A review of Cayman Islands hedge fund corporate governance and best practice, including in times of distress.
It may be business as usual for hedge funds as they seek to weather the market storm caused by Covid-19. However, the true economic effects are perhaps yet to be seen.
This five-part series considers some of the guiding principles that apply to corporate governance in a Cayman Islands hedge fund context and some of the best practices that boards of directors should be implementing as a matter of course, which may need to be re-visited and adapted in times of distress.
Part 3: Market Turbulence and Potential Distress
While the governance principles outlined in the previous parts of this series will continue to apply (and should be followed) throughout the lifetime of a fund, the board of directors must be prepared to adapt the governance practices established in a 'business as usual' environment, such as in the event of market disruption, where risk levels invariably increase and additional reporting and discussion is merited to ensure effective oversight of the fund and its service providers.
For example, when the markets are turbulent, it may be difficult for the investment manager to manage the fund in accordance with the fund's defined investment criteria, investment strategy and restrictions (although market disruption may of course also create opportunities for the investment manager). The calculation of NAV may also be more involved if any of the assets in the fund's portfolio become hard-to-value, e.g. because there is no directly observable market price for such assets. Furthermore, the use of leverage may heighten insolvency risk and liquidity issues may result in an inability to meet redemptions.
Accordingly, during a period of market turbulence, ad hoc or more regular meetings of the board of directors may be appropriate to enable the directors to fulfil their responsibilities. In particular, the directors should increase reporting from:
- the investment manager, e.g. as regards the liquidity profile of the fund, use of leverage and any departures from the investment criteria, investment strategy and restrictions. In a period of market turbulence, a continued understanding of the financial position of the fund and risk is key - the directors must ensure they are fully cognisant of the fund's risks and such risks are always appropriately managed and mitigated, with material risks being discussed at the board meeting and the board of directors taking appropriate action where necessary; and
- the administrator, e.g. it will be important to understand whether any redemption requests have been submitted and, if necessary, whether the investment manager can manage the sale of the fund's assets to satisfy such requests while protecting value for the remaining investors.
In addition, a thorough analysis of the assets constituting the fund's portfolio should be undertaken and reports should be provided to the board of directors as regards the calculation of NAV, including any deviations from the fund's calculation policy and/or where market prices are unavailable and asset values have been determined by, or in consultation with, the investment manager. Ultimately, the board of directors must ensure that NAV is fair, complete, neutral and free from material error and is verifiable.
Separately, it would be advisable for the directors, with a clear understanding of the broader factual matrix, to engage with legal counsel and audit the key terms of the constitutional documents of the fund, the offering memorandum, subscription agreement, any side letter arrangements, service provider agreements and the details of any credit facilities. Legal counsel will then be able to advise the board of directors on, for example:
- the range of defensive measures available to the fund to provide stability, should the fund become distressed, e.g. redemption gates, side pockets, suspensions, redemption in-specie, restructuring and synthetic side pockets;
- any considerations and/or risks associated with any preferential terms granted to investors further to any side letter arrangements. For instance, certain terms relating to liquidity or the exercise of the directors' discretion may be problematic or make a particular defensive measure more involved;
- whether a potential defensive measure (which may include a regulatory filing) may trigger an event-of-default or other obligation on the fund by reference to credit facility documentation or other agreement with a third party.
Crucially, any proposed solution must fall within the parameters of the fund's governing documents and the broader contractual arrangements the fund has entered into, failing which it is vital for the directors to understand the risks associated with any particular course of action (and how best to mitigate those risks). Ultimately, it is important for the board of directors to be prepared given how rapidly events can unfold in a distressed situation: the appropriate solution to manage the fund through its difficulties will always depend on the commercial circumstances at the time (including discussions with investors and, possibly, creditors) and the desired outcome.
Part 4 will consider corporate governance in distressed situations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.