Strategies For Addressing Investor Liquidity Concerns And Fund Capital Needs In Real Estate Funds

As the economic reaction to the COVID-19 virus continues to develop, certain investors may find themselves over-allocated to investments in private real estate funds because their private real estate investments have not been written down in value to the same degree as their public investments (the so-called “denominator effect”). Investors faced similar concerns during the Great Recession of 2008, leading certain investors to make a variety of requests to real estate fund sponsors in an effort to address this disconnect between their internal capital constraints and allocation issues and the requirement to fund future capital calls, including:

• Requesting the fund sponsor to reduce or terminate the investor’s future capital commitment;
• Requesting the fund sponsor’s consent to withdraw with respect to all or a portion of their interest;
• Exercising redemption rights in an open-end vehicle in respect to all or a portion of their interest;
• Requesting the fund sponsor to agree not to call capital from the investor for a specified period of time; and
• Requesting the fund sponsor’s consent to a transfer of all or a portion of the investor’s interest in the fund.

While the impact of the economic downturn caused by the COVID-19 virus is in its early stages, a number of investors have already suspended their investment activity and fund sponsors may begin to see requests along the lines described above depending on the severity and longevity of the current economic downturn and the denominator effect experienced by investors.  

At the same time, to the extent that fund sponsors begin to experience reduced access to the credit markets and reduced cash flows and sales proceeds, such sponsors may experience an increased need to call capital from investors to fund operating costs and debt service and to complete development or capital improvement projects. The potential need for additional capital creates a direct tension with potential investor capital constraints.

The purpose of this advisory is to highlight the issues that real estate fund sponsors should consider when evaluating any such requests from investors and to provide some insights on potential ways in which real estate fund sponsors may be able to address their fund’s capital needs while being responsive to investor liquidity constraints.

What should a fund sponsor consider when responding to such investor requests?

It is critical that prior to discussing alternatives with investors, fund sponsors are well-versed in what the fund sponsor is permitted to do and the consequences of various actions under:

• The fund’s organizational documents;
• The partnership law or other law governing the fund and the fund sponsor, in particular the fund sponsor’s fiduciary duties and other potential liability of the fund sponsor;
• The fund’s contractual obligations, such as side letters and credit facility agreements; and
• Securities laws, ERISA and tax laws.

Each of these areas is discussed in more detail below.

Political/Precedential Considerations

While this advisory largely focuses on the legal issues that fund sponsors should consider in responding to such investor requests, one of the most important issues that fund sponsors must confront is the political and precedential effects of their actions in this regard. Fund sponsors will desire to maintain the goodwill of their investors and, as a result, will be motivated to find solutions for their investors’ liquidity constraints. The second portion of this advisory is intended to provide some alternatives to fund sponsors to consider in order to address their investors’ liquidity constraints while also protecting the fund’s interests as a whole.  As part of protecting the fund’s interests, fund sponsors should be sensitive to the precedential impact of their actions in respect of any individual investor. Even if allowing an individual investor to withdraw or reduce its commitment does not trigger a contractual “most favored nations” right of other investors (as discussed below), other investors may nonetheless expect similar treatment. The concerns associated with each of the factors discussed below (for example, the fiduciary duty concerns associated with permitting an investor to withdraw or reduce its commitment) are heightened if a large number of investors are permitted to withdraw or reduce their commitment and ultimately the stability of the fund may be threatened by such events.

In the context of an open end fund where the fund’s organizational documents contemplate periodic redemptions and where a large number of investors could concurrently request redemption, these issues may be exacerbated. Redemption requests raise concerns both with respect to future liquidity needs as well as concerns with valuations given the current economic uncertainty. To the extent that an open-end fund receives or expects to receive a large number of redemption requests which the fund manager does not deem it prudent to satisfy, the fund may feel the need to defer or suspend redemptions depending on the fund’s rights within its organizational documents. In such circumstance, a fund manager may desire to pre-emptively discuss the fund’s strategy and future operations with investors to explain why it is prudent to limit or suspend redemptions.

