Hedge Fund Exit Strategies

Date: Friday, November 7, 2008
Author: Timothy M. Clark, Forbes.com

Because of the recent market turmoil, many hedge-fund investors have questions regarding what regulations are applicable to hedge funds, and how to withdraw their money from their hedge-fund investments if they want out. Indeed, hedge funds often present many different barriers to withdrawal, and there are essentially no regulatory prohibitions on these barriers.

Regulation Done Lightly

Perhaps the best way to understand the regulations that apply to hedge funds is to compare them with mutual funds. Mutual funds are investment companies that are required by law to register with the U.S. Securities and Exchange Commission (SEC) and, therefore, are subject to stringent regulatory oversight. Virtually every aspect of a mutual fund's structure and operation is subject to regulation under four federal laws, including the Securities Act of 1933, the Investment Company Act of 1940, the Securities Exchange Act of 1934 and the Investment Advisers Act. The Investment Company Act regulates the structure and operation of mutual funds and forces funds to safeguard their portfolio securities.

The SEC oversees the mutual-fund industry's compliance with these regulations. In addition, the Internal Revenue Code sets requirements regarding these funds' portfolio diversification and its distributions. Finally, mutual funds have directors who are responsible for oversight of the fund's policies.

Unlike mutual funds, hedge funds are almost never required to register with the SEC, and their managers are often not required to register. Hedge funds issue securities in "private offerings" not registered with the SEC under the Securities Act of 1933. In addition, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. Because these investment companies are lightly regulated, there are no requirements to ensure liquidity, redemption or diversification of investments. Like mutual funds, however, hedge funds are subject to prohibitions on fraud, and their managers have the same fiduciary duties as other investment advisers.

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The only qualification for investing in a mutual fund is having the minimum investment to open an account with a fund company, which is typically around $1,000, but can be lower. After the account has been opened, there is generally no minimum additional investment required, and many fund investors contribute relatively small amounts to their mutual funds on a regular basis as part of a long-term investment strategy.

A significantly higher minimum investment is required from hedge-fund investors. Under the Investment Company Act of 1940, certain hedge funds may only accept investments from individuals who hold at least $5 million in investments. This measure is intended to help limit participation in hedge funds and other types of unregulated pools to highly sophisticated individuals. Hedge funds can also accept other types of investors if they rely on other exemptions under the Investment Company Act or are operated outside the U.S.

Getting Out

Because there are no regulations governing the withdrawal provisions of hedge funds and because each hedge fund is unique, investors need to review the private placement memorandum and organizational documents to determine how quickly they can exit the fund. Investors should look for provisions that allow managers to slow the payment of redemption proceeds and the notice mechanics for withdrawal.

There are generally four different types of provisions in hedge-fund documents that can slow down the withdrawal of cash. First is what's called a "lock-up." Often, hedge funds will have a period from initial investment over which no withdrawal is permitted by the particular investor. This period is called a lock-up and is generally between one and two years but can be as long as four years and acts as a prohibition against withdrawals. The only way to get around this restriction is through manager consent, which is rarely given.

The next type of limitation on withdrawals is called a "gate." A gate allows a manager to restrict redemptions above a certain percentage of the fund's assets. For example, a common gate will restrict the total amount to be paid by the fund at any withdrawal period to 20% of the fund's assets. Therefore, if investors turn in redemptions on any particular redemption date for 25% of the fund's assets, investors entitled to withdraw will only receive their pro rata portion of the 20% amount. Remember, this limitation works even if you are past your applicable lock-up period.

Third, there may be other provisions in the organizational documents of hedge funds allowing the manager to take reserves if it believes there may be some liabilities in the future. These types of provisions generally allow the manager to retain an appropriate amount of cash to settle these potential future liabilities. Investors will only get their reserved cash when the potential liability has been extinguished.

Finally, some hedge funds provide for what are called "side pockets." Side pockets are a mechanism whereby illiquid securities that cannot be valued are put aside until the security is sold or can be valued. These types of provisions protect the manager from having to guess the value of such securities each time the portfolio needs to be valued. However, if there are side pockets when you try to redeem out of the fund the manager is not required to pay you your pro rata portion of the side pocket until such side pocket is sold or can be easily valued. Therefore, you may not see the cash attributable to such side pocket for months or even years after your redemption.

Finally, it is important to know the actual redemption mechanics for the hedge fund you have invested in. Does the hedge fund permit monthly, quarterly, semi-annual or yearly withdrawals? In addition, you should review the offering documents to determine when you need to notify the manager of a withdrawal so that you can get redemption on time. Notice of withdrawal may be as little as a few days or as long as 90 days prior to the withdrawal date.

Hedge funds are complex unregulated investment products. Investors should study the offering documents of the hedge fund to confirm their understanding of the withdrawal provisions and seek legal counsel if they have any questions.

Timothy M. Clark is a partner in the corporate group of global law firm Proskauer Rose LLP . His practice focuses on alternative investment funds, representing hedge funds, private equity and venture capital funds in fund formation, as well as structuring transactions such as mergers and acquisitions, private placements and equity offerings.