Private fund managers are currently experiencing a range of legal issues affecting their funds as a result of COVID-19. In this feature, we focus on the challenges being faced with valuations of alternative investment portfolios, and the impact that valuations and liquidity considerations may have on capital calls from investors, and on redemptions from open-end funds. What should managers be doing now to manage and address these issues?
With growing volatility and uncertainty stemming from the COVID-19 pandemic, private fund managers of alternative investments will need to consider the approach to be taken regarding fund and asset valuations, the degree of flexibility they have to depart from their historical approach, and whether they have an obligation to their investors to take a different approach. They will also come under increasing pressure from investors to act quickly and responsively in assessing these matters. The terms of the fund documents will need to be carefully considered to determine the approach to be taken.
Key considerations will include:
- the times at which the manager has an obligation to conduct or arrange valuations (whether these be annual or more frequent);
- the discretion that the manager has to conduct or arrange valuations more frequently (including whether they have a duty to exercise that discretion to conduct or arrange updated valuations); and
- the valuation methodology required to be adopted under the fund documents (including the ability to revise or depart from that methodology).
The approach to be taken will also be informed by the purpose served by valuations. With a closed-end fund, the valuations might only be used for reporting purposes to enable the investors to form a view on the value they should attribute when determining the valuations of their entire investment portfolios. With an open-end fund, in addition to being used for reporting purposes, the valuations might form the basis for determining the net asset value used to calculate the issue price or redemption price of interests in the fund.
Where valuations are being used for reporting purposes, managers should consider the following:
- the inclusion of appropriate qualifications, assumptions and disclaimers when reporting to investors; and
- providing heightened transparency to investors on the valuation methodologies, the degree to which they depart from those adopted historically, and the qualifications, assumptions, projections and forecasts that underlie the valuations.
Whether for reporting purposes or the calculation of issue prices or redemption prices, managers should also consider the following:
- conducting or arranging updated ‘out of cycle’ valuations in circumstances where the most recent valuations required under the fund documents may no longer be reliable; and
- whether there is flexibility to take a different approach to valuation (either within the existing valuation methodologies or by revising those methodologies).
The terms of the particular fund documents and any flexibilities afforded under those documents will be key in developing an approach to valuations in these critical times. In addition, for those managers and investors that apply the International Private Equity and Venture Capital Valuation Guidelines, special valuation guidance for valuations as at 31 March 2020 has now been issued by the International Private Equity and Venture Capital Valuation Guidelines Board. The guidance makes particular note of the following:
- The guidelines should be consistently applied across all investment types, industries and stages of investment.
- Strong valuation processes should continue to be followed.
- Fair value does not equal a ‘fire sale’ price.
- Fair value does represent the amount that would be received in an orderly transaction using market participant assumptions in the current market environment.
- Fair value is based on what is known and knowable at the valuation date.
- A view may need to be taken as to the potential for and impact of possible government subsidies that may impact individual companies and the overall economic environment.
- Care should be taken not to ‘double dip’ with respect to valuation inputs. If performance metrics have been adjusted to take into account lower expected performance, an appropriate multiple should be applied rather than a multiple derived from comparable public companies whose results have not yet included lower expected performance. The same concept applies when using the income approach, discounted cash flow. If future cash flows have been adjusted, the increase in the discount rate may be less than the increase in the discount rate if cash flows have not been adjusted for the impact of the crisis.
- Market participant views matter. Greater uncertainty may translate into greater risk, which may translate into greater required returns, which may translate into lower asset values.
- It may no longer be appropriate for recent transaction prices, especially those from before the expansion of the pandemic to receive significant (if any) weight in determining fair value.
Similarly, for those managers and investors that apply the INREV Guidelines, guidance has now been issued by the European Association for Investors in Non-Listed Real Estate Vehicles on the considerations for managers when reporting to investors on significant changes that have or could have a material impact on operations and performance.
In order to preserve liquidity in a time of growing uncertainty, private fund managers will need to critically examine the approach they are taking regarding capital calls to investors. The crucial factors in this analysis will be the degree of flexibility they have to depart from their historical approach and their ability to manage liquidity and fund new investment activity through other means.
Managers of closed-end alternative investment funds that make capital calls on investor commitments by issuing new fund interests will need to consider the dilutive impact that historic or revised valuations or valuation uncertainties can have on investors. Key considerations will include the ability to defer capital calls by managing liquidity and funding new investment activity through subscription credit lines or other credit facilities, or by recycling investment proceeds.
Subscription credit facilities can be considered by managers that do not have them in place for their funds. The terms of the fund documents will need to be carefully considered to determine the extent to which such facilities are permitted. However, it is not necessarily the case that the fund documents would need to specifically provide for these facilities in order for them to be permitted. Subject to the specific terms of the fund documents, subscription credit facilities might be permitted so long as they do not breach any prescribed borrowing restrictions and any restrictions on the giving of security over property of the fund. These facilities are not normally secured over the investment portfolio of a fund. Instead, they are typically secured over the right of the manager to make capital calls on investor commitments. Although their repayment term has traditionally been in the range of one to three months, a longer term of six to 12 months may also be available to some managers. In addition to deferring the need for capital calls, the historically low interest rate environment means that the use of subscription credit lines can also enhance internal rates of return to investors and, consequently, any carried interest or performance-linked remuneration to the manager.