Fund Organizational Documents

The fund’s organizational documents should be carefully reviewed to determine whether the fund sponsor has discretion to take the contemplated actions.  For example, the fund agreement will generally not allow for capital calls other than on a pro rata basis and will generally not be structured to accommodate allowing individual investors (but not all investors) to reduce their commitment and thereby be overfunded relative to their revised commitment.  Also, the fund agreement may provide that investor withdrawals are prohibited except in limited circumstances, such as to avoid ERISA violations or to avoid the fund having ERISA plan assets.  While the fund sponsor will typically have authority to permit transfers, the fund’s organizational documents will often contain provisions limiting the ability to effect transfers if the transfer would adversely affect the fund’s tax, ERISA or other status, or its ability to borrower under its credit facility, and the fund sponsor will be subject to the fiduciary duties and liabilities discussed below in determining whether to permit a transfer or a withdrawal.

Open end funds should carefully review their redemptions provisions, including when investors may elect redemptions, limits on the amount that can be redeemed, timing with respect to redemption requests and payments, ability of the fund to elect to not satisfy redemption requests (including obligations to use reserves or sell assets) and ability of the fund to suspend redemptions.

The fund sponsor should also carefully review the default provisions set forth in the fund’s organizational documents.  As part of considering an investor’s request to reduce its commitment, withdraw, transfer, redeem or defer capital calls, the fund sponsor should assess the ability of the investor to fund future capital calls if such request(s) is not honored and the fund’s remedies in the event of a default. While many of the issues discussed in this advisory are also relevant to defaults, addressing investor defaults also raises additional issues which are beyond the scope of this advisory.

Legal Considerations: Fiduciary Duties; Broker-Dealer; Confidentiality; Disclosure

Fiduciary Duties

A fund sponsor is subject to fiduciary duties to the investors in its fund. The nature and scope of those duties are in large part defined by the laws under which the fund is organized and the terms of the fund’s organizational documents. In addition, if the fund’s assets include “plan assets” subject to ERISA, the fund sponsor’s decisions with respect to such investor requests (whether or not the specific requesting investor is itself subject to ERISA) will be subject to the ERISA fiduciary standards applicable to such a fund. If the fund manager is registered as an investment adviser with the SEC then it will need to comply with the fiduciary duties imposed by the Investment Advisers Act of 1940 and the fund manager’s own policies and procedures.  As a general matter, when considering a request from any investor in this context, the fund sponsor should consider the interests of the fund as a whole. As a result, in considering whether to allow a particular investor to reduce its commitment or withdraw to defer capitals calls, to permit a transfer or to permit a redemption, the fund sponsor should consider the effects of these actions on the other investors and on the fund as a whole, such as:

• How will this action affect the fund’s ability to implement its intended business strategy, to fund its future operations and/or fund planned development activity?
• Will this action require other investors to fund a greater portion of their capital in particular assets and thereby reduce their diversification in those assets?
• Is this action inconsistent with the expectations of other investors?
• Will this action expose the fund or its management to risks of failing to qualify for securities law, ERISA “plan asset” exceptions, ERISA prohibited transaction exemptions, or tax exemptions or failing to achieve certain intended benefits or otherwise have an adverse impact on any other investor?
• Will this action reduce the borrowing capacity of the fund under its subscription secured credit facility or any other credit facility? and
• In the case of redemptions, can the value of the interests be appropriately assessed?

Because individual investors may be in different positions with respect to their own allocation issues and liquidity constraints, fund sponsors may find themselves in a difficult position in trying to accommodate all of their investors’ needs. In this regard, fund sponsors should consider all of the facts and circumstances and bear in mind their fiduciary duties to the fund as a whole.

Broker-Dealer

In the case of transfers, fund sponsors need to be careful not to act as a “broker” by taking too active a role in facilitating the transfer, which would require registration with the SEC and/or implicate state law requirements.  The determination of whether the fund sponsor is acting as a “broker” or the transferee or transferor qualifies as a “client” of the fund sponsor will vary depending on the particular circumstances.  Acting as a broker or adviser in connection with a transfer may also raise ERISA fiduciary concerns.  Accordingly, fund sponsors should consult with their counsel to address these issues prior to becoming involved (either directly or through any affiliates) in any transfers, particularly if an ERISA investor is involved.  Taking an active role in facilitating transfers could also implicate the “publicly traded partnership” rules (as further discussed below), and tax counsel should also be consulted.

