HEDGE FUND INTERESTS. Hedge Funds LENDING AGAINST STRUCTURAL AND LEGAL ISSUES

Transcription

1 Hedge Funds Lenders increasingly are asked to use hedge fund interests as primary collateral for loans. Such collateral presents a number of legal, structural, and monitoring issues. The first issue alone prohibitions on assignment makes you wonder why bother? Yet, there is a trend toward this type of lending, and in a highly competitive lending environment it is critical to stay abreast of developments. This article discusses six common issues and ways to address them. LENDING AGAINST HEDGE FUND INTERESTS STRUCTURAL AND LEGAL ISSUES As hedge funds continue to proliferate, investors are seeking to use hedge fund interests as collateral against loans. Even after the due diligence involved in understanding this type of collateral, a lender is faced with legal, structural, and monitoring issues, including: Prohibitions on assignment. Investor withdrawal rights, and the lender s ability to exercise those rights. Dealing with the potential for noncash distributions. Addressing the risk of future changes to the fund or future actions by its management. Security interest perfection. Master/feeder arrangements. Prohibitions on Assignment Hedge funds generally prohibit the assignment or transfer of interests without general partner or by Robert M. Wonneberger manager consent. These prohibitions are usually broadly framed to prohibit not only the sale of the interest by an investor, but also the granting of a security interest or other lien. Section of the Uniform Commercial Code (UCC) makes certain prohibitions and restrictions on assignment ineffective and provides some assistance in addressing this concern. While this statutory provision might seem to resolve the issue, its scope is limited. Although the section would allow for the existence of the security interest itself, it contains a number of explicit limitations, including: The security interest is not enforceable against the fund itself or its management. No duty or obligation is imposed on the fund or its management. Neither the fund nor its management need recognize the security interest or pay or render performance to the lender by RMA. Attorney Robert M. Wonneberger is a partner in the Stamford, Connecticut office of Shipman & Goodwin LLP and chairman of the firm s commercial law practice group. He has over 20 years of experience, and his practice includes lending to high-net-worth individuals; commercial, asset-based, and mortgage finance; debt restructures and workouts; problem loan resolution; and commercial law. 86 The RMA Journal February 2006

2 Hedge funds generally provide a mechanism allowing investors to withdraw from the fund or redeem their interests, subject to certain requirements and limitations. The lender cannot use or assign the borrower s rights. The lender cannot use or have access to any confidential information. The lender cannot enforce its security interest. Obviously, given these severe restrictions, UCC Section does not do that much to make the hedge fund interest attractive collateral. Because the legal framework to overcome the prohibition on assignment is insufficient, the lender must obtain the consent of the fund, its general partner, or its manager (as required under the fund documents) to the security interest. This consent should be in writing and should comply with any requirements in the fund s organizational documents. Often, the fund documents contain further conditions, such as legal opinions or a fee. Therefore, the written consent also should include a representation by the fund, its manager, or its general partner that all other preconditions to a valid assignment have been met. Even after the lender has consented, one major stumbling block remains. Although the consent would ratify the granting of the security interest, it is highly unlikely that any fund would be willing to grant consent in advance that would be broad enough to allow a secured lender to sell the fund interest after default. Fortunately, there s another way. Withdrawal Hedge funds generally provide a mechanism allowing investors to withdraw from the fund or redeem their interests, subject to certain requirements and limitations. Analyzing and evaluating these withdrawal rights may be a major component of the underwriting and approval of the fund as collateral. A lender can expect to find such things as [Hedge Funds] retain broad rights to suspend withdrawals based on general market conditions, the nature of their particular investments, and other factors. fixed times for withdrawals (e.g., the last day of each calendar quarter), required minimum advance notice of withdrawal, and time frames after the withdrawal date in which payments will be made. Often, the fund documents provide for an initial lockup period, running from the date of investment, during which no withdrawals can be made. Funds generally retain broad rights to suspend withdrawals based on general market conditions, the nature of their particular investments, and other factors. Accordingly, in evaluating the ability to withdraw from a fund, in addition to the procedural and other provisions set forth in the fund documents, a lender should: 1. Evaluate the nature of the fund s investments as described in the fund documents to determine whether the investments likely can be liquidated within the withdrawal time frame. 2. Evaluate the fund s track record with respect to processing and funding withdrawals and prior suspensions of withdrawal rights. To ensure the lender s ability to access the collateral if necessary, the fund must agree at the outset that it will honor the lender s exercise of the withdrawal or redemption rights of the borrower. The lender should have the exclusive right to exercise these rights and all parties should agree that the fund will not recognize any withdrawals or redemptions by the borrower. Any proceeds from withdrawal or redemption should be paid directly to the lender and not to the borrower. Finally, the borrower should agree in the loan documents that a withdrawal or redemption constitutes a commercially reasonable disposition of the collateral. 2 Some fund documents also include a provision allowing the fund, on the effective date of a withdrawal or redemption, to segregate a portion of the fund s assets equivalent in value to the amount of the withdrawal. The withdrawal payment or payments are made as the assets are liquidated over time, and the assets remain at risk to the fund s investment strategy. 87

