. 1, 2009); “How Should Hedge Fund Managers Adjust Their Marketing to Pension Funds in Light of Potential Downward Revisions to Pension Funds’ Projected Rates of Return?
,” Hedge Fund Law Report, Vol. 3, No. 11 (Mar. 18, 2010). Nonetheless, just as you cannot buy insurance after a storm hits, so a hedge fund manager would have difficulty interpolating a mandatory redemption provision into fund documents once the rationale for such a redemption crystallizes. Instead, the time to consider and draft provisions in hedge fund documents is before they become necessary. Put another way, hedge fund documents – and they are not alone among legal documents in this regard – generally should be drafted to accommodate worst-case scenarios and low-probability events. The advisability of this approach was borne out during the credit crisis, when gate and liquidating trust provisions – quiescent in fund documents for years before the crisis – were suddenly put into practice. See “Steel Partners’ Restructuring and Redemption Plan: Precedent or Anomaly?
,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009). Thus the timing of this discussion. To assist hedge fund managers in appreciating the range of circumstances in which mandatory redemption provisions may be useful, this article first catalogues eleven distinct rationales for using such provisions. Notably, all of these rationales can apply in good times or bad. That is, the breadth of these rationales indicates that mandatory redemption provisions are not just tools to be used when investors are beating down the door. The article then describes a practice that we call “reverse due diligence.” While the use of this phrase in the hedge fund context may be novel, this practice it describes is not, and it should be an ongoing activity at hedge fund managers. The article then discusses the mechanics of mandatory redemption provisions in hedge fund governing documents, including the drafting of such provisions, triggering events, notice requirements and fee considerations, including suggesting (for the benefit of institutional investors) the novel (as far as we have been able to determine) possibility of a “reverse redemption fee.” Finally, the article examines the interaction of mandatory redemption provisions and side pockets, and discusses alternatives to mandatory redemptions that may effectuate similar goals.