Author: Jaitly LLP

Those of you who know me will recognise an old hobby horse.  The importance of a fund’s constitutional documents.

There have been a few interesting cases reported from the Cayman and BVI courts that are worth bearing in mind – if for no other reason than to emphasise why any due diligence on a fund cannot be done properly without a thorough reading of the constitutional documents and in particular the articles of association.  

I have often been chided for my interest in these documents.  Investment teams are quick to point out that these documents are no more than standard templates churned out by lawyers.  But they are relevant because they form the basis of the contract between shareholders and the fund.  Their significance increases when a member needs to exercise rights to get back investments in the face of suspensions and other impediments that a fund board may put up when an investor is trying to recover their investment.  

This importance has been emphasised by the ruling of the Privy Council in a Cayman case that was heard before it on appeal – Culross Global SPC Limited v Strategic Turnaround Master Partnership Limited.  The ruling given in December 2010 is relevant because a subsequent ruling in March 2011 in the BVI is not consistent with the Cayman ruling and therefore underlines the importance of understanding what the articles of association say about a redeeming investor’s status in order to determine what rights may exist to recover money.

These cases have revolved around determining the status of a redeeming shareholder.  The distinction between whether you are a member or a creditor of a fund determines what rights you may have to enforce the recovery of money owed to you.

Where a shareholder is trying to get out of a fund that is making losses – the member will have a clear interest in trying to minimise its losses by crystallising the amount owed to it and then enforcing its rights as a creditor of the fund in order to be paid a distribution in priority to other members.   A creditor typically would be able to enforce its rights by applying to the court for a winding up order against the fund if money owing to the creditor is not paid when the amounts fall due.  

In addition, the Privy Council judgement analyses in great detail how the articles of association have been constructed and then looks at a common mechanism used by offshore lawyers to incorporate the prospectus into the articles – which the judges rejected on the facts of this particular case because of the caveats and disclaimers used by the lawyers in the prospectus.  

Establishing the status of a redeeming member was also clarified in a case in the BVI but takes a position contrary to the Privy Council decision in the Cayman case.  In Westford Special Situations Fund Ltd v Barfield Nominees Limited & Ors  the Court of Appeal took a different view from the court of first instance (which had taken an approach similar to the Cayman Privy Council decision) and determined that BVI insolvency law does not recognise a redeeming member as being a creditor with locus for the purposes of applying for the winding up the company even though they may be a creditor of the fund in a wider sense.  

This of course can create a difficulty for a redeeming member if they are no longer a member of the company because the articles are often constructed so that upon redemption a member ceases to have any rights as a member but by virtue of this ruling is also not a creditor of the company able to enforce its rights by seeking a winding up of the fund.  

Because of the differences in approach in these offshore jurisdictions, investors would do well to ensure that they seek clarification of the position or seek to have the articles amended to ensure that their position and rights of enforcement are expressly articulated as part of the due diligence that they complete.

Amending articles is an expensive business which investment managers will be reluctant to do but it may be even more expensive if the position is unclear and investors have to place themselves at the mercy of the offshore court lottery in order to recover investments.

©Jaitly LLP

When considering the protection of assets a classic response is the requirement to segregate assets.  What does this mean in practice?  Everyone understands, for example, when buying a house in the UK, that the money that flows through the purchaser and vendor’s solicitors should be segregated as client money – but not many understand what this really means and how sometimes the risk is not in fact mitigated at all.  Client money status, express and constructive trusts and segregation can all be complicated areas but the dangers can still be illustrated quite simply.

The same opaqueness to the implications of practical and legal segregation and their associated risks applies to assets held in fund structures too.  The usual structure for fund investments is that the fund is a separate entity from that of the manager managing it, and that this separation or segregation helps avoid what is known as co-mingling risk.  The irony of course is that sometimes  this separation protects the manager far more than it protects the fund and its investors because the manager can introduce a whole range of risks into the fund without placing itself in any jeopardy (other than reputationally) – whether it is to introduce leverage, cross class liability (another form of co-mingling) or jurisdictional risk.  

Lets start with leverage and cross class liability – take a fund with two different classes – one with no leverage and another with 2x leverage.  If there is cross class liability – not untypical – then on a risk reward basis which is the class to invest in?  I would argue the levered class.  Why is this so?  Lets take an extreme example to illustrate the point.  If each class has one shareholder with $100, fully invested – then the NAV of both classes is $100 but the levered class is carrying a liability of $100 against its assets of $200.  Lets say the value of the assets falls by 75%.  The NAVs are now $25 for the unlevered class and negative $50 for the levered class because the liability for the $100 borrowed remains unchanged.  Now lets assume the prime broker or other provider of finance declares a default on the fund because the fall in value of the assets of that magnitude has been defined as an automatic default event in its contract and it exercises its rights on the assets held as collateral.  The $50 of assets in the levered class is taken by the prime broker but there is still a $50 dollar shortfall – if there is cross class liability then the $25 in the unlevered class can also be taken by the financier in satisfaction of the debt – either because the prime brokerage agreement allows for it or because the fund then goes into liquidation and the prime broker as the only creditor gets its hands on the remaining $25 as the sole asset of the liquidated fund thereby suffering an overall shortfall of $25 on its original lending.  In such a scenario the shareholder in the unlevered class class is unprotected from the liabilities of the levered class, so they may as well benefit from the potential rewards of investing in the levered class if an investment in the fund can really be justified rather than having the illusion of safety from the fig leaf that is the unlevered class.

