Given the tremendous market volatility in recent weeks, fund managers may be confronted with withdrawal and distribution requests. It is during times like these when fund assets are held in undervalued or illiquid securities that managers may want to look for options beyond distributing cash.
According to Kevin Cott of Cott Law Group, “Most fund offering documents are drafted by legal counsel to provide fund managers with broad discretion to determine both when to make an in-kind distribution to an investor and the composition of those distributions.”
If a fund is closing during a time of market volatility and the fund manager makes a final distribution of funds to investors in cash, they could be forced to sell investments at a less-than-opportune time in order to liquidate holdings. Alternatively, the manager may elect to distribute the holdings in-kind, allowing for investors to realize future gains on the undervalued holdings.
It also may be advantageous to distribute in-kind investments if the fund holds illiquid investments. Some securities have lock-up provisions that make liquidating impossible or that would incur a steep penalty if sold. These securities can be distributed out pro rata to investors without diluting the value. If management fees or performance allocations are earned prior to distribution, distributing illiquid investments at their fair market value can also have advantages to the fund manager, but management should be careful to include any necessary discounts when valuing.
The advantages of using in-kind investments not only are for a fund closing but also may be seen when satisfying routine withdrawal requests and distributions. There may be times when the fund has insufficient cash to satisfy a withdrawal request. If only liquid investments are sold to generate cash to meet withdrawals, it could leave remaining investors with an imbalanced portfolio and higher liquidity risks going forward.
Alternatively, if illiquid investments are sold to pay out a withdrawal request, it may be at unfavorable prices. In these instances, a fund manager may determine the best course of action for both withdrawing and remaining investors is to distribute shares of certain investments pro-rata to withdrawing investors.
Kevin Cott added, “Although fund managers may view the discretion and decisions described above as necessary to taking certain positions and avoiding excessive cash reserves, sophisticated investors may push back and negotiate specific protections — limiting in-kind distributions to marketable securities, implementing most favored nations clauses, etc.”
Before a decision is made to do anything other then a cash distribution for withdrawals, it is important for fund managers to review their operating documents with legal counsel to ensure compliance. The fund’s tax advisor should also be consulted to review potential tax implications to both the fund and investors when making this election.