3 Usually, the investor is given the right to request that the segregated assets be distributed directly to the investor. In these situations, a lender should seek an agreement by the fund and the borrower that the right to request the distribution of the segregated assets can be exercised by the lender. Distributions in Kind Even in situations where the fund does not have the ability to segregate assets to address withdrawals, most funds can make distributions to investors in cash or other noncash assets. Depending on the nature of the fund s investments, the assets distributed in kind may be extremely illiquid. There are a number of ways that a lender can address this possibility. 1. The loan documents should make it clear that any distributions in kind will not be considered payment on the loan and the distributed assets will simply be held as additional collateral. 2. The collateral description in the loan documents must be broad enough to ensure the perfection of the security interest in any in-kind distributions. 3. If the loan is secured by interests in multiple funds, or if a single fund is otherwise not Depending on the nature of the fund s investments, the assets distributed in kind may be extremely illiquid. the sole collateral for the loan, a lender may wish to include provisions in its loan documents allowing it to continue to hold the in-kind distributions as collateral until all other collateral is liquidated. This will at least give the lender the opportunity to have the loan repaid in full by cash proceeds of other collateral, and possibly eliminate the difficult process of liquidating the assets distributed by the fund. 4. The loan documents should contain the types of provisions generally included when collateral may include nonpublicly traded securities. Such provisions include the following: The assets can be sold at private sales. The lender is not obligated to register securities or delay disposition to allow the borrower or another party to register the securities. The lender may place certain restrictions on purchasers, such as an agreement that a purchaser is buying for its own account for investment and not with a view to distribution or resale. Changes or Other Issues Regarding the Fund In a loan transaction in which one or more hedge fund interests are primary or important collateral, changes to or affecting one or more of the funds could adversely impact the loan. A lender can address this situation by including in the loan documents a list of the events and circumstances that would cause concern and the consequences of those occurrences, such as the option to declare an event of default or a requirement for additional collateral. Obviously, the list will depend on a number of factors, including the lender s analysis and underwriting criteria, the borrower s financial situation, and the particular terms of the fund, so a one-size-fits-all list cannot be provided. However, the list may include such things as: 1. Amendment of the fund s organizational documents in a way that adversely affects the borrower s interest in the fund or its withdrawal or redemption rights (or perhaps any amendment of any type). 2. A change in fund management, including not only the managing member or general partner of the fund, but also the individual or individuals responsible for investment policies or day-to-day investment decisions (usually listed in the private placement memorandum). 3. Termination of the fund. 4. A fundamental change in the investment philosophy or policies of the fund. 5. Any actions by the fund or its general partner or manager to terminate the borrower s interest or that compel the borrower to withdraw from or redeem its interest in the fund. 6. Any exercise by the fund of its right to suspend or limit redemptions or withdrawals by investors. 88 The RMA Journal February 2006

4 Perfection One of the most important issues that must be addressed is perfection of the lender s security interest in the borrower s hedge fund investment. As with all types of collateral, the method of perfection depends on how the asset is classified within the framework of Article 9 of the UCC. In the typical situation, the hedge fund is a domestic limited partnership or limited liability company and the borrower s interest in the fund is a limited partnership or membership interest. 3 The question often arises as to whether an interest in a hedge fund is classified under the UCC as a security, more generally a financial asset, or instead falls within the catchall category of general intangible. Section 8-103(c) of the UCC provides the necessary guidance on this issue. That section provides that an interest in a partnership or limited liability company is not classified as a security unless one of three conditions is met: 1. It is dealt in or traded on securities exchanges or in securities markets. 2. Its terms expressly provide that it is a security governed by UCC Article It is an investment company security. Section also provides that an interest in a partnership or limited liability company held in a securities account is a financial asset. Hedge funds, almost by definition, are not publicly traded, so the first criterion above will not apply. A review of the fund s organizational documents should verify that the fund has not opted into the provisions of Article 8 and the second criterion will not apply. As set forth in Section 8-103(b) and the official comments, an investment company security is an investment vehicle issued by an entity registered under the Investment Company Act of Since hedge funds take great pains to ensure that they are not required to register under the Act and do not, in fact, register, it should be relatively simple to establish that the third criterion will not apply. In most cases, basic analysis and fund document review should demonstrate that the hedge fund interest does not constitute a security under the UCC. Therefore, as long as the hedge fund interest is not held in a securities account, it will constitute a general intangible as described in UCC Section 9-102(42). Once this classification is made, perfection becomes a relatively simple process. A security interest in a general intangible is perfected by filing a financing statement in the appropriate filing office (UCC Section 9-310). The collateral description in the financing statement should describe the borrower s interest in the fund, identify the fund by its exact legal name and jurisdiction of organization, and include a reference to proceeds of the fund interest (as addressed in Distributions in Kind above). Master/Feeder Arrangements Certain overall hedge-fund structures raise additional considerations. In a master/feeder arrangement, the investor invests in a fund (the feeder fund), which, in turn, invests all of its assets in a second fund (the master fund). It is the master fund that makes the actual investments. This arrangement adds, among other things, an additional layer of analysis and an additional set of withdrawal procedures and restrictions. At a minimum, a lender may wish to verify that the master fund is consistent with the feeder fund in terms of such things as investment philosophy and ability to withdraw. Of In most cases, basic analysis and fund document review should demonstrate that the hedge fund interest does not constitute a security under the UCC. course, this problem is compounded when the borrower invests in a fund of funds (a hedge fund that invests in other hedge funds). Agreement by the Fund In most cases it is advantageous to obtain written agreement from the fund regarding a number of issues that support the loan and the collateral arrangement. This may take the form of an agreement by the fund alone, a bilateral agreement between the fund and the lender, or a tri-party agreement among the fund, the lender, and the borrower, depending on a number of factors, including the 89

