Granting Enhanced Liquidity and/or Transparency to Investors
James Tinworth, Managing Associate
Simmons & Simmons LLP
As the hedge fund industry has become more institutionalised, requests for enhanced liquidity and/or transparency have become increasingly common and increasingly demanding. This article reviews the options available to an FSA-authorised hedge fund manager (assuming that it manages funds structured as Cayman companies) and the main issues surrounding each option.
New Share Class
A new share class with enhanced rights could be established: having different share classes in a fund, each with different terms, is permitted by Cayman law.
A new share class will need to be created in accordance with the articles of association and Cayman law and may require the consent of the existing shareholders.
The directors will need to consider their duties (primarily a duty to act bona fide in what they consider is in the best interests of the company) and, for example, whether their duties require them to disclose and/or offer the new shares to all investors. The directors should also consider whether adequate disclosure (of the fact that new classes with different rights could be created) has been given to shareholders in the prospectus.
Where the fund's prospectus and/or its memorandum and articles of association provides flexibility to grant the relevant enhanced rights in a side letter, however, it is more common for a side letter to be entered into than it is for a new share class to be established.
The advantages of using a side letter include: (i) it should not require the consent of the existing shareholders; (ii) it avoids the potentially greater costs involved in establishing a new share class, which may include amending a number of documents (including the prospectus, the articles of association, investment management agreement etc) when compared with the costs involved in negotiating a side letter; (iii) it avoids the increased administrative/operational burden of having a new share class and; (iv) a new share class is more permanent, in that once a side letter is terminated any enhanced rights granted are switched off.
A fund enters into an "investment contract" with each of its investors. In the case of a fund structured as a Cayman company, the investment contract between the fund and its investors (shareholders) comprises the fund's prospectus, its memorandum and articles of association and its subscription agreement/application form. A side letter seeks to amend the terms of the investment contract between the fund and the relevant investor.
AIMA's Offshore Alternative Fund Directors' Guide contains a detailed consideration of the role of the board of a Cayman corporate fund in relation to side letters. In summary, the directors must confirm that the fund's prospectus and/or its memorandum and articles of association provides flexibility to grant the relevant enhanced rights in a side letter and they must consider their duties.
The position of an FSA-authorised fund manager is made clear by the AIMA guidance on side letters, which provides:
"[FSA-authorised fund managers] will be required to disclose the existence of side letters which contain 'material terms', and the nature of such terms, where the [FSA-authorised fund manager] is a party to the side letters or is aware that a fund of which the [FSA-authorised fund manager] or an affiliated entity is the investment manager is a party to them."
More favourable liquidity and/or transparency rights would be "material terms" and therefore, either appropriate disclosure should be made to existing and prospective investors (who may, or may not, ask for the same enhanced liquidity and/or transparency) or it should be agreed that the same rights will apply to all shareholders.
In order to secure large-scale investments from institutional investors, a fund manager may agree to establish a separate managed account with its own pool of assets alongside the reference fund, and the managed account client may request enhanced liquidity and/or transparency than that granted to investors in the reference fund.
In this situation, given that the managed account is separate from the reference fund, the duties of the fund directors will not be relevant.
The AIMA guidance on side letters will also not strictly be relevant. What remains is that the fund manager will be required to comply with the applicable FSA rules and primarily, those rules regarding the management of conflicts of interest.
An FSA-authorised firm must manage conflicts of interest fairly, both between itself and its "customers", and between a "customer" and another "client". In this situation, the "customers"/"clients" of the fund manager will be the reference fund and the managed account client.
The FSA rules regarding the management of conflicts of interest provide that a general disclosure of potential conflicts is not sufficient and require fund managers to identify the potential conflicts of interest to which their businesses are exposed and to design and implement appropriate measures (in the form of a conflict of interests policy) to prevent those conflicts from arising (where practicable) and to manage those conflicts that do arise.
At the point when a fund manager grants enhanced liquidity/transparency to a managed account client, therefore, the fund manager is not obliged to make any specific disclosure to the reference fund's directors if the fund manager had adequately disclosed the general nature and/or sources of conflicts of interest before undertaking business for the reference fund (eg, in the investment management agreement with, or the prospectus of, the reference fund). Further, the fund manager will not be required to agree that the enhanced rights will apply to all shareholders in the reference fund. Instead, the fund manager should manage its conflicts of interest in accordance with the relevant FSA rules. It may even be the case that the relevant conflicts will only need to be actively managed (a) at the point that a managed account client with enhanced liquidity/transparency decides to redeem its investment, given the prevailing circumstances and market conditions at the time, and (b) at the point when any enhanced information is provided.
Additional Feeder Funds
Having managed accounts with separate pools of assets causes a number of issues for both investor and fund manager, the key issue being that managed accounts with separate pools of assets removes the fundamental advantage of collective investment: pooling.
In a classic master-feeder fund structure, the obvious way to combine the flexibility that the managed account offers for granting enhanced rights to investors while retaining pooling could be for a new feeder fund to be established where necessary instead of a separate managed account.
This could also have an additional advantage in that the terms and the operation of most managed accounts will be controlled by the relevant investor, whereas the fund manager should have more control over the terms and operation of an additional feeder fund.
The most relevant consideration in this situation will be of the duties of directors of the master fund vehicle. In this respect, the issues described above under "New Share Class" and "Side Letters" may be relevant, although it should be noted that such issues should be more straightforward to deal with than at feeder fund level.
The directors of the master fund may also be directors of one or more of its feeder funds. While this should not strictly be relevant when considering the duties owed to the master fund, the directors should consider whether adequate disclosure has been given to shareholders in each feeder fund's prospectus that further feeder funds may be created, which invest in the master fund (and which may have enhanced liquidity/transparency rights).
In relation to enhanced liquidity, it is difficult to see how the fund manager could be subject to conflicts of interest, given that the master fund will be the fund manager's only "client" on whose behalf the fund manager will be buying/selling investments.
In relation to enhanced transparency, however, the discussion under "Managed Accounts" above regarding how the fund manager should manage any conflicts of interest between a "customer" and another "client" will also apply here.
Whether the use of additional feeder funds to grant enhanced liquidity/transparency to investors may become more common is uncertain. What is certain, however, is that investors will continue to ask for enhanced liquidity/transparency rights and that the granting of such rights is a complicated area.
In whatever manner enhanced liquidity/transparency may ultimately be granted, the fund manager and each of the relevant fund vehicles will need to carefully consider their position throughout, and when negotiating enhanced liquidity rights, investors, fund directors and fund managers should constantly keep in mind the purpose behind (and mutual advantages of) redemption notice periods, gates, suspensions etc and what can be, what should not be and what is not negotiable.
This article first appeared in AIMA Journal (Q42010, Page 24). For more details, please visit www.aima.org