Confidentiality

As part of permitting a transfer, the fund sponsor will generally be asked to provide a limited waiver of the fund agreement’s confidentiality requirements in order to permit the transferor to disclose certain fund information to the transferee. Accordingly, it is important that the waiver narrowly and precisely define the extent to which the transferor is permitted to disclose confidential fund information to the transferee, that each prospective transferee enter into a confidentiality agreement whereby it agrees to protect all such information it receives, and that the fund sponsor have confidence that such confidential information will in fact be protected.

Disclosure Requirements; Anti-Fraud Provisions

In evaluating an investor request to withdraw or reduce its commitment or defer capital calls or redeem its interest, fund sponsors should consider the disclosure obligations to prospective and existing investors.  

With respect to prospective investors if a fund is in the midst of capital raising, a fund sponsor is liable under federal and state security laws if, in connection with selling securities, it makes an untrue statement of a material fact or omits to state a material fact that is necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. A significant reduction in commitments to the fund or significant redemptions may require a fund sponsor to disclose to prospective investors that the existing fund size and/or target fund size has changed. Moreover, a fund sponsor would need to consider how such a reduction in commitments or redemptions and the prospect of possible future reductions or redemptions may affect the future stability of the fund’s resources and whether the actual and/or potential impact of these changes is a material fact that should be disclosed to prospective investors.  Any agreement to defer capital calls for a period of time would require a similar analysis.

Investment advisers (whether or not registered) are subject to certain anti-fraud provisions under the Investment Advisers Act. With its adoption of an anti-fraud rule in 2007 targeting investment adviser conduct with respect to pooled investment vehicles (including registered funds and certain unregistered funds), the SEC served notice that it will be devoting particular attention to not only the conduct of fund sponsors and disclosures made in connection with fund offerings, but also fund sponsor conduct and disclosures with respect to existing fund investors.  Given the SEC's heightened sensitivity to the treatment of prospective and existing fund investors and the rule's relatively high standard of conduct (mere negligence may result in a violation), fund sponsors, particularly those registered with the SEC and subject to inspection, will want to consult with their counsel to analyze their proposed responses to investor liquidity needs in light of these anti-fraud provisions.

Contractual Obligations

Side Letters

Certain fund investors may have side letters containing “most-favored-nation” (MFN) provisions which enable such investors to elect to receive similar rights as those granted to other investors in their side letters (subject, in some cases, to size or other limitations). Those MFN provisions must be carefully considered when a fund sponsor is faced with a request from an investor in this context. Depending on the nature of the MFN provisions, permitting an investor to withdraw, reduce its commitment, redeem or transfer may allow other investors to exercise similar rights under their MFN provisions. As noted above, even if an investor is not able to elect a right to take similar action based on a MFN right, fund sponsors should also carefully consider the precedential effect of permitting an investor to take any of these actions and whether it will lead other investors to seek similar treatment.

Credit Facility Implications

A real estate fund’s subscription secured credit facility may be the most viable near term liquidity solution for many funds and investors. However, fund sponsors must pay careful attention to the “rules of the road” with respect to these facilities when evaluating investor requests for withdrawals, commitment reductions or transfers.

It is important to note that most credit facilities obligate the borrower (the fund) to deliver to the lender prompt notice of any notice it receives from any investor that the investor will not fund a capital call, wants to terminate its commitment, wants to redeem its interest, wants to transfer its interest, or take other similar actions relating to the investor’s capital commitment (this may be true even if the fund sponsor has no intention of honoring such a request). Similarly, the borrower is obligated to provide simultaneous notice to the lender of any notice the borrower sends to any investor(s) in this regard.

