Contingent Dislocation Funds: Nimble Structures Built for Market Events

In this Ropes & Gray podcast, asset management partners Melissa Bender and Jessica Marlin discuss how contingent dislocation funds can be used to capitalize upon recent market events. They discuss mechanics, event triggers, pros and cons of different capital call structures, and how these funds can help sponsors and investors take advantage of market opportunities.

Transcript:

Jessica Marlin: Welcome to this Ropes & Gray podcast. I’m Jessica Marlin, a partner in our New York office, and today, I’m joined by Melissa Bender, a partner in our San Francisco office. We are part of Ropes & Gray’s global asset management practice. On this episode of our credit funds series podcast, we’ll be discussing contingent dislocation funds (or CDFs), and sometimes also referred to as market dislocation or contingent capital funds. In the current environment with market uncertainty in the wake of a number of bank failures and bailouts, we think it will be important for private fund sponsors to be nimble in offering new products that are able to react to investor needs and market demands. We’ll be discussing the features of CDFs, the different variations we see, and the risks that come with managing them and investing in them.

A CDF is typically structured as a private vehicle or a sleeve of available commitments in which a sponsor is only permitted to call capital once a dislocation event, or trigger, occurs. A dislocation event can be any market disruption. Recent examples of dislocation events include the 2008 financial crisis, the COVID-19 pandemic, and Russia’s invasion of Ukraine. Another type of trigger might be tied to a change in an index or other market events that signal a transition from a bull to a bear market. In launching CDFs, sponsors are looking to take advantage of an unexpected market event or a movement on an immediate basis, and having the capital at the ready allows them to move swiftly to make new investments. Typically, if the event doesn’t happen after some period of time, LPs are released from their commitments.

CDFs were born out the 2008 financial crisis as a way for fund sponsors to take advantage of opportunities in the bear market. During the COVID-19 pandemic, we saw sponsors scramble to take advantage of the temporary downturn in the market. As the economy enters a new period of uncertainty, it’s likely we’ll see an increase in opportunities to invest in CDFs. Melissa, do you want to discuss some of the key features of CDFs?

Melissa Bender: Sure—thanks, Jess. Similar to PE or credit funds, CDFs are typically private, closed-end vehicles that require a commitment up front. CDFs, like PE or credit funds, have a drawdown mechanism, but a CDF’s drawdown mechanism is triggered upon a market dislocation event. As Jess mentioned, in some cases, we’ve seen CDFs structured as a sleeve of commitments available in an open-end fund, although this is a less common. CDFs primarily invest in liquid assets, like public securities or debt, although this is not universally true. The investment period in a CDF is a shortened version of that of a PE or credit fund, with one unique feature—the dormancy period. During the dormancy period of a CDF, an investor’s commitment is binding, but the fund is inactive. The dormancy period can be any range, but we often see a range of anywhere from 12 months to more than four years before expiration, with most funds being somewhere in the middle. During the dormancy period, sponsors must balance having dry powder available in the event that the dislocation is triggered with LPs’ interests in deploying capital in the near term.

Once the dislocation event is activated, a CDF will have a limited investment period followed by a harvest period. A CDF’s investment period and harvest period are significantly shorter than that of a typical PE or credit fund.

CDFs are most commonly established as a commingled funds, but we have also set them up as single investor funds. As is the case with many single investor funds, the terms are often highly negotiated and tailored to the investor’s needs.

Alternatively, a CDF can be structured as a bolt-on vehicle that serves as a supplemental commitment to a main fund, where the bolt-on vehicle is only drawn on during a dislocation event. When using the bolt-on structure, the CDF will usually have the same investment strategy as the main fund, offering sponsors additional dry powder when a market dislocation event occurs. Sponsors can tailor the timeline, terms, and size of a bolt-on CDF based on various factors such as investor base, market opportunity, and ability to deploy capital. For example, the sponsor of a high demand main fund can require participation in a bolt-on CDF. This type of structure may also be employed in an open-end fund, with investors who participate in the CDF only having exposure (or having increased exposure) to the opportunistic investments.

