Contingent dislocation funds: What are they and how they can help sponsors and investors take advantage of market opportunities

Amid the current environment of market uncertainty – in the wake of a number of bank failures and bailouts – private fund sponsors will need to be nimble in offering new products that are able to react to investor needs and market demands.

With that in mind, we sat down recently to discuss, in this podcast, how contingent dislocation funds (or CDFs) can be used to capitalize upon recent market events. They also used the opportunity to talk through the common features as well as the different variations they see, as well as the risks that come with managing them and investing in them.

Here is a short summary of some of the points we discussed. To listen to the full podcast, please click here.

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.

Some common features of CDFs include:

• 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.
• 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.

Who do CDFs appeal to?

• In general, we see CDFs offered by fund sponsors with investors who trust them to manage these relatively new and unusual vehicles.
• CDFs also appeal 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.

What are the risks?

• 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.