How will CD4 investors ever be able to sell or exit their fund?

Summary: It turns out that a majority in all four CD funds voted against E&P's Merger Proposal, and given CD4 investors were the only ones who had any chance of benefiting, it is even more humiliating for E&P that they also voted against - presumably because they simply don't trust E&P! But this leaves CD4 investors with an unresolved key problem: E&P has provided no feasible mechanism for them to sell or exit their investment; they can only wait for distributions that are mostly several years away.

In this post, I excerpt the shocking truth about what the CD4 PDS said about the ability to sell/exit, and then recommend what a responsible entity should do immediately (list the fund).

Thanks to E&P there is still no right to exit for CD4 at any time!

Details:

1. The CD4 PDS was appallingly designed to trap investors for many years and should never have been recommended or advertised to anyone by any ethical advisor, platform, broker or fund

I was genuinely appalled at what I actually found in the fine print of the 100pg PDS. If the key statements revealing this trap were highlighted to prospective investors (e.g. the way I have below), I doubt virtually any would have invested in it.

pg 12: Term of the Fund

"The Fund does not have a fixed investment term and is designed for the long-term investor. The Responsible Entity intends that the Fund will hold investments indirectly through the LP for up to 10 years and to make distributions as the investments are realised. There will be no right to redeem Units unless the Responsible Entity chooses to make a pro rata withdrawal offer. When the Units are fully paid, the Responsible Entity may seek to publicly list the Fund in order to provide liquidity. Investors are cautioned that an investment horizon of less than 10 years in the Fund may not provide sufficient opportunity for an increase in the value of underlying investments of the Fund."

pg 17. Unit Liquidity Risk

"Once the Units are fully paid up, the Responsible Entity may apply for the Fund to be listed, or if it remains unlisted the Fund may return capital to investors by way of capital distributions as investments are realised. However, neither outcome can be guaranteed. Unitholders may have limited or no opportunity to realise their investment in the Fund as there is no fixed term for the Fund, there will not be a right to redemption of Units unless the Responsible Entity chooses to make a pro rata withdrawal offer, and the Fund will be unlisted. While there will not be a ready market for selling Units, the Responsible Entity has the discretion to permit transfers."

pg 33. 5.4 Liquidity, redemptions and transfers

"Once Units have been issued under the Offer, investments in the Fund should be considered illiquid. The Fund will not have an ongoing or periodic redemption facility. 

The Responsible Entity retains the right, but has no obligation, to provide liquidity to Investors and if it decides to do so, it will notify Investors and advise them of its policy for redemptions or withdrawals, which will be subject to the Fund’s constitution and the Corporations Act.

Investors may be able to exit the Fund by transferring their Units to a third party. Please note there is no ready market for transfers of Units and there is no guarantee that Investors may find a purchaser for their Unit holding. The Fund’s Constitution provides that all transfers of Units must, among other things, be in a form approved by the Responsible Entity and will only be effective upon entry into the register of Unitholders. Notably, the Responsible Entity may refuse to record any transfer in the register without giving any reason for the refusal."

pg. 36. 6.1 Specific investment risks to the Fund: g) Investment horizon and default risk

"Investing in private investments requires a longer term commitment to the asset class, typically five to 10 years, and this will mean that realisation of value through capital growth may be similarly timed. The ability for the Fund to exit the LP is extremely limited during its life (a maximum of 16 years)."

pg. 40. 6.3 General investment risks: a) Unit liquidity risk

"Investors have no rights to withdraw from the Fund, unless the Responsible Entity makes a withdrawal offer. The Responsible Entity does not currently intend to make any withdrawal offers. As a result, investors will have limited opportunity to realise their investment in the Fund as there is unlikely to be a ready market for selling Units. 

The Responsible Entity considers an investment in the Fund to be a long-term investment. Potential Investors should only invest in the Fund if they are willing to adopt a long-term investment approach.

The Fund does not have a fixed term, but the Responsible Entity expects that the Fund’s investment term will be up to 10 years. It is important that investors understand that if they invest in Units they have no right to exit the Fund, and to receive the proceeds of redemption or a return of capital, at any time. 

In particular investors should have no expectation of an exit right after 10 years and should not invest in Units if a longer, potentially significantly longer, investment term of the Fund, the illiquidity of the Units or no exit rights is not suitable for them. 

Once the partly paid Units are fully paid, the Responsible Entity may seek to publicly list the Fund in order to provide liquidity."

pg. 81. 12.1 LP Agreement

"The LP will continue until the date that it is wound up and dissolved, which will be the earlier of: a determination by the GP to wind up the LP following the disposal of all assets and distribution of proceeds; the withdrawal of the GP from its duties as general partner; of the occurrence of an insolvency event in relation to the GP; or the end of the 14 year term following the initial closing date, such term being extendable by the GP for up to two additional years."

pg. 86. Additional Information: 13.1.9 Withdrawals will be limited

"The Constitution provides for Unitholders to request redemption of their Units while the Fund is liquid, as defined in the Corporations Act, but the Responsible Entity is not obliged to accept or process such requests. Once the Fund’s assets are invested through the LP, the Fund is expected to be illiquid, and he Responsible Entity will only be able to redeem Units pursuant to a pro rata withdrawal offer under the Corporations Act."

