- November 23, 2016
- Posted by: vincentkinjal
- Category: Direct Lending, Fund Administration, Fund of Funds, Hedge Funds, New Funds, Private Equity / Venture Capital, Raising Capital, Real Estate, Tax Liens
Everyone knows being in a relationship is hard. However, what’s even harder is when it has to come to an end. As much as you’d like to believe your investors love you and want to be with you forever, it is possible they have a wandering eye, or you just aren’t what they thought, so they need to move on. Whatever the case may be, are you prepared for investor redemptions? It is helpful to understand the process associated with a situation like this. Make sure you discuss this process with your attorney and administrator when you first create your fund documents. Make sure that the terms and process fit into your investment strategy and work from a practical standpoint. Having a well thought-out exit strategy will only benefit you both once it is all over.
Depending on your strategy and liquidity expectations, funds typically have a lock-up period where investors cannot request a redemption from the fund. It can be tricky at times to determine when a lock-up period ends for an investor who has invested in the fund at more than one time. You will need to track the various dates and amounts of investment and determine how much of an investor’s capital account can be redeemed at various times. Once the lock-up period has passed for the investor, the investor can redeem part or all of their capital account by providing you and/or your administrator with written notice of their intent. Many times the redemptions occur after the month-end capital account for the investor has been calculated, and you know how much is available for redemption. Since you will need to have sufficient cash available to pay the investor, you would want to receive sufficient advance notice to be able to liquidate investment positions if necessary. It is very common to see a 15- to 45-day advance notice period required.
In order to reduce the burden on the manager of going through the process of making cash available for redemptions on a regular basis, many funds only allow redemptions on a quarterly basis and some even only at year-end.
For investors requesting a full redemption from the fund, there is usually a 5% to 10% holdback of the account balance to ensure that the capital account being redeemed is correct, based upon the year-end audit. Very rarely do these amounts get adjusted, especially if you have a good fund administrator handling your accounts. This may be quite unpalatable to some investors, in particular those who redeem early in the year and then must wait until the following February or March to get the remaining holdback.
It is also helpful to know about some tax considerations for redeeming investors. The account balance of an investor is made up of a number of components, including the capital they invested and the income allocated to them during the time they were in the fund. This also includes their proportionate share of the unrealized gains or losses of the unsold securities in the fund portfolio. If you redeem from the fund and there is a built-in unrealized gain in your capital account, the amount of unrealized gain will usually be converted to realized gain when the fund’s tax preparer allocates the attributable taxable items to each of the investors on their Form K-1 at year-end.
So, when it comes down to it, there is much to consider when you and an investor decide to go your separate ways. Make sure you’ve covered all of your bases so everyone can make a clean getaway. Following through with a proper exit strategy ensures a smooth break up, and may even leave an impression that causes some rekindling in the future!