The recent real estate downturn that impacted the US and global economies has reached far beyond the real estate and mortgage finance sectors themselves. Within the private investment fund1 world, one would assume that real estate funds and distressed debt funds would bear the brunt of the economic crisis of the last two years. However, this has not been the case – instead, the crisis has spread well beyond these traditional boundaries and has affected private investment funds in other sectors as well as the investors in these funds. Among other impacts, through a chain of events, the real estate downturn has developed into a liquidity crisis for venture capital funds and their investors, a development which is the focus of this article.
This article briefly discusses the impact of the real estate downturn on venture capital funds, focusing on three areas:
- The impact of the real estate downturn on cash flow and liquidity for hedge funds and their investors.
- How the hedge fund liquidity crisis spread to venture capital funds and their investors.
- How venture capital fund managers have responded to the impact of the real estate downturn.
The crisis was a wakeup call for IFIs to re-examine their businesses and business practices, having taken some knocks, as asset, commodity and oil prices fell, hurting their balance sheets and liquidity position.
The impact of the real estate downturn on cash flow and liquidity for hedge funds and their investors.
While the real estate downturn directly impacted real estate funds and distressed asset funds as would be expected, the downturn also had a relatively unexpected impact on hedge funds and their investors. This created a liquidity and cash flow crisis within the hedge fund sector that has had far-reaching effects on other classes of private investment funds, including venture capital funds.
Traditionally, nearly all hedge funds focused on liquid assets such as listed securities, options and futures, and other derivatives, with only a few niche players acquiring illiquid assets. In the 1980s and 1990s, however, a number of new and existing private investment fund managers, as well as established hedge fund managers, formed hedge funds focusing on illiquid assets. In the 2000s, hedge funds continued their move into illiquid assets generally, and interested in further enhancing their returns, directly purchased large pools of mortgage-backed securities (MBSs). They also continued to purchase other real estate-related assets such as loan participations and real estate, becoming a major player in those markets. A number of such hedge funds focused, in particular, on the high-yield, distressed segment of these markets.
This created a dilemma for hedge fund managers because hedge funds, unlike venture capital and other private equity funds, permit periodic redemptions, typically following an initial lockup period. Because of this, a hedge fund manager must ensure that enough of the hedge fund's assets are liquid to permit orderly withdrawals of capital by investors on demand. This was not a problem as long as MBS and real estate prices remained stable because hedge fund managers could always resell a portion of a hedge fund's assets at a reasonable price to meet redemption requests.
This all came to an end with the real estate downturn beginning in late 2007, which had an immediate and substantial effect on MBS, loan participation and real estate values and resale prices. Many hedge funds were also exposed to counterparties such as Lehman Brothers, meaning they were unable to access substantial portions of their portfolios. Finally, the downturn in the stock market that accompanied the real estate downturn, and changes in valuation methodologies, put further pressure on hedge funds. In many respects, these three developments created a "perfect storm" in terms of liquidity for hedge funds.
As a result of these developments, many hedge fund managers could no longer rely on their ability to resell assets in the aftermarket to fund redemption requests and at the same time, had to mark down the value of their hedge funds' assets, resulting in a "double" liquidity hit for the hedge funds. Hedge fund investors, facing their own liquidity issues, simultaneously made large numbers of redemption requests all at once. Subscriptions by new existing investors slowed down or, in some cases, completely stopped, further reducing the amount of capital available for redemptions. As a result, many hedge fund managers suddenly faced severe cash flow and liquidity issues.
To deal with the liquidity issues, many hedge fund managers have used whatever means were at their disposal to slow investor redemptions. This includes getting investors to agree to extend "lockup" periods during which withdrawals are not permitted, utilising "gates" whereby investors can only withdraw a fixed percentage of the fund's aggregate capital on any given withdrawal date; suspending redemptions based on subjective "material adverse event" provisions and objective "force majeure" and similar provisions, moving assets into illiquid side pockets that may not be redeemed until there is a realisation event for the underlying assets, imposing so-called "synthetic" side-pockets whereby hedge funds transfer assets to newly formed subsidiaries and distribute equity interests in the subsidiary to redeeming investors, and other means. In other cases, hedge funds have simply dissolved and gone through the formal liquidation process.
How the hedge fund cash flow and liquidity crisis spread to venture capital funds and their investors.
Venture capital funds are arguably better-equipped to deal with the types of liquidity issues that impacted hedge funds as they do not typically permit investors to redeem their interests in the fund on a regular basis. However, the issues with hedge funds' cash flow and liquidity noted above have nonetheless had a heavy impact on venture capital funds because of the resulting adverse effect on hedge fund investors' liquidity and cash flow. This impact was caused by the interrelationship between the hedge fund and venture capital (and other private equity) fund sectors and the cash flow and liquidity programs utilised by investors, particularly large institutional investors that deploy substantial amounts of capital throughout all private investment fund asset classes.
Unlike hedge funds, venture capital funds typically have capital call provisions whereby the funds call down capital from investors over an extended time period of generally up to six years or even longer in some cases. This model works fine as long as investors have cash on hand to meet the capital call obligations, but it breaks down in cases where investors are faced with liquidity and cash flow issues, even if the issues do not arise from the venture capital funds themselves. Historically, large institutional investors have invested in both hedge funds and private equity funds such as venture capital funds, and have used their ability to regularly withdraw capital from hedge funds to provide capital to meet venture capital funds' capital calls. In this sense, hedge funds have served as a relatively liquid means of earning reasonable returns on capital while it awaits deployment to venture capital and other private equity funds. As long as hedge funds were relatively liquid and could meet such investors' redemption requests, this system worked.
