Best of both worlds

Andres Rueda is an associate in the corporate department and investment management group at law firm Lowenstein Sandler PC in New York. He can be reached at +1 646 414 6869 and at arueda@lowenstein.com.

The debt and equity instruments and balance sheet assets of troubled companies can often be acquired at a substantial discount from par value, historical trading value or book value. So-called ?distressed funds,? or funds that specialize in stressed or distressed investments, engage in a variety of strategies to exploit this discount and thereby secure oftentimes handsome profits for their investors.

Some of these strategies may be highly liquid. This would be the case with respect to a distressed fund that simply buys or sells short the publicly traded securities of troubled companies.

On the other hand, a distressed fund may engage in strategies that by their nature entail impairments on liquidity. A distressed fund that focuses on turnaround strategies, acquiring controlling stakes in the voting stock of troubled companies in order to impose changes on those companies' governance structures and business models, may require a relatively long holding period for a given investment in order to successfully implement a turnaround. Similarly, a distressed fund that accumulates substantial amounts of a company's non-performing debt may experience significant cash flow pressures as it negotiates with the company's management or asserts claims through the bankruptcy or other judicial process.

The success of a distressed fund depends on the expertise with which its strategies are implemented, and on sound planning. The first step in the planning process involves selecting the appropriate structure for the fund in light of its intended investment strategies. One of the fundamental considerations in this regard involves the anticipated liquidity of the fund's target investments. And yet, the liquidity of a distressed fund's portfolio may fluctuate widely over time in light of prevailing market conditions. The investment manager of a distressed fund may thus find it difficult to accurately forecast liquidity.

A distressed fund investing in securities for which an established public market exists or that are otherwise liquid and easy to value should generally be organized as a traditional, open-end, liquid securities-focused ?hedge? fund, as opposed to a closed-end, committed capital ?private equity? fund targeting illiquid investments. Recently, however, a number of funds that encompass both liquid and illiquid strategies have adopted ?hybrid? structures that meld the features of these two other types of structures.

The hedge fund model provides for rolling investor subscriptions, and for the periodic disbursements of a management fee. An incentive fee or allocation is also frequently payable, usually at year-end, subject to a ?highwater mark? to prevent the investment manager from earning a fee over the appreciation of assets under management that is merely a recoupment of previous losses. These fees may be based on unrealized appreciation, but the availability of readily ascertainable valuations for the hedge fund's portfolio positions lessens the conflicts of interest that would otherwise be apparent. The high liquidity of traditional hedge fund investments allows hedge funds greater flexibility in processing withdrawals than might otherwise be the case. Withdrawal requests will generally be processed after the lapse of any applicable initial lock-up period, whether at month-end or quarter-end, subject to sufficient notice to the hedge fund's investment manager.

Unlike a hedge fund, a private equity fund does not allow for rolling subscriptions. There is usually a single closing, although sometimes additional closings are held within a window period that does not generally exceed six months because of valuation concerns and the possibility of disadvantaging either existing or incoming investors. Like its hedge fund counterpart, the investment manager of a private equity fund is usually entitled to a management fee and an incentive fee, but these are generally not periodically disbursed or marked to market. Management fees are typically based not on assets under management, but on committed capital (whether called or not) or on capital that has actually been called. The incentive fee takes the form of profit splits that occur only upon the liquidation of an investment through a so-called ?waterfall,? subject to the investors' recovery of their capital allocated to that investment and all previously liquidated investments, along with a preferred return. Voluntary withdrawals are generally not available. Instead, investors are entitled to their share of the waterfall distributions. To prevent investment managers holding both profitable and loss-making investments from manipulating the ?waterfall? by liquidating profitable investments first, a ?final accounting? is held when the private equity fund is liquidated, which is usually required to happen six to ten years after the fund's inception. At that time, a ?clawback? may be triggered forcing the investment manager to return to the fund for re-distribution to the investors up to the totality of the profit splits received to date by the investment manager.

A distressed fund that anticipates both liquid and illiquid investments may instead adopt a ?hybrid? model that treats the fund's investments differently depending on liquidity. The ?hybrid? model allows an investment manager to hold investments that are both liquid and illiquid under the umbrella of a single fund, but without subjecting the fund's entire portfolio to the constraints of the private equity structure. Thus, a hybrid fund may at least partly allow for the benefits that the hedge fund model allows to a fund's investment manager and investors, namely the periodic disbursement of mark-to-market fees and the availability of rolling subscriptions and withdrawals upon adequate notice.