The fund sponsor should be cognizant of the potential impact many of these actions may have on the fund’s borrowing capacity under the credit facility. If the investor at issue is “Included” for purpose of calculating the fund’s borrowing base under the credit agreement, any withdrawal, commitment reduction or termination, redemption or transfer would result in an “Exclusion Event” whereby that investor’s capital commitment would be excluded from the borrowing base. Note that any default by an investor with respect to its subscription obligations, including a failure to fund a capital call, will also result in an Exclusion Event.  In addition to reducing the fund’s overall borrowing capacity, in certain cases an Exclusion Event may necessitate a significant capital call upon the investors in order to re-balance the credit facility.

Unfortunately, many credit facilities include an even more problematic remedy for the lender in the case of certain investor defaults. While the Exclusion Event remedy is intended to address particular investor default issues, if investors constituting 15% or more of the total fund capital commitments default in funding their capital commitments, it is often the case that an overall event of default is deemed to have occurred under the facility, entitling the lender to demand repayment of the entire facility. This is a scenario that should be carefully monitored and thoughtfully anticipated, with a goal of never crossing such 15% default threshold.

When considering an investor request, the fund sponsor must be aware of the credit facility lenders’ consent rights in this regard. Typically, any termination or reduction of an investor’s capital commitment or withdrawal will require at least the Administrative Agent’s consent, and very often the consent of all or a percentage of the lenders in the syndicate. In more recent credit facilities, investor transfers do not require lender consent, but may require a significant capital call in order to re-balance the credit facility. Fund sponsors should also keep in mind that there is a common exception to the “non-recourse” nature of these credit facilities as they relate to the fund sponsor in cases where the fund sponsor consents to any of these types of investor requests without obtaining the requisite lender consent, with the result being that the lenders could sue the fund sponsor directly for any losses the lenders incur in that instance. An overlay to this consent requirement is the fact that many of the older subscription lines are currently significantly below current market rates and, as a result, lender consents may be conditioned upon the fund agreeing to provide some form of economic incentive to the lenders.

ERISA, Tax and Other Considerations

Fund sponsors should carefully consider the effects of any proposed withdrawal, commitment reduction, redemption or transfer on the fund’s ERISA or tax status or on any intended tax benefits. As discussed above, permitting a withdrawal, commitment reduction, redemption or transfer that has any of these effects may result in liability for the fund sponsor.

ERISA

A proposed commitment reduction, withdrawal, redemption or transfer of an interest should be evaluated from the perspective of the fund’s ERISA “plan assets” status. In particular, if the fund is relying upon the “less than 25% benefit plan investors” exception from plan assets status, the fund sponsor should take appropriate measures to ensure that the reduction, withdrawal, redemption or transfer will not threaten compliance with such exception.  Any assignment documents should contain representations designed to confirm such compliance.

In addition, transfers to or from an ERISA plan can potentially constitute a non-exempt prohibited transaction under ERISA or Section 4975 of the Code which, in turn, would typically require rescission of the transaction and payment of excise taxes, which could be significant. Accordingly, fund sponsors should consider including representations in the transfer documents from both the transferor and the transferee to the effect that the proposed transfer will not give rise to a non-exempt prohibited transaction under ERISA or Section 4975 of the Internal Revenue Code of 1986 (the “Code”) or constitute a violation of any comparable law applicable to government plans.

Finally, funds relying on the “venture capital operating company” exception or “real estate operating company” exception from plan assets status should consider whether any potential commitment reduction, withdrawal, redemption or capital call deferral could have an impact on the fund’s ability to satisfy the 50% “good assets” test applicable to these exceptions.

The foregoing concerns may also apply to plan investors not subject to ERISA. Those investors may be subject to laws, rules or regulations similar to ERISA or may require such treatment as a contractual matter.

Tax

Reductions in commitments, transfers, redemptions and withdrawals all need to be evaluated in light of the fund’s tax-related transfer restrictions and any other potential tax impact on other investors in the fund (including the fund sponsor). The nature and extent of the potential tax issues will depend on the structure of the fund and the terms of its organizational documents. Fund sponsors should carefully review the tax implications of any such actions with their tax counsel and accountants.