Theoretically, CDFs can follow any investment strategy and invest in any type of asset class. However, CDFs usually focus on certain asset classes, with credit and distressed equity being the most common. Regardless of the strategy or asset class, it’s important to keep in mind that the premise behind the vehicle is that when the market trigger event occurs, the sponsor is able to quickly take advantage of the dislocation. Therefore, CDFs generally avoid illiquid assets, which require more complex due diligence, and thus, longer investment lead times. However, given that the U.S. economy may be facing a tighter public debt market in the wake of recent bank failures and bailouts, CDFs may be ripe to take on private credit opportunities despite the fact that they’re less liquid than their broadly syndicated or publicly traded alternatives.

The rate and structure of fees charged by CDFs are similar to those of PE or credit funds. However, management fees are usually not incurred until a market dislocation triggers the investment period. Nevertheless, given the nascent nature of CDFs, the differences in strategies, and the fact that fund sponsors’ will have varying leverage when negotiating with prospective LPs, it is difficult to determine the “market norm” for CDF fees. Jess, can you discuss some of the other unique features of dislocation funds?

Jessica Marlin: Sure—thanks, Melissa. Let’s dive deeper into the dislocation events, capital calls, and flexible structures that characterize CDFs.

First, the dislocation event or economic trigger that kicks in a CDF’s drawdown mechanism can take many different forms. Typically, the dislocation event is based on data points that have been an indicator of distressed cycles in the past. Some examples of such economic triggers include an average monthly high-yield bond spread exceeding a specific amount, the option-adjusted spread of several indices exceeding a specific amount over a trailing predetermined period, and high-yield default rate exceeding specific historical averages. One risk of investing in a CDF with an economic event trigger is the potential for a false signal, or a “flash crash,” where the trigger is activated as a result of a “false positive” in the market, and the investment period begins without any worthwhile opportunities available for investment.

To protect against a flash crash, sponsors usually carve out the discretionary right override a dislocation event, keeping the CDF in the dormancy period despite hitting the event trigger. Flash crashes can also be avoided by using a “maintenance trigger” in place of a market event trigger. If a maintenance trigger is used, the trigger conditions last for a predetermined length of time before the drawdown mechanism is activated. While an objective trigger is attractive in that it provides certainty, some degree of sponsor discretion or the ability to obtain a waiver of the trigger may be necessary in order to avoid triggering the CDF or missing an opportunity when unforeseen circumstances arise in the market. Some of the triggers have the feature built in depending on the specific index that it refers to.

As an alternative to using the quantifiable triggers we just discussed, some CDFs have a list of quantifiable market inputs that the sponsor must weigh to determine whether a trigger has been breached, giving the sponsor more discretion over whether to call capital and start the investment period. Such inputs may include longer-lasting downgrades of ratings, changes in spreads, and financing trends. Some CDFs even allow for a trigger to be activated in a sponsor’s sole discretion.

As a practical matter, sponsors always retain some amount of discretion over whether the investment period has been triggered.

CDF sponsors also have some flexibility when it comes to capital calls. There are two main approaches. The preferred approach, used in most CDFs, is for sponsors to wait until the market dislocation event has happened to trigger the fund’s investment period. Sponsors will then call portions of LPs’ committed capital in intervals. The length between capital calls is usually at the discretion of the sponsor, and sponsors will typically have the right to call all of the capital immediately following the dislocation event in their discretion.

In a minority of CDFs, sponsors will call capital on the closing date of the fund, before the investment period has been triggered. Sponsors will then hold that capital in relatively liquid investments, so they can easily and quickly redeploy the capital once the trigger event has occurred. This is easier if the sponsor already operates a cash management or similar liquid vehicle where they can park the cash. This approach enables sponsors to quickly begin investing when the trigger event occurs, avoids hitting investors with unexpected capital calls, and could provide sponsors with the cash to cover early organizational expenses. However, this minority approach has several downsides. For example, sponsors must actively manage the liquid investments, conduct audits and issue K-1s for the vehicle, among other administrative and expense burdens before making any performance-generating investments; investors also experience a cash drag on the liquid interim investments; and the clock on the preferred return may begin to toll as of the initial capital call. For these and other reasons, most CDFs are structured so that capital is not called until the market dislocation is triggered.