Once hedge funds ran into liquidity issues caused by the real estate downturn and utilised available methods of denying or deferring investors' redemption requests, a problem developed for venture capital fund managers because investors could no longer rely on hedge fund redemptions to fund their capital call obligations. This problem was exacerbated by the fact that many large institutional investors, interested in enhancing returns, increased their exposure to real estate and distressed debt hedge funds prior to the real estate downturn. As a result, these investors had a relative large proportion of their capital subject to hedge fund lockup periods and other withdrawal restrictions, resulting in less capital being available for venture capital fund capital calls. Finally, even if investors could withdraw capital from hedge funds, in many cases it was subject to substantial losses, further reducing their amount of available capital.
How venture capital fund managers have responded to the impact of the real estate downturn.
Venture capital fund managers have taken a number of actions in response to investor liquidity and cash flow problems. In some cases, investors have informally requested that managers defer capital calls for up to one year to permit investors to refresh their available capital. Some venture capital fund managers have slowed their capital deployment and therefore, have not needed to call as much capital. Other managers have reduced the size of their venture capital funds and investors' capital commitments, which has allowed investors to reduce their overall unfunded commitments to the venture capital fund asset class. Finally, some fund managers have simply returned capital less fees and expenses and terminated their funds early.
In some cases, even after venture capital fund managers have taken the above steps to reduce pressure on investors, some investors still have not had enough capital available to meet their capital call obligations. This has led to a much higher level of venture capital fund investor defaults since the real estate downturn began. Typically, venture capital funds' legal documents provide managers with a number of remedies following an investor default, some of which are fairly draconian. Managers have utilised a number of strategies to deal with these defaults in a manner which reduces the impact on non-defaulting limited partners, including the following:
- Forfeiture: A fund manager may deem a defaulting investor to have forfeited a portion of its interest in the fund. The forfeited portion generally ranges from 25%-75%, more typically toward the higher end of this range. If a manager utilises this remedy, it should be expressly stated as a remedy in the fund's legal documents because a defaulting investor will often challenge the forfeiture in litigation on a variety of grounds. Forfeiture provisions should also be carefully drafted as they can constitute unconscionable penalties under the laws of some states.
- Pro-rata Offer to Purchase: Many funds' legal documents provide a procedure whereby the fund manager may offer the defaulting investor's interest in the fund to other fund investors or certain large fund investors on a pro rata basis. Typically, the defaulting investor will be paid out over a time period such as three years (or after the fund's liquidation) and will be issued a promissory note upon purchase.
- Forced sale: The fund manager may arrange for a trusted large investor, either an existing investor or a third-party, to purchase the defaulting investor's interest at cost or at a reasonable discount. The cost is sometimes negligible to the extent the investor has a large remaining capital commitment and has not yet contributed much capital. While this may be a useful tactic, it is often not available under a venture capital fund's legal documents because the fund manager is required to undertake the aforementioned pro-rata offer process before utilising other remedies.
- Buyback at a Discount: The fund manager may have the fund itself repurchase the defaulting investor's interest at cost or at a discount to its value. The manager should carefully evaluate the use of this strategy before implementing it as among other things, the fund may have to satisfy certain solvency tests, there may be conflict of interest and valuation issues that need to be addressed, and there may be adverse tax consequences for remaining investors.
- Affiliate Purchase: The fund manager may have one of its affiliates purchase the defaulting investor's interest at cost or at a discount to its value. This tactic should be used with caution as it potentially raises conflict of interest issues and may implicate the fund manager's fiduciary duties to other investors.
- Loss of Rights: Typically, a fund's documentation will strip the defaulting investor of voting rights, information rights, entitlement to future distributions and other rights. This is crucial as it limits the strategic options available to a defaulting investor and limits the use of so-called "strategic" defaults.
- Interest and Expenses: Even if a defaulting investor ultimately pays its capital contribution, it will usually have to pay interest on its defaulted capital contribution which accrues to the benefit of non-defaulting investors. The investor will also be assessed for expenses incurred by the fund manager in connection with its default, together with interest on the expenses.
- Withdrawal: In some cases, the fund manager may permit the investor to withdraw from the fund, with the fund paying the investor out over a period of time. Often, however, this is not permitted under a fund's legal documents and, in any event, it may lead to objections from non-defaulting investors. Generally, it should be an express remedy under the fund's legal documents if it used.
The above remedies can be used separately or in combination. A venture capital fund's legal documents should be drafted in a manner which makes it clear which remedies are available to the fund manager as lack of clarity is often a source of litigation. Whichever means a venture capital fund manager uses, it is important for the manager to avoid significant tax, legal or other implications for the fund's investors and the manager itself, including characterisation as a capital shift for tax purposes and conflict of interest and fiduciary duty issues for the manager.
In conclusion, the real estate downturn has had a severe impact on the liquidity and cash flow of hedge funds, which quickly spread beyond the hedge fund sector to other classes of private investment funds including venture capital funds. This has, in turn, reduced hedge fund investors' cash flow and liquidity and, since many such investors are also large investors in venture capital funds, has resulted in many such investors being unable to meet their capital call obligations to venture capital funds. As the real estate market stabilises, the hope is that these liquidity and cash flow problems will begin to subside. However, the long-standing impact of the real estate downturn will likely continue to affect venture capital funds for the foreseeable future and fund managers should continue to actively take steps to mitigate the adverse effects of the real estate downturn.
David Riley is a partner and member of the Corporate Practice at Morrison & Foerster LLP.
This article first appeared in the 3rd Quarter 2010 issue of NVCA Today. For more details, please visit nvcatoday.nvca.org