Creating “Recovery Classes” to Help Raise Hedge Fund Investor Capital

In light of recent volatility in the markets and generally lackluster performance in the hedge fund industry, many investors have seen their hedge fund investments lose value. Consequently, raising new capital and retaining existing capital has become increasingly difficult for hedge fund sponsors. Not surprisingly, one of the most commonly asked questions of late by fund sponsors is: Are there any creative structures to help raise and retain capital for their funds?

One possible solution is to utilize what are colloquially referred to as “recovery classes.” The way that a recovery class generally works is as follows: In a typical hedge fund that charges an incentive allocation – subject to a standard “high water mark” – separately with respect to each contribution made by an investor, an investor whose fund account is “under water” may invest new money in a newly established recovery class and avoid being subject to an incentive allocation on that new money until the aggregate net asset value of the investor’s capital in the fund recovers all of the previous losses. Consider the following example, suppose that an investor has contributed a total of $100 to a fund that charges an incentive allocation on each capital contribution subject to a standard high water mark, and the value of that investment has since declined to $25 (such that the investor must recoup the $75 of lost value before the fund sponsor may receive an incentive allocation on that investment). Now suppose that the fund creates a new recovery class and that investor invests $100 of new money in the recovery class (for a total current investment value in the fund of $125). Under a recovery class structure, this investor will not be subject to an incentive allocation on the new $100 investment until the value of its overall investment surpasses $200 – i.e., the sum of the current value of its initial investment ($25), the new money contributed to the recovery class ($100) and the amount subject to the high water mark on the initial investment ($75). After surpassing $200, the investor would be subject to an incentive allocation on its initial $100 contribution even though that particular contribution would still technically be under water for purposes of the loss recovery account.

This arrangement provides an incentive for existing investors to contribute new capital to the fund in return for the prospect of deferring an incentive allocation on any increase in the value of that new capital until the investor’s prior losses are recouped. Recovery classes generally are not difficult to set up and, as highlighted above, may have benefits both for fund sponsors and investors.