How and When Should Hedge Fund Managers Value Securities Used to Satisfy Redemption Requests In Kind?

Hedge fund governing documents frequently permit hedge fund managers to satisfy redemption requests in cash or in kind.  To pay redemptions in cash, managers typically use cash in the fund or – in the absence of sufficient cash on hand – sell securities to generate cash.  To pay redemptions in kind, managers typically deliver to investors portfolio securities or interests in a special purpose vehicle established to hold and gradually liquidate portfolio assets.  Managers typically use the in-kind distribution mechanism in declining or liquidity-constrained markets because sales of assets into such markets would occur at a discount, thus generating less cash than sales of the same assets over longer time horizons.  While redeeming investors are rarely enthusiastic about receiving assets rather than cash, an important argument in favor of in-kind redemptions is that they can preserve value for non-redeeming investors and thereby enable a manager to satisfy its fiduciary obligation to the fund.  Not surprisingly, redemptions in kind were a recurring theme during the credit crisis.  See “Steel Partners’ Restructuring and Redemption Plan: Precedent or Anomaly?,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  Some of the harder questions raised by redemptions in kind relate to valuation.  For example, if a manager agrees as of December 31 of a given year (the “as of date”) to distribute a certain number and type of securities to a redeeming investor, but only distributes those securities months or years later (e.g., because of a suspension of redemptions), who bears the risk of a decline in value of the securities between the as of date and the actual distribution date – the fund or the investor?  In other words, would the manager in this scenario be required to distribute more securities to the investor so that the investor receives in securities the dollar value of its fund interest on the as of date?  Or would the investor be required to internalize the decline in value of a fixed number of securities?  The answers to these questions depend on the governing documents of the fund, other relevant documents (e.g., side letters) and external law.  A recent decision from New York’s intermediate appellate court illuminates these questions and offers guidance to hedge fund managers in drafting in-kind distribution rights in fund documents and side letters.  See also “Schulte Partner Stephanie Breslow Discusses Hedge Fund Liquidity Management Tools in Practising Law Institute Seminar,” Hedge Fund Law Report, Vol. 5, No. 43 (Nov. 15, 2012).

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