Structural considerations
A simple hybrid structure could involve a hedge fund with large ?side pockets.? These side pockets can be used where an investment's liquidity becomes impaired. For example, suppose a distressed fund commits a substantial portion of its assets to the securities of a company that subsequently files for bankruptcy. Although this portfolio may retain value despite the bankruptcy filing, the market for the securities of a bankrupt company can be extremely thin, and valuations may prove difficult to obtain. Among other problems, the fund may be unable to tap into this investment to honor withdrawal requests from investors.

One of the fundamental considerations in planning and implementing a strategy for a distressed fund involves the anticipated liquidity of the fund's target investments.

A possible solution is to ?carve out? the investment from the fund's portfolio into a side pocket for all relevant purposes (including withdrawal requests) until an event occurs that increases the liquidity of the investment, such as a third-party sale. An investor can only withdraw its pro rata capital from a side pocket upon a liquidity event such as the sale of a segregated investment or the availability of mark-to-market valuations (for example, as in the case of securities that become registered for public trading). Side pockets are often valued at the lower of cost or market for fee purposes, and are usually ?capped? at a certain percentage of the fund's assets under management. If the bulk of a distressed fund's portfolio consists of investments that are by their nature illiquid or may easily become illiquid, a hedge fund model with large side pockets may not be a satisfactory solution.

Another alternative is to implement a hybrid structure that parses investments according to their liquidity into different buckets that are not merely segregated, but that follow altogether different mechanics. The accounting can be complex, and may involve separate fee arrangements for the fund's liquid and illiquid investments. This hybrid model would allow investors to make withdrawals from the liquid portion of the fund's portfolio, and would assess mark-to-market management fees and year-end incentive fees, subject to a highwater mark, with respect to those liquid assets alone.

The model would however require the liquidation of illiquid investments after a fixed (albeit relatively lengthy) period, upon which a ?waterfall? fee would be assessed. The proceeds from the liquidation would then either be automatically distributed to investors, or reinvested into the liquid portion of the fund's portfolio (and thus available for investor voluntary withdrawals). Instead of a final accounting and a ?clawback,? a hurdle rate that gets periodically re-set can be used to adjust both the highwater mark (for the fund's liquid investments) and the waterfall (for the fund's illiquid investments) in light of the fund's cumulative performance.

Accrued management fees for any given illiquid investment could be paid by investors participating in that investment from their share of the liquid portion of the fund's portfolio or from additional capital contributions, and calculated in reference to committed capital or another metric. Alternatively, these fees could be debited (plus interest accruing thereon) ?off the top? of the waterfall upon the investment's liquidation, based on actual liquidation value.

Rolling subscriptions can be accomplished by admitting new investors in series so that each investor participates only in illiquid or non-mark-to-market investments that post-date the fund's issuance of the series of interest to which the investor subscribes, but may participate pro rata in the fund's existing liquid portfolio.

A cap could be placed over the percentage of the fund's assets that may be allocated to illiquid investments. The investment manager could be given authority to deviate from this cap, either at its discretion or should specific ?triggering? events occur (for example, the downgrade by a recognized rating agency of a target company's debt instrument). The cap could be progressively lowered, so that the percentage of the fund's portfolio that may be committed to illiquid investments would decrease over time as the fund matures. Caps could also vary depending on industry sectors for target investments.

A shortcoming of the hybrid structure could occur in the context of poorly performing funds that trigger substantial investor withdrawals from the liquid portion of the fund's portfolio. For example, a hybrid fund may need operating capital to service its private equity investments. Alternatively, the fund may have committed itself to undertake follow-on private equity investments. Adjustments may accordingly need to be made to ensure that the fund has sufficient liquid assets to service its illiquid assets and any outstanding commitments. This could be accomplished by absolute limits on the liquid assets available for withdrawal, or by requiring additional capital contributions from existing investors.

Investments in troubled companies by their nature are subject to uncertainties which may have an impact on liquidity. In addition, a distressed fund's investment manager may not have identified the fund's target investments as of the fund's launch date, and may therefore not be in a position to determine their likely liquidity. This may help to explain the growing popularity of hybrid models in the distressed fund context, despite their increased complexity.