Managers should also consider the extent to which their fund documents allow them to retain income or capital proceeds from investment portfolios to build liquidity within the fund, or to recycle those proceeds as an alternative to making capital calls.
Some funds may start to come under pressure from investors with liquidity stress who are looking for early access to their investment. This may come from some small to mid-sized superannuation funds (including in response to the new laws permitting members early access to superannuation fund withdrawals), from funds of funds or from certain investment platform investors. Fund managers will want to seek room to carry out a managed realisation program and avoid a distressed seller discount being applied on top of an already depressed market value. Managers should revisit their fund documents to assess their ability to suspend the acceptance or timing of payment of redemptions or to take advantage of rights to gate large volumes of withdrawals.
Due to the above mentioned valuation and liquidity challenges, some fund managers may wish to suspend redemptions, but meanwhile continue to process new issuances. Depending on the situation, new issuances may be in respect of capital calls made on existing undrawn capital commitments or potentially to facilitate further raisings (such as to take advantage of a perceived asset buying opportunities). Managers should review their fund documents to ascertain whether there is flexibility to suspend redemptions while permitting new issuances.
Managers should also revisit the terms of side letters entered into with large investors for any special redemption rights afforded to them, including to assess larger redemption risks and priorities as between large investors. This will be important in terms of managing overall liquidity, as well as, depending on the fund structure, potential claims for unequal treatment. Similarly, managers should revisit the terms of fund documents and side letters regarding any exemptions to investors from any lock-up obligations.
Depending on the jurisdiction and structure of the fund, regulators may be required to be notified of suspension or gating of redemptions. Also, individual side letters may require disclosure of a suspension to investors.
A manager will not want to prematurely dispose of an investment at a loss (and compromise its performance fee potential) in order to meet redemption requests from investors seeking liquidity coming out of the COVID-19 pandemic. Managers should review their fund documents to understand the scope to create a side-pocket to hold especially illiquid assets whose values have been unduly impacted by or have become difficult to determine because of COVID-19. Governing documents will generally prohibit the redemption from the side-pocket (referable to the relevant portfolio of side-pocketed illiquid assets), meaning that investors may continue to access redemption rights from the main (liquid) part of the fund, but may be required to hold on to their exposure to the side-pocketed assets pending an increase in value or an ability to determine value.
The exit of large investors from Australian landholding entities (including open-end real estate, agriculture and infrastructure funds) will need to be carefully managed from a tax and stamp duty perspective. For example, access to concessional withholding tax rates for non-resident investors in Australian managed investment trusts (MITs) is dependent on the trust having the right spread of ‘white list’ investors. Some managers will have made ‘reasonable endeavours’ commitments to ensure the trust is able to maintain status as a qualifying MIT and therefore access concessional withholding tax rates.
The likely post-exit percentage holdings of continuing investors will need to be considered in light of thresholds under landholder duty rules in each State or Territory where land is held. Managers should review their fund documents to assess whether they are able to pass on the implicit duty cost to the exiting investor.
Clearly, the issues faced by managers will vary depending on the fund structure, asset types and terms of fund documents. However, it is likely that some or all of the following further considerations will be important:
- Managers should review any force majeure provisions in key contracts (including administration agreements, custody agreements and management agreements). A threshold question is whether the current pandemic is covered by the particular form of provision. If applicable, the provision might require a party relying on a force majeure right to follow certain procedural steps to avail itself of those rights. Also, rights will vary depending on the form of the provision, including suspension or revocation of the contract. Some insurance policies will require a notification to the insurer of events that led to the force majeure being relied upon.
- From a regulatory perspective, Australian financial services licensees will see the current liquidity squeeze as a prompt to review their internal liquidity risk management processes and stress testing measures in light of the guidance by ASIC on the need for regular testing of liquidity risk management arrangements (including ASIC Regulatory Guide 259 Risk Management Systems of Responsible Entities, which ASIC has said is relevant also for operators of unregistered managed investment schemes).
- Hedge funds and other funds that have entered into derivative positions with counterparties should review prime brokerage and ISDA agreements to assess the rights and requirements of the counterparty arising out of the current events. The drop in value of certain portfolio assets may trigger margin calls or the need for the posting of different collateral. Given value uncertainty, counterparties will likely have the right to apply haircuts for certain posted collateral. Managers should review event of default provisions to assess whether the counterparty has a right to act, and assess the right action needed to avoid any premature closing of positions or termination by the counterparty.
Weathering the storm
A clear understanding of the terms of fund documents, side letter undertakings and agreements with service providers and other counterparties will be critical in a market thrown into some turmoil by COVID-19. This may open up tools available to some funds, such as the use of subscription credit facilities or side-pocketing of illiquid assets whose values have been impacted or have become difficult to determine. Managers will need to take particular care in managing liquidity and affording equitable treatment to investors. This will be particularly crucial for managers of open-end investment funds when pricing and managing new issuances and any redemption requests throughout these times of valuation uncertainty.
This publication is introductory in nature. Its content is current at the date of publication. It does not constitute legal advice and should not be relied upon as such. You should always obtain legal advice based on your specific circumstances before taking any action relating to matters covered by this publication. Some information may have been obtained from external sources, and we cannot guarantee the accuracy or currency of any such information.