When it comes to forming an offshore investment fund, fund managers have a plethora of options regarding the legal structure of the fund. There are several key legal decisions to be made, including the choice of offshore jurisdiction, type of business vehicle and the fund’s fee structure. One such fundamental, albeit sometimes overlooked, fund formation decision is the choice between employing an open-ended and close-ended fund structure.
The fundamental difference between an open-ended and a close-ended fund pertains to the liquidity restrictions on investors redeeming their subscriptions. For open-ended funds, investors have the choice of whether to partially or completely redeem their subscription on each Redemption Day, subject to the redemption terms specified in the Fund’s offering document. In other words, if investors choose to redeem their shares in the Fund, the fund is obligated to repurchase those shares at a price equal to the NAV-per-share on the relevant Redemption Day. Close-ended funds on the other hand provide no internal mechanism for investors to redeem their subscriptions. Investors’ subscriptions are tied-up for the lifetime of the fund unless investors can find a buyer for their shares on the secondary market. If investors are unwilling or unable to sell their shares in the fund, then investors will not receive the value of their shares until a time of the fund manager's discretion: sometimes not until the point at which the fund is wound-up.
Liquid versus illiquid assets
Liquidity restrictions on redeeming investors’ shares in the Fund tend to mirror liquidity restrictions on the Fund’s underlying assets. If the Fund wants to invest in illiquid assets such as real estate, unlisted companies and other alternatives, then it is likely that the Fund will need to put restrictions on investors’ ability to redeem their shares. Otherwise, the Fund may be unable to satisfy investor redemption requests due to its inability to realise the fair value of its illiquid investments in a short period of time - what is sometimes referred to as a 'liquidity gap'. This also protects non-redeeming investors by ensuring that non-redeeming investors do not implicitly subsidise redeeming investors as a result of the Fund’s liquidity being compromised by excessive investor redemption requests.
When it comes to fund regulation, open-ended funds are subject to jurisdictional regulations whilst closed-ended funds are exempted from offshore regulation. This is because close-ended funds fall outside the definition of a mutual fund as a result of the fact that investors' equity interests are not readily redeemable. However, close-ended funds must still comply with AML regulations and are subject to the same FATCA and CRS registration and reporting requirements as open-ended funds.
Alternative liquidity restrictions
Ultimately, a close-ended structure may not be suitable for all types of fund – especially funds investing in liquid assets where investors may not wish to hold their investment for a prolonged period of time. Blanket restrictions on investor redemption requests represent a significant limitation on investors' ability to redeem at will, so fund managers should only countenance such restrictions when there are restrictions on the liquidity of the Fund's underlying assets.
Nonetheless, open-ended funds can still include certain provisions to manage the liquidity of investors’ shares such as side pockets, lock-ups and gates. Side pockets allow funds to separate liquid from illiquid investments such that illiquid investments are held in a separate share class of which investors are given a pro-rata share. Shares in the new side pocket class can only be redeemed when the illiquid assets can be accurately valued, which ameliorates the liquidity issues arising from investors redeeming their shares during periods in which the fund cannot realise the full value of its illiquid investments. Alternatively, lock-up periods can be used within a participating share class to effectively prevent investor redemptions within a given timeframe. If investors choose to redeem their investment during the lock-up period, then they will have to pay a substantial redemption fee which disincentivises investor redemptions until the lock-up period comes to an end. Gates, on the other hand, allow fund managers to suspend investor redemptions when there are significant net outflows from the fund in order to maintain the liquidity of the fund’s assets.
As a result, the wide variety of liquidity mechanics available to fund managers ensures that liquidity management does not fall solely within the domain of portfolio management but further pertains to the legal structure of the fund. As alternative investments gain increasing popularity with fund managers around the world, understanding the implications of open-ended and close-ended fund structures will only continue to grow in importance.