Make the right move: Hedge fund investing for family offices

Liquidity terms: When can investors exit, and what happens in troubled times?

Many hedge funds offer investors a quarterly redemption opportunity. Liquidity limitations are, however, many and varied; among them are lock-up periods, suspensions, gates, holdbacks and reserves, and in-kind distributions:

• Lock-up periods: A period during which voluntary redemptions are not permitted. Investors should understand whether lock-up periods apply to their investment, choose the class of interest with the period that best suits their need for liquidity, and ensure that the downside of a longer period is appropriately offset by benefits, such as fee discounts.
• Suspensions: A means of switching off voluntary redemptions, typically in response to conditions outside the sponsor’s control. Investors should carefully consider the events that trigger suspension and question any that appear to involve undue sponsor discretion.
• Gates: A means of slowing voluntary redemptions, ostensibly to protect a fund from being forced to sell positions prematurely. Investors should differentiate between “fund-level” (everyone queues together) and “investor-level” (each investor is capped individually) gates. Fund-level gates can strand disciplined investors if others rush the door, and as a result have become relatively uncommon in hedge fund offerings.
• Holdbacks and reserves: Amounts held back from distributions. These are fair in principle – one does not want a fund to over-distribute capital – but investors should consider the breadth of the sponsor’s authority and the timing for any true-up in respect of a redemption holdback.
• In-kind distributions: Distributions of non-cash assets. If the sponsor can meet a redemption by distributing securities to the redeeming investor, investors should consider seeking a right to advance notice and a cash election option (sponsor to sell for their account on commercially reasonable terms), as well as clear valuation and cost-allocation rules.

Key consideration

Investor-level gates are more common than fund-level gates. Seek notice and a cash election option for in-kind distributions.
 

Side pockets: How are illiquid and hard-to-value assets handled?

A “side pocket,” in hedge fund terms, is a segregated account created to house an asset that is hard to sell or value. After falling out of favor with investors for some time following the global financial crisis (GFC), side-pocket mechanisms are again appearing in many hedge funds and give rise to several considerations:

• Eligibility. Investors should consider what assets qualify for side-pocketing – are the criteria clearly disclosed and sensible? Excessive sponsor discretion can be problematic. Understand whether any limitations on side-pocket exposure are hard limits or only guidelines, and whether they apply at the level of the fund as a whole or at the level of each individual investor. Is there the ability for investors to opt out of side pockets?
• Retroactive designation. Can the sponsor side-pocket assets after their acquisition, or must the decision be made at the time of the initial investment? Typically, it is the former, which may be acceptable if the criteria are clear.
• Past practices. If the fund has been operating for some time, to what extent have investments been side-pocketed, and how has the manager applied the fund terms, to the extent there is discretion or any lack of clarity?
• Valuation discipline. Management fees on side-pocketed assets are often paid at the lower of cost and fair value, unless a reliable means of valuation is expected; incentive (performance-based compensation) typically crystallizes only on realization of the position, not on interim unrealized marks. Investors need these terms to be clear.
• Holding periods. Are there time-based mechanisms to force or incentivize the liquidation or “deemed realization” of long-side-pocketed assets, or can assets remain in side pockets indefinitely until actually realized?
• High-water marks. Hedge fund sponsors earn incentive on appreciation above a “high-water mark” (HWM). But, in certain cases, side-pocketing can improve the odds of the sponsor earning incentive on the performance of the fund’s liquid portfolio. An often-overlooked issue in reviewing side pocket terms is how the sponsor will treat any existing HWM when assets are segregated. If the sponsor can cause a portion of the HWM to “travel” with the asset, so that it is set aside until the position is realized, this favors the sponsor. It is also important to consider what happens to the HWM when an investor redeems while capital remains side pocketed. Investors will want to maximize their ability to recoup losses before the sponsor takes incentive upon later side-pocket realizations.

Key consideration

Make sure the criteria for side-pocketing and exposure limitations are clear; consider how fees will be charged on side-pocketed capital; and look hard at how the high-water mark mechanics are handled.
 

Sponsor-investor alignment: To pay for alpha, consider a hurdle?

Family offices (like other investors) want to pay for outperformance. One approach is to ask that incentive be subject to a “hurdle,” whereby a fixed or floating base level of performance must be met before incentive is payable.

Such hurdles can be “soft” or “hard,” and are typically subject to annual resets in order to avoid a permanent drag from a bad year. A request for a hurdle may be resisted, or met with a proposal for a tiered incentive, with an above-market rate of incentive included for truly exceptional outperformance (e.g., 0% until X, 15% from X to Y, 25% above Y).
 

Transparency: The need for position and exposure data that you can aggregate

Customary quarterly summaries and exposure reports can be insufficient for family offices seeking to achieve institutional-level risk aggregation/analysis. Third-party aggregation services can assist, but they depend on access to timely data. In addition, a range of events and circumstances may be material to an investor’s analysis and monitoring of private fund investments.

Investors should consider whether they need:

• Monthly exposure reports, e.g., net and gross, by sector/region/market cap; by factor if equity, or rating/maturity if credit.
• Change of strategy and valuation policy notice rights.
• Bespoke key person and material compliance/litigation notice rights, e.g., rights to know of material key person redemptions, or regulatory inquiries, sanctions exposure, or trading halts impacting liquidity.

Key consideration

In formulating side letter requests, consider the need for enhanced reporting, and cover transparency rights in any “most-favored nations” request.
 

Conflicts: Crossing positions, use of affiliated servicers, expense allocation

As hedge funds and their sponsors becomes more complex businesses, potential conflicts of interest proliferate. Investors should ensure that they understand the sponsor’s policy and procedures around principal transactions and cross trades, and the use of affiliated servicers (brokers, etc.). In addition, check that permitted expense categories seem appropriate. Certain legal and regulatory costs might not be appropriate fund expenses, for example. Additionally, ensure that you understand how shared expenses will be allocated.

In reviewing hedge fund terms, family offices will be concerned with liquidity, sponsor-investor alignment, transparency, and conflicts, among other issues. When these terms are appropriately calibrated, hedge funds are best placed to behave predictably. In building side letters for hedge fund investments, family offices can seek to address issues that include fees, liquidity-related concerns (such as restrictions on retroactive side-pocketing), and bespoke transparency/reporting requirements. Further guidance on side letter protections can be found in The family office playbook for investing in private funds.