5 extent of the agreement, the nature of the overall financing arrangement, and the preference of the parties. The exact provisions of the agreement are, of necessity, transaction specific and often fund specific. However, some of the provisions that should be considered include the following: 1. Consent by the fund, its manager, or its general partner, as required, to the security interest in favor of the lender and an acknowledgment that all prerequisites to approval of the assignment have been met (as described in Prohibitions on Assignment above). 2. Agreement by the fund that the lender can exercise the withdrawal or redemption rights of the borrower and that the fund will honor that exercise. 3. Agreement by the fund that it will not honor any attempted withdrawal or redemption by the borrower. 4. Agreement that all distributions with respect to the borrower s interest in the fund will be paid or delivered directly to the lender. 5. A representation regarding the current balance of the borrower s capital account in the fund. 6. A representation regarding the date of the borrower s investment or investments in the fund. This should help avoid any disputes regarding when any holding or lockup period expires in the event that the lender needs to realize on its collateral. 7. Representations identifying by date and title the fund s organizational documents (at a 90 The RMA Journal February 2006 minimum its operating agreement or agreement of limited partnership) and its private placement memorandum. 8. Representations supporting the classification of the fund interest under UCC 8-103(c), as described in Perfection above. 9. Agreement by the fund to provide the lender with notice of any change in its organizational documents or private placement memorandum. 10. Agreement by the fund to provide notice to the lender of any change in its investment philosophy. 11. A waiver of any confidentiality requirement to the extent it would prevent the borrower from providing the fund s financial information to the lender. A lender may also attempt to include an agreement by the fund to provide financial statements directly to the lender at the same time they are provided to investors. 12. Agreement not to change the name of the fund without providing advance written notice to the lender. This will allow the lender to amend the collateral description in its financing statement in order to reflect the proper name of the collateral. Conclusion Using hedge fund interests as collateral provides a number of challenges. In addition to the financial analysis of the fund, there are structural and legal issues that can significantly affect the use of a fund interest as collateral. These go beyond the obvious questions of security interest perfection and assignability, and include addressing the various characteristics and peculiarities of this type of investment vehicle. Proper analysis and documentation can help mitigate some of these issues and strengthen the lender s position when dealing with this type of collateral. Contact Robert M. Wonneberger by at rwonneberger@goodwin.com. Notes 1 Section of the Uniform Commercial Code provides: Except as otherwise provided in subsection (b), a term in a promissory note or in an agreement between an account debtor and a debtor which relates to a health-care insurance receivable or a general intangible, including a contract, permit, license, or franchise, and which term prohibits, restricts, or requires the consent of the person obligated on the promissory note or the account debtor to, the assignment or transfer of, or creation, attachment, or perfection of a security interest in, the promissory note, healthcare insurance receivable, or general intangible, is ineffective to the extent that the term: (1) would impair the creation, attachment, or perfection of a security interest; or (2) provides that the assignment or transfer or the creation, attachment, or perfection of the security interest may give rise to a default, breach, right of recoupment, claim, defense, termination, right of termination, or remedy under the promissory note, health-care insurance receivable, or general intangible. 2 Under Section of the Uniform Commercial Code, the secured party and the debtor may determine by agreement the standards measuring the fulfillment of, among other things, the duties of a secured party to dispose of collateral in a commercially reasonable manner, and those standards will be binding as long as they are not manifestly unreasonable. 3. Other types of fund interests, such as stock in an offshore corporation, raise additional legal and other issues and are outside the scope of this article.