Fund sponsors of funds that utilize REITs in their structures need to evaluate whether any potential reduction in commitment, transfer, redemption or withdrawal may result in the REIT potentially failing the prohibition on REITs being “closely held,” failing to maintain its status as a “domestically-controlled REIT,” or becoming a “pension-held REIT.” While the covenants contained in the fund’s organizational documents and side letters need to be reviewed, the fund sponsor should also evaluate whether an action proposed to be taken could otherwise adversely impact other investors, as such actions could raise fiduciary duty and/or investor relations issues.

For any fund that is organized as a partnership, transfers should be evaluated in light of the “publicly-traded partnership” rules and any transfer restrictions related thereto in the fund’s organizational documents in order to ensure continued treatment as a partnership for federal income tax purposes.

For any proposed transfer by a non-US investor, fund sponsors should be cognizant of certain rules enacted under the Tax Cuts and Jobs Act (the “TCJA”) relating to transfers of partnership interests by non-US investors. These rules generally subject such non-US investors to tax on the gain recognized, to the extent that a sale of the partnership’s underlying assets would have given rise to income effectively connected with a U.S. trade or business if sold for fair market value. In such a case, the transferee is also generally required to deduct and withhold 10% of the amount realized by the transferor.  To the extent a transferee fails to so deduct and withhold, the fund itself could be liable for such withholding, implemented by withholding from distributions to the transferee a tax in an amount equal to the amount the transferee failed to withhold (plus interest). While the requirement for a partnership to withhold has been suspended by administrative guidance, fund sponsors should take steps to ensure as a matter of diligence that either no withholding applies to the transfer or, if such withholding does apply, that the transferee will properly withhold the appropriate amount. Fund sponsors should also be aware that they may be asked to provide certain tax-related certifications to the parties to a transfer to assist them in determining whether such withholding applies.

Fund sponsors should consider if aggregate transfers could result in an ownership change under the tax rules for any corporate portfolio company or other corporate subsidiary and the implications of any such change, including potential limitations on the use of any net operating loss carryforwards.

If the fund has a built-in loss on its assets (i.e., its adjusted tax basis in its assets exceeds their fair market value), a transfer of interests in the fund may require the fund to adjust the tax basis of its properties under Section 743 of the Code. To the extent the fund is a “fund of funds,” invests through joint ventures, or otherwise holds its investments through lower-tier partnerships, any such lower-tier partnerships may also be required to make a “743 adjustment” in respect of transfers of fund interests. These adjustments could result in significant additional accounting costs and complexity for the fund and for the lower-tier entities. Depending on the terms of any lower-tier partnership agreement, the fund may be liable for any such additional costs incurred by the lower-tier partnerships. In most fund agreements, the fund-level costs will be passed along to the transferee and/or transferor, but fund sponsors should review their fund documents carefully to understand the exact extent to which they may be entitled to pass along such costs, especially as it relates to lower-tier partnerships, and should discuss any potential 743 adjustments with their accountants.

Any proposed reduction in the capital commitments or contribution obligations or a redemption of one or more investors may raise issues for a fund if the fund’s organizational documents are structured to comply with the “fractions rule” or if it otherwise liquidates in accordance with capital account balances. The limitations inherent in those forms of agreements may prevent the investors from fully achieving the intended economic result of the reduction, potentially leaving too high or too low a balance in some investors’ capital accounts vis-à-vis others. Also, arrangements that result in management fees that are not strictly proportionate to commitments are generally not permitted under the fractions rule, and thus alternative approaches may need to be considered. Fractions-rule funds may also be limited in their ability to specially allocate expenses associated with a transfer to the transferor and/or the transferee. Withdrawals at a discount to fair market value could raise fractions rule issues for a fund as well as potential tax issues for the non-withdrawing investors in the fund.

