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What should fund managers consider in the face of large redemptions?

Apr 06, 2020

As a result of market volatility and economic concerns due to COVID-19, fund managers may face a significant uptick in redemptions.

Prior to this occurrence, if possible, an initial step should be to consult the fund’s offering documents. Fund offering documents may allow for redemption limits, such as fund level gates, investor level gates, suspensions of redemptions or defensive notice provisions.

In addition to fund offering documents, the firm’s policies and procedures should also be consulted for relevant redemption guidance.

Gates are one mechanism to slow redemptions and limit the negative impact on a fund’s value without expressly prohibiting or suspending redemptions. A gate limits the ability of investors to redeem from a fund either at the fund level or the investor level and can be either discretionary or mandatory.

For example, a fund level gate could limit total fund redemptions to 25% per quarter, at the discretion of the fund manager. In this regard, redemption requests from all investors would be aggregated and compared to the fund’s threshold specified in its offering documents. Alternatively, an investor level gate is evaluated at the investor level without regard to redemption requests from other investors, such as a 25% per quarter redemption limit per investor. Investor level gates might not be called gates at all. Since they are at the investor level, they can be part of a carefully crafted redemption process outlined in the fund’s offering documents, such as the staggering of investor withdrawals.

Ideally, gates should be designed to be equable, not incentivize redemptions, and maintain fund value.

Equitable gates promote fairness to both redeeming and remaining investors. One consideration is how redemption request dates factor into the redemption process. If priority is given to early redemption requests, it may motivate additional investors to redeem faster than they otherwise would have. In addition, the liquidity of the portfolio should be reflected in the timing and size of gates to limit the harm from fire sales, while also providing reasonable liquidity to investors.

If gating is not an option, fund offering documents should be reviewed to see whether they allow for, or require, a suspension of redemptions if certain criteria are met. For example, suspensions could be required as a result of a significant amount of redemption requests or the suspension of a net asset value determination. Otherwise, a thoughtful notice period provision might allow for a more systematic approach in creating liquidity to meet redemption needs.

Regardless of the redemption methodology selected, proper disclosure is critical.

According to Nicole Kalajian, counsel at Stradley Ronon Steven & Young, LLP, “as per the warnings of the SEC order against Aria Partners in 2018, fund managers must be careful not to allow redemption preferences without proper disclosure.”

Kalajian further explained, “in Aria Partners, when two fund investors sought full redemptions at approximately the same time, one investor was redeemed on 60 days’ written notice and another investor was redeemed on 90 days written notice. After the redemptions were requested, the fund declined in value, which had the unintended effect of the investor who was redeemed on 90 days’ notice receiving significantly less than it would have received on 60 days’ notice.” In connection with such variances in redemption practices, as well as other alleged violations, Aria Partners agreed to a $150,000 civil monetary penalty.”

If faced with an influx of redemption requests, it is also important to consult with relevant service providers, such as fund’s administrator, as well as the LP advisory committee or fund board (if applicable). A plan should also be put in place for proper communications with investors, and compliance staff should be involved in such discussions.

The SEC will likely review the handling of investor redemptions during this period of market stress. As a result, it’s fund managers should consider consulting  with outside counsel in connection with the proper handling of such redemptions.

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Shana Sparber, CPA
Senior Manager
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