Debt funds have been a tried and true strategy to scale a lending business.
If managed well, they can provide immense opportunity for investors, and allow lenders to control the borrowers, servicing, and capital. If managed poorly, they can be a recipe for disaster. Whether it’s an unforeseen disaster like this COVID-19 outbreak, the global financial crisis of 2008, or the trade recessions of the 90s, it is imperative that fund managers prepare their funds to withstand the stresses of volatile markets and a potential recession. This article will discuss the legal tools and practical solutions to protect a fund from heightened redemption requests from investors.
Managing a Fund during the COVID-19 Crisis
Thanks to the COVID19 outbreak, the entire U.S. economy is currently at a standstill. This has caused a completely different type of economic downturn: a “freeze-out”, if you will. It is also an opportune time for fund managers to ensure they have the necessary powers, investment terms, and disclosures in place to ensure they can protect the fund, investors’ capital, and the fund managers themselves in the event this does spiral out of control.
Two commonly overlooked “tools” for fund managers are (1) the ability to suspend redemptions; and (2) indemnification rights for the fund manager.
Tool #1: The Ability to Suspend Redemptions
Since Geraci LLP’s inception in 2007, funds designed by our team have included specific withdrawal / redemption provisions to ensure that the fund manager has enough powers to limit redemptions or suspend them entirely. These limitations are strategic in that they install limitations on an ongoing basis, but also give the fund manager authority to suspend redemptions altogether.
There are two key redemption restrictions a debt fund must have to ensure it protects the fund as a whole:
1. The fund manager can suspend withdrawals based on reasonable circumstances:
- Inability to liquidate assets without detrimental impact to the fund
- It isn’t reasonably practicable to evaluate the value of the fund’s assets
- The fund does not have the liquidity or cash availability
2. Funds also must install key withdrawal limitations as a going concern, including:
- A cap of 10% of the fund’s assets in a fiscal year, and
- Investors who are withdrawn are done so 25% over the following 4 quarters.
These withdrawal limitations are essential to prevent a “run on the fund” scenario from building up and leading to unnecessary disputes and liability. Further, a fund manager’s capability to do so will allow it to preserve capital, transact workouts and modifications, and find sensible liquidity.
These were cultivated as an alternative to the commonplace “best efforts basis”, as the latter was too subjective, and created significant risk of litigation, as courts would be relied upon to interpret disputed facts.
Tool #2: Indemnification Rights for the Fund Manager
Suspending redemptions alone is not enough. The fund also needs indemnification rights for the fund manager. One unfortunate byproduct of having restrictions to redemption is that investors oftentimes band together to try to sue their way out. We’ve found that indemnification clauses that require the fund to indemnify the fund manager up to a finding of gross negligence is a very useful tool to quell investors. The reasoning is simple: costs and expenses incurred by the manager, including legal expenses to defend against investor lawsuits, must be paid by the fund. This tool disincentivizes investors from pursuing expensive legal action and incentivizes cooperation with the fund manager to exercise sound workouts and modifications, and preserve capital. In actual cases seen during the last recession, funds that had these tools in their funds prevented significant losses as compared to funds that did not.
An Additional Tool: The Fund Manager’s Character and Judgment
These tools are important, but so is the character of the fund manager who uses them. Fund managers must be sure to exercise strong business judgment and put the interests of the investors before their own, especially during a recession. Further, they should be emphasizing strong reporting, transparency, and leadership to ensure investors are fully informed, understand the situation, and remain calm.
We are recommending fund managers concentrate on loan servicing and investor relations. Examples of some best practices include the following: directly communicating with investors, explaining strategies to convey investor confidence, and delivering updated or expanded disclosures surrounding global pandemics, disasters, and other acts of God. While unfettered optimism may not be a good idea, explaining your plans to come out the other side with a clear strategy to return to normalcy and succeed in the newly shaped landscape is a recommended tactic.
Thankfully, many fund managers are already well-equipped, and investors are not panicking. These fund managers are likely contemplating and preparing for the possibility of suspending withdrawals. It is essential for fund managers to avoid a sudden announcement, however. As investors come to you with requests to redeem, we recommend practicing strong investor relations tactics to convey confidence in explaining your reasoning and your long-term plan.
We believe that, as a community, we will weather this storm. Geraci will provide ongoing content and be available to assist fund managers through any investor related issues they may be facing.