Of course the response to concerns such as this was to set up segregated liability structures such as Segregated Portfolio Companies in the Cayman and in Ireland.  So that then must be the answer to the problem?

If only life were that simple.  One of the standard risks that lawyers put in the prospectus of such a segregated portfolio company is that the segregation may not be recognised in a jurisdiction in which the assets are held.   Is it a real risk?

The trouble is that the legal segregation is in the country of incorporation – but the assets are invariably not held in those offshore jurisdictions.  The assets are held by financing parties in financial centres such as London, New York and Frankfurt. There has been a lot of work and analysis done in the last few years on protecting assets  in different jurisdictions from the insolvency of counterparties but the Lehman Brothers Bankhaus AG case in Germany, for example, has thrown open a whole series of uncertainties in Germany on segregation in relation to client monies.  France too has its own issues as to how segregation plays out in the event of insolvency – we are therefore far from having proper certainty of outcome for assets managed in these structures which can play out quite differently from what was originally envisaged and which are dependant on the type of investments, liabilities, operation of collateral and different legal rules. And, all of this is before taking into account that a lot of the broking agreements that funds enter into would in any event, more often than not, waive the segregation rights in order to enable assets to be used freely by the broker such as for re-hypothecation.

There is therefore much to be done before asset segregation really works and protects investors from the risk of contamination from other investment strategies and those of the counterparties with whom they are investing.  Until that is sorted out, a lot of the so called asset segregation processes will not stand up to scrutiny and investors will remain unprotected at times of trouble and strife.

Good due diligence would examine these underlying arrangements for segregation to highlight the connected risks and not rely on the investment manager’s  arrangements to provide adequate safeguards without detailed examination.

©Jaitly LLP

This month I thought it would be appropriate to focus on the issues of asset protection that are necessary when considering fund investments.  The AIFMD has approached this issue by requiring funds to have a depositary.  The Pensions Regulator in the UK issued a discussion document at the end of January dealing with issues around asset protection in Defined Contribution Schemes in which a principal of Jaitly LLP played a role.

Of course alternatives and hedge funds in particular are becoming an important aspect of pension investment strategies as trustees and consultants consider greater exposure to these types of investments to manage their investment portfolios.

Asset protection means different things to different people – the AIFMD takes a relatively narrow approach requiring a depositary with risk management and liquidity requirements as part of the operating conditions for the manager.  The UK Pensions Regulator in its discussion document recognises  a much broader approach by considering the impact of wider issues such as fees, administration and record keeping, valuation methods, insurance, compensation schemes and security lending all of which can have just as significant an impact on the protection of investor assets as might the use of a custodian.

Hedge Funds can be viewed by some as riskier investments – but depending on the investment strategy they need not be.  Indeed as absolute return vehicles one of the underlying  principles of a hedge fund investment should be the preservation of capital and hence the protection of assets.

The analogy to houses in this month’s title is apt because of the use of leverage in investment strategies and their impact on asset protection.  It is a concept that needs to be understood far better by investors.  As with a house – financiers provide funds which are secured against the value of the house.  This leads to financiers introducing margins of safety in case the value of the house should fall by requiring that amounts lent should not exceed say 70% of the current value of the property (a concept ignored by sub-prime lenders).  With a business that borrows money – the principle is no different and the lending is secured by taking out fixed and floating charges on the assets of the business which the financiers assess as giving them a margin of safety in the event of a default.

In a hedge fund too the principle is similar but the nature of leverage and the deal that is negotiated with the financiers – the prime brokers – is important to understand, as that will have a significant impact on the safety of those assets for investors.

So lets take a simple long short equity  fund that states that its gross exposure will normally not exceed 130%.  Note this is only an intention – it does not prevent the fund from going beyond this limit.   What does that mean?  It means that the sum of its long and short exposures will not normally exceed 130% – but it could.  For example its investments held long could be 100% of the value of the fund and its short exposures 30% or other combinations totalling 130%.   It is able to do this by borrowing 30% of the value of its assets.  Funds with little negotiating power may agree to the prime broker securing the value of all the assets against the borrowing.  If the fund deals in risky transactions the prime broker may require wider margins of safety to take into account difficulties in asset valuation or fluctuating asset values.  Others may negotiate that the assets secured cannot exceed say 140% of the level of borrowing.  Others may provide for assets up to 200% of the borrowing and so on.  The assets secured in this manner are referred to as encumbered or collateralised assets.  

