Market instability: should you suspend NAV calculation?

One of the effects of the current Covid-19 pandemic has been that the values of many markets and individual assets have declined rapidly and significantly, and become subject to greater volatility than at any time since the financial crisis of 2007–2008.

At the same time, while a liquidity crisis like 2007–2008 seems unlikely, institutional investors have nevertheless sought to de-risk their portfolios and cash out of more liquid holdings; perhaps with a view to having cash on hand to meet other commitments, such as earlier-than-anticipated drawdowns from closed-ended funds.

This convergence of highly volatile asset prices and the likelihood of unusually high redemption requests presents hedge fund managers with a dilemma: are “true” asset prices currently so difficult to determine that striking an accurate net asset value (NAV) is impossible, making a suspension of NAV calculation the fairest option for all investors? Here we consider some of the factors managers should bear in mind when weighing up a possible suspension.

  1. What is the contractual position? The fund’s PPM and constitutional documents need to be reviewed carefully to confirm under what circumstances a NAV suspension may be imposed (often, PPMs contain broad language permitting suspensions during conditions of market turmoil as a result of which a significant portion of the fund’s assets cannot be valued accurately), as well as the mechanics of how the suspension will work. It is also worth confirming whether any provisions exist in the constitutional documents, management agreement or other documentation that might enable investors to remove the fund directors and/or manager if they disagree with the suspension.
  2. Is the suspension justifiable? Generally a suspension may be justifiable in circumstances where it would risk prejudicing remaining investors were redemptions requests to be settled at an inaccurate pre-suspension NAV, or where comparable factors apply. The fund directors and manager must be mindful of their fiduciary obligations in imposing the suspension, and the manager may also be subject to regulatory obligations (such as the Financial Conduct Authority’s (FCA) general requirement to treat all investors fairly).
  3. How will the suspension be communicated to investors? Effective and sensitive investor communications may be the difference between a temporary suspension before resuming business and a “rush for the exit” by investors. Managers should consider how investors are likely to view the suspension; for example, how does it relate to the fund’s strategy and how it was sold to investors? Clearly, the more liquid investors expect a fund’s portfolio to be, the more difficult it may be to demonstrate that a NAV suspension is a consequence of external factors rather than mismanagement.
  4. What happens to existing redemption requests? Fund documents will typically state that investors who have already submitted redemption requests may cancel those requests, rather than risking their redemptions being settled at an unknown post-suspension NAV (and the FCA has said in its guidance on fund suspensions that it expects details of how to cancel requests to be communicated to investors, and that sufficient time should be given to allow investors to make an informed decision). Consideration should also be given to whether pre-suspension redemption requests take precedence over requests submitted during the suspension period (assuming that is permissible).
  5. What management fees will be payable during the suspension? Management fees are typically calculated as a percentage of NAV, but how will this be done if the NAV is suspended? The pre-suspension NAV may be inappropriate; in particular, if the previous NAV struck is likely to be substantially too high. It may be better to calculate management fees based on estimated NAV during the suspension period, and perhaps offer some level of discount to investors, to sweeten the pill. It would be very difficult to justify paying any performance-based compensation based on an estimated NAV.
  6. Might the suspension trigger a default under any fund counterparty documentation? For example, funds are generally obliged to report NAV under financing or prime brokerage arrangements, but this might be impossible during a suspension period.
  7. Are any regulatory notifications required? For a Cayman Islands fund, it will be necessary to notify the Cayman Islands Monetary Authority of a NAV suspension. Similarly, the FCA must be informed if a fund is managed by a UK manager.

Although still a significant step, many investors will have experienced NAV suspensions during the financial crisis and they are no longer necessarily the death knell for a hedge fund. The key point is that the suspension must be in the best interests of the investors and the fund as a whole – and, almost as importantly, that it must be clear to investors that the suspension has been imposed to protect their, and not the manager’s, interests.