This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.
Summary and implications
This is the third briefing, the last in our summer series on fund exits. In our first briefing we summarised exit mechanisms for closed-ended funds and in our second briefing we examined open-ended funds. In this briefing we will look at the general issues that apply to all types of funds.
The process for terminating or exiting a fund will be set out in the fund documentation, which is why it is essential that these provisions are carefully drafted. Semi-open-ended funds usually have longer lifespans than closed-ended funds with redemptions provisions that are more restrictive than in open-ended funds.
In all types of funds, however, fund managers should follow the provisions carefully to ensure that there are no breaches of the agreements and the fund manager is acting in the best interest of all investors at all times. The hybrid nature of a semi-open-ended fund makes careful drafting particularly important so that the investors are clear on the exact timings of their ability to exit and potential fund extensions, if the life of the fund is not infinite.
Property funds are long-term investments and it is difficult to cover all eventualities in the fund documentation, say 10 years in advance. Fund managers and lawyers do not have crystal balls foretelling the future. Many argue that in fact it is better to have clear provisions on the powers to amend the fund terms than it is to be too prescriptive in setting out what should and should not be done in specific situations.
In this way, should a situation arise that is not covered by the fund documentation there is either a consultative process with the investors or, if specific powers need to be granted to the fund manager, the fund documentation can be amended without requiring unanimous consent to provide for this.
Fund managers and investors should give careful consideration to the following factors when planning their strategy for fund terminations:
Fund managers and investors must carefully plan their exits in accordance with the timescales set out in the fund documentation. Often there are provisions in semi-open-ended fund documentation for consultation with investors' advisory committees in advance of termination dates.
Now we see fund managers taking the initiative to open discussions with investors much earlier than even the fund documentation requires to fully consider the best options for the fund with the investors. Fund managers who engage with investors early are able to develop and implement a workable strategy that provides the best fit for the investors as a whole.
Nevertheless, time limits set out in fund documentation must be strictly adhered to. Failure to do so may mean the fund manager is in breach of the fund terms.
Discussions on terminations are often scheduled to fit in with the fund manager's consideration of the refinancing issues of the fund. When debt matures in relation to an asset of a fund, a fund manager must consider whether to refinance the asset or dispose of it. The decision will depend on the performance of the asset and the availability of debt and at which price. Before a fund manager can pursue such a strategy he will need to appreciate the likelihood of the fund terminating on its expected date or the chances that the investors will agree to extend.
Often the ability to refinance assets will be a key component of a fund manager's and investors' decision to terminate a fund. Sometimes a loan facility that is ring-fenced to an asset can be valuable if it can be transferred to a buyer. As we discussed in our previous briefing, banks have become much stricter with the loan terms which can be severely restrictive.
Fund managers will have a constant eye out for when the best value will be achievable for the fund assets and whether a portfolio sale or single asset is the best way forward. This will depend on the assets and the market conditions (and the external financing in place for each asset as discussed above).
The sales process can vary in length depending on the complexity of the deal structure and assets. Often the sales process will involve a number of advisers. The fund manager should take into account the likely timescales for reaching completion, particularly towards the end of the life of the fund.
Fund managers must be clear about the purpose of any extension: is the extension to effect an orderly disposal of the assets or to enable the fund manager to continue with the implementation of an asset management strategy? Prior to an extension the fund manager should produce a new business plan to set out the vision.
Often the process of extending the fund will be coupled with amendments to the fund terms. The procedure to amend the fund terms will again be laid out in the fund documentation and must be strictly adhered to. Fund documentation often requires investor consent to any amendment save in the case of minor amendments which can sometimes be done in the fund manager's sole discretion.
Fund managers have reported that the process of engaging with investors can be challenging, particularly when they are faced with a divergence of investor requirements. One size generally does not fit all and fund managers may be required to present strategies for asset disposals that only suit some of the investors or at least enough of the investors to make it workable.
Fund managers often use the investors' advisory committee forum as part of a collaborative and consultative process. Engaging with investors like this has proved useful in achieving a manageable solution for the parties. In this way, investors are also given a greater feeling of influence over the strategy to be adopted by the fund and, as a result, more control, even if their actual rights remain the same under the fund documentation.
End of term processes
After the debt and asset strategy has been implemented, there are a number of remaining issues for the fund manager to deal with. A few of these are discussed below.
Distributions and payment of carried interest
Interim distributions will have been made to each investor as each asset has been sold and in accordance with the fund documentation. The fund manager will do a final calculation of the carried interest which will then usually be distributed as a capital payment or, alternatively, as a fee under the management agreement.
Carried interest is typically calculated on a whole fund return and paid at the end of the life of the fund. Asset by asset carried interest calculations are less common and are heavily resisted by investors (investors do not want to see fund managers overpaid as a result of early successful asset sales), even those that contain clawback provisions.
The fund documentation will set out the distribution provisions which the fund manager must follow carefully.
The fund will have a number of contracts that it has entered into for supplies and services and these will need to be terminated. The main agreements are usually with the asset and property managers which tend to contain automatic termination provisions on termination of the fund or sale of the last asset, whichever is earlier.
There will always be a risk of ongoing liabilities but generally a fund will have given warranties on the sale of its assets (especially if they have been sold in corporate wrappers). Buyers of the fund assets will require comfort that the entity giving warranties will not be wound up with no assets to claim against in the event of a breach of warranty. To combat this fund documentation often contains a clawback obligation on the investors. Unsurprisingly, investors seek to limit this obligation in time and percentage amount of the distributions they received.
Consequently, it is usually only after the expiry of these periods that the fund vehicles can finally be audited and wound up. Keeping asset holding structures in place has cost implications. Certainly, no fund manager wants to clawback distributions made to investors in order to pay for the continued maintenance of the SPV holding vehicles.
Managers are finding alternative ways to deal with the risk of ongoing liabilities. Often this may involve taking out insurance policies to protect against future claims. Others are looking into ringfencing the liabilities in a fully funded separate vehicle that is owned by the manager but has no recourse to the investors. This is considered a risky strategy from the point of view of the manager.
The fund documentation may provide for the appointment of a liquidating trustee to wind up the partnership, which may or may not be the fund manager. It is the liquidating trustee's role to sell the assets of the fund (if any remain), make distributions and ensure that all debts, obligations and liabilities of the fund are provided for before arranging the liquidation of the fund and striking off of any companies. They will also arrange for the final accounts of the fund to be produced.
Winding up any UK fund vehicle is a regulated activity under the Financial Services and Markets Act 2000 and can only be done by a person authorised by the Financial Conduct Authority, which when coupled with the requirements of the Alternative Investment Fund Managers Directive will usually mean that this function is performed by the authorised fund manager.
When people embark on new projects, the end is often the last thing on their mind. But without clear provisions on how investors can exit or how the fund will be wound up, parties would be left confused and dissatisfied. We hope that this summer series of briefings has been helpful in understanding the issues surrounding exiting a fund. Managed properly, both investor exits and terminations of funds can ensure that all parties leave happy and contented. In the best case scenario, investors and fund managers can go on to further successful investments in follow-on funds or new funds. We, at Nabarro, are here to help make that happen for you.