The prime brokers can then re-hypothecate the encumbered assets – this enables them to borrow from third parties and to put up the re-hypothecated assets as security for that borrowing as if it was their own asset.  This is what caused such problems for funds that were financed by Lehmans because collateralised assets had been re-hypothecated and were being retained by counterparties when Lehman had defaulted on its obligations.  Where the assets collateralised had no limits – i.e the prime broker treated all the funds assets as collateralised then the problem was exacerbated even further – and then there was of course the problems with record keeping that meant that tracing and differentiating between encumbered and unencumbered assets became a major problem.

How this will operate in relation to the depositary requirements of the AIFMD needs to be fleshed out by the EU and ESMA in accordance with Chapter III and Article 18 (a) 16 of the directive.   The UK Pensions Regulator is also consulting on the issue through its discussion document.  Both are also looking at risk management and liquidity.

It does seem therefore that there is a real need for certain basic principles to be clearly articulated so that investors interests are protected in relation to leverage:

• a requirement for disclosure of how leverage will operate on a fund and what impact this will have on liquidity and risk management
  
• a requirement to disclose what the manager of the fund will and will not be permitted to do in relation to leverage and what protections and controls will operate to ensure that the manager does not breach these parameters
  
• a requirement to provide an explanation of the circumstances in which rights against collateralised assets can be exercised by financiers and how collateralised security shall be managed 
  
• a requirement to explain the types of recourse available (if any) to investors in the event that assets are lost
  
• a requirement to disclose how assets will be custodied, including sub custodial arrangements 
  
• a requirement for custodians and depositaries to be adequately capitalised and to carry appropriate insurance or bonding in relation to those assets and possible loss
  
• a requirement for custodians and depositaries to segregate the assets from their own with adequate record keeping and regular disclosure .

It is only then that the regulatory environment within which investors make investment decisions will operate to protect investors assets and enable investors to make informed decisions relating to risks around leverage.

©Jaitly LLP

It has been a period with conflicting news stories – first there were the stories about hedge fund managers who had failed to achieve the promised distribution by launching UCITS funds (referred to as Newcits).  Then there was the story of a survey, that contrary to expectations, showed that Newcits had outperformed their hedge fund counterparts and now there are reports of a major hedge fund closing its UCIT structure and returning capital to its investors because reports suggest that the tracking error was widening.

Newcits were supposed to be the hedge fund managers insurance policy against the AIFMD and the way to get distribution in Europe.  They have been marketed as better regulated, less risky and more liquid products than their hedge fund equivalents.

These claims need to be treated with some caution because it is distribution and regulatory arbitrage with the AIFMD that are the real drivers that attempt to make a virtue of the Newcit.

I have heard many cite the example of the UCIT structure used as a feeder fund to invest in Madoff, others cite the trade off they are prepared to pay for in the form of lower returns in return for reduced volatility and the enhanced liquidity of these products.

The great danger with Newcits is that marketing spin would have you believe that through the use of these structures  investment risk can be replaced with improved liquidity risk.  It cannot.  An illiquid investment remains an illiquid investment regardless of whether it is housed in a Newcit or a hedge fund.  Just because NAVs are prepared fortnightly do not make the product more liquid – the manager still makes judgements on the amount of liquidity that will be necessary and it will still be the more liquid part of the portfolio that will be realised first in the event of redemption notices.  It may be true that  regulatory requirements force more of a focus on liquidity requirements and indeed valuations – but it is investment strategy and markets that determine liquidity and not choices of investment vehicles and domicile.  UCITS can gate redemptions and managers still need to manage liquidity by realising investments.  

In so far as the claim goes that these products are less risky  – one needs to ask what makes them less risky?  Is it the counterparty concentration risk limits?  The use of VAR as a risk assessment methodology? Valuation requirements?  Restrictions on the use of derivatives limiting exposure to the net asset value?  The nature of financing that may be permissible?  Of themselves these strands are all good things to have – and many hedge funds have claimed the use of these for many years – Irish listed hedge funds have had similar counterparty exposure limits, many hedge funds claim to use VAR methodology (for what its worth) – so I am not altogether convinced about the significant improvements that Newcits provide – sure the requirements need to be adhered to and yes they do move towards a better framework for risk but they do not necessarily offer significant improvements on what hedge funds claim apart from being mandatory requirements.

How about better regulation?  Unarguably there is more to deal with and monitor – but does this necessarily mean that it is better?  I have visited enough investment managers in my time and observed large tomes of compliance manuals gathering dust on shelves.  I have also as a chief operating officer been party to discussions on how to get around regulatory requirements that did not quite suit the hour of the day.  It is the application of joined up proactive regulation that would be meaningful if it is done within a culture of real risk management – but that does not need rules – it needs attitude.  

So what is it that you need in order to make sense of investments in Newcits?  Everything.  The due diligence needs to be as detailed as it should be for a hedge fund.   The hurdles the Newcits must go through to comply, set, just that, hurdles.   The investor must still complete its due diligence on both investment and operational aspects because structure and hurdles not withstanding the risk management, the liquidity and valuation claims, the investment strategy all still need thorough examination.

And if you remember that investment risk cannot be converted into reduced liquidity risk by changing the wrapper into a Newcit then you are streets ahead of some investors in Newcits and you may even be beginning to make sense of it all.

©Jaitly LLP