Can Redemption Notes Help Manage Liquidity
Liquidity in private investment funds is rarely simple. Investors often expect to receive cash when they redeem, but some funds use Redemption Notes instead.
These notes give the fund time to meet redemption obligations while protecting liquidity for remaining investors.
What Are Redemption Notes?
A Redemption Note is an unsecured, subordinated debt instrument issued by the fund. The fund uses these notes when it cannot immediately pay redemptions in cash because of illiquid investments or market conditions.
Instead of paying investors in cash, the fund issues a written promise to pay later — usually within five years or less. Once issued, the note serves as full payment for the redeemed units, turning the investor from an equity holder into a creditor of the fund or its Sub-Fund.
How Redemption Notes Work
When a unitholder submits a redemption request, the fund decides whether to pay in cash or issue Redemption Notes.
- Investor Choice: Investors can accept the notes or defer redemption until a later valuation date when cash may be available.
- Automatic Withdrawal: If investors refuse the notes, the redemption request is automatically withdrawn for that portion.
- Issuance: The notes are issued by the Master Fund or a Sub-Fund that holds limited partnership interests in the Master Fund. The issuer’s ability to repay depends on the value and liquidity of those assets.
Redemption Notes cannot be traded or transferred easily. Investors must hold them until maturity or repayment to receive value.
Do Redemption Notes Change in Value?
Redemption Notes have a fixed face value, determined at issuance — usually equal to the redemption value of the investor’s units. Their value does not change with the fund’s NAV.
However, the actual amount recovered may differ:
- If the fund realizes investments at or above book value, investors receive full repayment.
- If the assets underperform or remain illiquid, repayment may be reduced or delayed.
Because these notes are not marked to market or tradable, they do not gain value like equity. They are static claims that depend on the fund’s ability to generate liquidity.
Can Redemption Notes Bear Interest?
Some funds may issue interest-bearing Redemption Notes to compensate investors for delayed payment. This approach is uncommon but can help maintain investor confidence during liquidity challenges.
Funds may add interest to:
- Offset the time value of money for long-term notes,
- Preserve investor goodwill, and
- Reflect standard market practices for deferred payments.
Most private funds issue non-interest-bearing notes because they are meant to bridge short-term liquidity gaps, not generate returns.
Implementing Redemption Notes When Not in Fund Documents
If a fund’s governing documents do not already authorize Redemption Notes, managers must take formal steps before issuing them.
Key steps include:
- Reviewing existing fund documents for redemption flexibility,
- Consulting legal counsel on whether an amendment or consent is required,
- Securing investor approval through a formal consent or resolution,
- Updating offering documents to define terms (maturity, ranking, interest), and
- Communicating transparently about the rationale and repayment plan.
Proper legal review and investor engagement protect the fund’s governance and maintain investor trust.
Redemption Notes vs. Side Pockets
Both tools help manage illiquidity but operate differently:
- Side pockets keep investors in the fund by isolating illiquid assets until realization.
- Redemption Notes move investors out of the fund by replacing their equity with a debt claim.
- Side pockets fluctuate with asset values, while Redemption Notes remain fixed until repayment.
In short, side pockets delay liquidity within the fund; Redemption Notes defer payment outside the fund.
Redemption Notes vs. Gates
Gates restrict redemptions before they happen; Redemption Notes defer payment after approval.
- Gated investors stay in the fund and redeem later.
- Redemption Note holders become creditors waiting for repayment.
- Gates usually apply across all investors, while Redemption Notes may apply selectively.
Both mechanisms protect fund stability but affect investors differently.
Risks and Considerations
Redemption Notes introduce specific risks:
- Credit Risk: Repayment depends on the fund’s financial strength and asset performance.
- Liquidity Risk: The notes are illiquid and may take years to repay.
- Recovery Risk: Investors may receive less than the face value if assets underperform.
- Currency Risk: Notes may be denominated in another currency.
- Tax Risk: Redemption Notes are not qualified investments for Registered Plans (e.g., RRSPs, TFSAs).
Conclusion
Redemption Notes offer funds a practical way to manage liquidity without selling assets at a loss. They protect remaining investors but shift credit and timing risk to those redeeming.
Managers must handle these instruments transparently and within the limits of their legal framework. When structured correctly — with clear terms, proper approvals, and open communication — Redemption Notes can balance fairness, stability, and trust in the fund’s redemption process.
Please Contact Alex Chapman at [email protected] or 1-203-308-4690 to see if Redemption Notes can work for your fund.