09/01/2011 08:56:00 AM EST
Limiting Redemptions by Limited Partners
Hedge funds usually give their limited partners an
ability to redeem their interests at certain periods during the investment
period. That ability is often subject to a "gates provision" that limits a
quick outflow of capital. The provision is general there to avoid a liquidity
crisis in the hedge fund which could hurt the remaining investors in the fund.
The ability to use a gates provision was recently fought
over in the Delaware Chancery Court. The facts are bit strange. The fund had
one investor. The apparent intent was for this first investor to be the seed
investor and the the fund manager would go out and get addition investor for
the fund. The seed investor would also get a share of the revenue from later
the management fees and incentive fees paid by later investors. In exchange,
the seed investor agreed not to redeem its capital for three years. With only
one investor, the gates provision sticks out like a sore thumb.
The fund was set up in late 2007; a bad time to start
investing. The manager deployed little of the funds capital and had no success
raising funds from other investors. By early 2009, the seed investor let the
fund manager know that they would be redeeming their capital at the end of the
three year lock-up. The relationship turned sour.
[You] should remember that our right to raise the [G]ates
ensures that we will continue to manage your money throughout the litigation....
[W]e are fully prepared to litigate this matter to the
bitter end because we will continue to manage your money, and collect
management and incentive fees, until this matter is resolved many years hence.
Sure enough, on the three year anniversary the fund
manager returned only the 20% required under the gates provision to the seed
The perceived problem was that the seed money agreement
did not address the gates provision in the partnership agreement of the
fund. The investor argued that the seed money agreement acted as a waiver
of the manager's ability to apply the gates restriction on the third
anniversary. The manager argued that it merely supplemented the gates provision
by adding additional limitations on withdrawal.
There is some arguing over how the contract provisions
work together, but the court also piles on a fiduciary duty on the fund
manager. After all, the fund is a partnership and the manager is the general
The gates provision had an outlet that allowed the
general partner to waive or modify the conditions relating to withdrawals for
certain large or strategic investors.
The fund manager never identified a justification for
using the Gates in view of the Hedge Fund's investment portfolio. The only
motivation for raising the Gates was to enable the Paiges to continue to receive
the management fees payable under the Seeder Agreement for a longer period.
The court found that it was the self-interest of the
general partner rather than the good of the limited partner in the fund that
kept the gate up. The Delaware's Revised Uniform Limited Partnership Act
permits the waiver of fiduciary duties, but the waiver must be set forth
clearly. [6 Del. C. § 17-1101(f)] The court found no provision in the
Partnership Agreement that says that general partner does not owe fiduciary
duties to the Fund and its investors.
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