Considerations for Liquidating a Hedge Fund

It is no secret that the COVID-19 pandemic has prompted a surge of hedge fund liquidations, often due to turbulent markets impacting performance and difficulty raising assets; and further, founders of many prominent hedge funds decided it was time to retire, prompting younger talent to start their own firms. EisnerAmper sat down with William Bakker, CEO, Double Header Solutions, which provides outsourced CFO/COO/CCO services for alternative investment firms and family offices, to discuss how funds can seamlessly execute wind down to meet their investor fiduciary obligations before they move onto their next endeavor.   

EISNERAMPER:

What are the things firms need to consider when shutting down their hedge funds?

BAKKER:

There are many things firms need to consider when shutting down their funds. Typically, the first step is notifying their prime broker to sell their portfolio so they can make the final distributions to investors. Then, they contact their accountants to do their final audit and tax returns.  While the final audits are being performed, the fund’s administrator will facilitate an initial distribution with a 10% holdback until the audit is completed.   After that, they work with offshore legal counsel to liquidate their offshore corporation, deregister with the U.S. Securities and Exchange Commission and the offshore body, whether it be a Cayman Islands structure or some other jurisdiction.

Constant consultation with the fund’s prime broker, fund administrator, fund auditor/tax firm and onshore/offshore law firms are extremely important to get investors their capital back in a timely fashion. 

Investment advisors need to be reminded they have a fiduciary duty to liquidate the fund in a professional, timely manner and avoid negligent behavior.  We recommend having one point person at the firm to be assigned to oversee all of these service providers.   

EISNERAMPER:

What things do firms need to consider on the management company side?

BAKKER:

On the management company side, there are a handful of things to consider, primarily human resources (HR) functions.

The HR functions of a fund’s management company are generally handled by professional payroll organizations (PPOs), which handle COBRA and 401(k) distributions to employees. However, PPOs will need the managing member of the management company to authorize these steps to move forward. 

One issue is with respect to employees who do not respond to notices to move 401(k) money to another retirement vehicle.  A management company cannot close until all moneys in the 401(k) are distributed.  Thankfully, there are service providers that will accept 401(k) money into their own IRA vehicles and they will be responsible for contacting the departed employee so the management company can close.  Also, a final Form 5500, the annual return of an employee benefit plan, is required and that is prepared by the PPO and signed by the managing member.  

Other things that need to be sorted at the management company level include terminating office leases, insurance for commercial liability (E&O at the fund level), copier leases, Bloomberg Terminal contracts, etc. All of these should be carefully reviewed with attention to renewal dates to make sure contracts are not “automatically” renewed.

With respect to management company/GP entities, final payments to members should always be made in accordance with the respective operating agreement.  We see very complex profit/loss allocations received from the underlying fund as well as how management company expenses are allocated.  Those calculations should be carefully reviewed before payments are made.

EISNERAMPER:

Can you discuss the tax considerations for funds when shutting down?

BAKKER:

Closing a fund at year-end is preferred to avoid having to file a tax return in the subsequent tax year.  Any income generated in a fund in the year after the date established as the liquidation period will require a tax return filed in that subsequent tax year.  That is why it is important to have a fund with no positions in it before date of liquidation.  Non-marketable securities are tricky but can be solved by putting in a Liquidating Trust.

EISNERAMPER:

Information security has become more prominent with the majority of the funds industry working remotely during COVID-19. What IT things do firms shutting down need to consider with respect to their registered documents?

BAKKER:

Most firms outsource their IT functions. If funds have all their documents on an internal server, they need to move them to the cloud.

EISNERAMPER:

What about the name of the fund? What do firms need to do when shutting down?

BAKKER:

The funds themselves need to file a Certification of Cancellation with Delaware. Every fund pays registered agent fees to do this.  However, before they file the Certificate, they need to do a final tax return and close their bank account. In addition, if they have an offshore fund, they have to notify the respective regulatory body in that jurisdiction of the closure.

EISNERAMPER:

Are there any final thoughts you would like to share?

BAKKER:

Firms should try completing their liquidation in a twelve-month period. Firms need to recognize that their investor base will demand transparency and will want their capital returned as soon as possible. Allocators are also going to have questions. It is paramount for all investor concerns to be answered; and document retention is key for both electronic and physical correspondence.