As we’ve discussed, CDFs are flexible in structure and offer sponsors more discretion than other private investment vehicles. One other unique feature of CDFs is that sponsors can potentially build in mechanisms to convert the vehicle to a longer-term or different structure in the future. We’ve seen CDFs that are originally designed to be closed-end with the flexibility to convert into an open-ended fund or an evergreen fund, or have the ability to roll assets over into a new or different fund. Conversion mechanisms can be appealing to both sponsors and investors, as they leave open the possibility that performing assets can continue to perform in a new structure and continue to be held while they continue to appreciate. Nevertheless, conversion features carry certain risks, including difficulties in determining what types of features will be desirable five years from now and LPs who later decide they don’t want to participate in the converted fund.

Melissa, do you want to discuss the types of sponsors and investors that CDFs might appeal to?

Melissa Bender: Happy to. There are certain types of sponsors and investors that are better suited for CDFs when compared to others. In general, we see CDFs offered by fund sponsors with investors who trust them to manage these relatively new and unusual vehicles. CDFs are also appealing to sponsors because they allow them to quickly take advantage of distressed market conditions while avoiding the barriers they might face if they were to hastily launch a fund once an economic downturn occurs. Often, sponsors fail to launch vehicles in time during temporary downturns, whereas CDFs can begin investing as soon as the market dislocation event occurs. We often see institutional investors invest in this type of fund, as they are able to make commitments to more novel structures and without the expectation that capital will necessarily be put to work in the near term.

Let’s also touch on the risks associated CDFs. The downsides to investing in a CDF are very similar to the risks of investing in other types of funds. One unique risk to sponsors of CDFs is that they may put time and effort into raising a CDF only to find that they never deployed the capital because the dislocation event is not triggered before the dormancy period expires. LPs also face this risk—they may pay organizational expenses for a fund that never enters the investment period. Even if the dislocation event is triggered, there may not be sufficient opportunities in the market to invest all of a fund’s available capital during its relatively short investment period. Likewise, in the event of a flash crash, LPs may experience a prolonged cash drag because there are not actually adequate investment opportunities to take advantage of following the drawdown. Sponsors of CDFs are also faced with the risk that LPs may default on their commitments during an unexpected market dislocation event. For this reason, sponsors may choose to limit CDFs to LPs who sponsors are confident will have cash available in a market downturn. Marketing CDFs also poses certain challenges as they are new and unique products, and the terms do not fall within industry “standards” such as those you might see in a PE or credit fund, so allocators may struggle with how to bucket them.

Sponsors should also consider allocation issues. To the extent sponsors are managing multiple vehicles that have the ability to make similar investments as the CDF, they will need to consider how those opportunities will be allocated if and when the CDF dislocation event is triggered. Obligations to the existing fund may in fact limit the opportunities available to the CDF.

Lastly, we note that given the complexity of the CDF product, it is essential to have experienced counsel working with you and sharing their in-depth knowledge—from designing fund terms to disclosing the risks, to managing the fundraise and addressing inevitable investor questions and concerns.

Despite these complexities and risks, CDFs are nimble vehicles that are likely to become more popular in the days ahead given the current ongoing market uncertainty. Thank you, Jess, for joining me for this discussion, and thank you to our listeners. Please visit our website at www.ropesgray.com/assetmanagement, or feel free to reach out to any of us at Ropes & Gray via email or phone for more information on CDFs or other topics of interest in the asset management industry. You can also subscribe to this Ropes & Gray series wherever you typically listen to podcasts, including on Apple and Spotify. Thanks again for listening.