Except where prohibited under the fractions rule, reductions in capital commitments of some investors may require future income allocations to be made in a manner that adjusts the investors’ capital accounts to be in proportion to their new commitment percentages (assuming the reduction is intended to apply to both pre-existing and future investments). This may cause additional taxable income to be allocated to either the investors that are having their commitments reduced or the remaining investors, depending on the circumstances. Any such adjustments may require amendments to the fund’s organizational documents and therefore may require investor consent.

For fund sponsors that utilize a contribution waiver/fee offset, take special distributions in lieu of management fees and/or have waived certain carried interest allocations and/or distributions (in light of the change in law under the TCJA that generally requires a more than three-year holding period in order to get long-term capital gain treatment on carried interest gains), any reductions in commitments may result in additional risk that the fund will not generate sufficient gains (or depreciation recapture, if applicable) to permit the fund sponsor to fully recover the waived fees or waived allocations and/or distributions.  Any such arrangements should be carefully evaluated with tax counsel based on the applicable situation to determine the potential impact on the fund sponsor.

What can a fund sponsor do to address the fund’s capital needs while being responsive to investor liquidity constraints?

For real estate fund sponsors who have recently raised a fund and have made no or limited investments, to the extent that there is a lack of acquisition opportunities or a limited desire to make new investments in the short term, this may mean that there is not an immediate need to call capital from investors. For these funds, the lack of immediate need to call capital may be enough to assuage investor liquidity concerns. In this regard, fund sponsors should be careful not to commit to refrain from calling capital unless they are also willing to inform the lenders under their credit facility and potentially inform all of the other investors. Alternatively, there may be an opportunity for such fund sponsors to obtain investor consent to extend the fund raising period or investment period (or both) in consideration for agreeing to not call capital for a period of time. This may be beneficial both to investors with immediate liquidity concerns and to fund sponsors who do not expect to be able to invest the entirety of their capital commitments in the near term due to the current freeze in the credit markets. This may also lead to investors seeking a reduction in the management fee charged on commitments during the period of time that the fund manager expects to make limited investments.

For real estate fund sponsors who are facing immediate capital needs or who are dealing with investors whose liquidity issues require them to take immediate action, they may consider the following:

• Utilizing the credit facility as an alternative to capital calls;
• Favoring transfers over withdrawals or reductions in commitments;
• Making distributions that are subject to recall to increase borrowing capacity; and
• Permitting limited commitment reductions or redemptions.

Utilizing the Credit Facility

Increased or continued borrowing by the fund under its credit line as a substitute for making capital calls in the near term may be viewed as a favorable approach by many investors with liquidity concerns, while also minimizing many of the sponsor concerns mentioned above. Investors who may have been somewhat skeptical of the fund’s use of these credit facilities in the past or may have sought restrictions on the time period that borrowings under a credit facility can be outstanding before they are repaid with capital contributions, may now favor borrowings and not repaying borrowings with capital calls, and this turn of events may present opportunities for fund sponsors to bolster their borrowing base under the credit line and their flexibility with regard to its application. The following are a number of ways to accomplish the foregoing:

• To the extent that the current fund documentation includes limitations on the use of the credit facility (such as a requirement that no draw under the credit facility may remain outstanding for more than a specified period of time), the current economic environment may present an opportunity to revisit the same with the investors and perhaps liberalize those provisions by way of an investor approval process.
• The credit facility may impose certain “concentration limits” on the investors for purposes of calculating the borrowing base that perhaps could be liberalized.
• The credit facilities often include an upsizing “accordion” feature that should be promptly considered and discussed with the Administrative Agent.
• Certain investors may have failed to deliver the requisite documentation (e.g., parent entity comfort letters) and/or financial information to the credit facility lender in order to allow the fund to receive maximum borrowing base credit for those investors’ capital commitments. Now may be the time for the fund sponsor to revisit those issues with such investors in order to maximize the fund’s borrowing capacity, and the investors at issue may be more willing to cooperate if the alternative is a capital call.
• Fund sponsors must typically deliver to the lenders annual financial statements for all non-rated “Included” investors in order to maintain their Included investor status in the credit facility’s borrowing base.  If the delivery of such information is not otherwise an obligation of the investors under the fund documentation, fund sponsors have historically been reluctant to ask investors for such information. Again, the current need to maximize borrowing capacity and the investors’ desire to postpone capital calls may suggest that the time is right to make these requests for financial statements to the extent they are required by the lender to maintain Included investor status.
• Fund sponsors should consider their extension options (if any) under their credit agreement, and anticipate how and when to most effectively initiate the same. Relatedly, if the fund sponsor is considering an extension of the fund’s investment period as mentioned above, a coincident extension of the term of the credit facility should also be pursued with the lenders.
• As discussed in more detail below, fund sponsors may consider distributing operating cash flow and/or capital event proceeds to the investors if the fund has the ability to recall such capital pursuant to its organizational documents. Such distributions would increase the fund’s borrowing capacity under its credit facility by increasing the aggregate uncalled commitments of the investors. Note that if this distribution option is to be pursued, fund sponsors should not be quick to permanently reduce the maximum size of the credit facility as capital calls are made, which is often done for purposes of minimizing the unused fee payable by the borrower. Those reductions are typically permanent and might negate the fund sponsor’s ability to build up the fund’s borrowing capacity via distributions.
• Fund sponsors should keep in mind that subscription line proceeds typically can be used for any permissible fund expenditure, including paying down other debt or even making distributions to investors.

Favoring Transfers

As compared to alternatives of reducing commitments or permitting withdrawals or redemptions, permitting transfers is generally a more favorable approach for the fund sponsor. Because the size of the fund does not change, transfers do not generally expose fund sponsors to the same level of risk that the fund will not be able to execute its business strategy or to claims by other investors that the fund sponsor is violating its fiduciary duties by not acting in the best interests of the fund as a whole.

However, as noted above, fund sponsors need to consider a number of factors in permitting transfers, including the qualifications of the transferees, credit facility lender consents, effects on the credit facility’s borrowing base, tax aspects of the transfer and protecting the confidentiality of fund information. A number of these matters can be addressed through coordination with the credit facility lender and requiring transferees to execute confidentiality agreements and assignment documents that confirm investor qualifications. Fund sponsors should also consider the change in make-up of the fund’s investors (both in respect of the fund sponsor’s current fund and subsequent funds) if institutional endowments, pension plans or foundations are replaced by secondary market funds or other secondary market investors.

Distribute Rather Than Reserve

Rather than reserve cash proceeds in order to fund capital needs, a fund may be well served to distribute such cash to its investors, assuming it has the ability under its organizational documents to recall such capital. This approach would address investor liquidity constraints in two respects. First, it provides investors with cash distributions, and second, the ability to recall such capital means that the fund will have greater borrowing capacity under its credit facility. The fund can therefore continue to borrow off of the credit line in lieu of making capital calls for a longer period of time. The consequence for the investors is that they will have immediate use of the cash to address their current liquidity needs. The fund sponsor should carefully review its credit facility documents and organizational documents to determine whether this is a viable option. The fund sponsor should also clearly note to investors that such returned proceeds are subject to recall in order to avoid a situation where investors have not adequately planned to meet such future recall.

In the event that the fund’s organizational documents do not permit a recall of distributions, the benefit to investors of making current distributions may be an opportunity for fund sponsors to seek to amend the fund’s organizational documents to permit or expand upon the fund’s right to recall distributions.

Limited Commitment Reductions or Redemptions

While giving investors the option to reduce their commitments or satisfying redemptions requests would generally be expected to be an alternative of last resort and needs to be considered in light of the fiduciary issues and other factors discussed above, doing so on a limited basis may engender investor goodwill and prevent a “run on the bank.” This approach may be especially attractive to larger funds who expect difficulty putting all of the capital to work in the current environment, particularly if the fund sponsor’s economics are not significantly damaged.  In the case of an open-end fund experiencing significant redemption requests, a limited pro rata redemption coupled with an explanation of the fund’s going-forward strategy may dampen demand for significant further redemptions. As noted above, however, any such limited redemption would need to be assessed in light of future capital needs as well as concerns regarding valuations.

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