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 investor.

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 partner.

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.

Sources:

• Paige Capital Management v. Lerner Master Fund (.pdf - 103 pages)
• Delaware Court of Chancery Orders Hedge Fund to Return Lerner's Seed Money (99% of Fund) by Francis Pileggi
• Cleveland Browns' Lerner to Get Fund Investment Back, Delaware Judge Rules by Jef Feeley in Bloomberg

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