2. Did summary or marketing information given to investors suggest better exit liquidity than is actually the case?

The summary information in the PDS Letter of Introduction says:

"We are pleased to offer you the opportunity to invest in Cordish Dixon Private Equity Fund IV (Fund). The Fund is the fourth fund in the Cordish Dixon Private Equity series, comprising Cordish Dixon Private Equity Fund I (Fund I), Cordish Dixon Private Equity Fund II (Fund II), Cordish Dixon Private Equity Fund III (Fund III), and the Fund (together, the Series). For this Fund, the unit pricing structure has evolved so that the per Unit Application Price of $1.60 will be paid in instalments, with the first instalment of $0.32 payable on application."

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It advertises CD4 as a continuaton of CD1, CD2 and CD3 and notes a key change in structure being the partly paid nature but does not flag the massive change to exit liquidity in the structure other than the below statement.
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"While the Fund will not be listed on ASX initially, after the Units are fully paid, the Responsible Entity may seek to publicly list the Fund in order to provide liquidity."

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Compare this single, unalarming statement on exit liquidity with the much stricter constraints I highlighted in Section 1 above. In my view, it is unexcuseable not to clearly summarise the massive structure change to exit liquidity. All the Responsible Entity had to do was include this single summary paragraph that was in the details on pg. 17:

"Once the Units are fully paid up, the Responsible Entity may apply for the Fund to be listed, or if it remains unlisted the Fund may return capital to investors by way of capital distributions as investments are realised. However, neither outcome can be guaranteed. Unitholders may have limited or no opportunity to realise their investment in the Fund as there is no fixed term for the Fund, there will not be a right to redemption of Units unless the Responsible Entity chooses to make a pro rata withdrawal offer, and the Fund will be unlisted."
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3. What was the investment time horizon given to investors in summary and marketing information?

In the fine print I've excerpted, the maximum time horizon for the LP is 16 years and "investors should have no expectation of an exit right after 10 years."

But in the 18th March 2018 ASX announcement of the CD4 IPO it says:

"The Fund will aim to provide investors with capital growth over a 5-10 year investment horizon through exposure to small-to-mid sized private investment funds, as well as direct investments, consistent with the investment strategy of the Fund."

Combined with the fact that the 18th March 2018 announcement makes no mention whatsoever of the exit liquidity constraints and one can understand how investors might be angry if they overlooked this issue in the fine print or were not properly informed by a financial advisor.

I have yet to find other public summary or marketing information at the time of the CD4 IPO, but suspect this failure to adequately warn investors was widespread. If you have copies/links please do email them to me via the About page.

4. What should E&P do about CD4 exit liquidity?

My view is that:

- CD4 NTA performance (18.4% annualised as of 30 Sept 2022) has been excellent and even if current valuation markups are scaled back after the typical lag factors (3 months plus infrequency of transactions), there are still gains over the $1.60 investors have put in (Post-tax NTA is $2.58 at 30 Sept). 

- Investments are early stage and the only reasonable right to liquidity currently is to direct all cash realisations sent by the LP to the Fund to be used for distributions or buybacks.

- CD4 should be listed ASAP as this will allow for full exit liquidity for investors who need it, especially those who didn't understand the constraints of the investment they were buying (e.g. relied on financial advisors or summary information that didn't flag the massive exit issue.)

- In order to avoid a massive NAV discount, a truly responsible entity would be providing much more accurate information on what CD4 is invested in and the reliability of valuations (e.g. by listing all exits versus the last carrying value used in the NTA).

- No new investors will be buying CD4 at NAV (and NAV isn't going to be radically marked down voluntarily) but with more details on what CD4 owns, cash weighting, transaction and realisation history, and its valuation reliability, new informed investors will gradually replace poorly-informed investors who didn't fully understand what they were buying.

See:
> What companies do CD4 LP Funds own as of Sept 2022?
> What can be done to reduce the NAV discount and provide liquidity?

Excerpt from the Explanatory Memorandum:

pg 37:

"Once LITs begin trading at a discount, this becomes a very difficult cycle to break (as seen with the buybacks in Fund I and Fund II which failed to close the discount to NAV at which each of Fund I and Fund II were trading). Further, if Fund IV were listed, it would also be expected to trade at a material discount to NAV."

pg 56:

"Fund IV has provided a significant NAV return of 17.3% per annum since its inception as a result of increases in the fair value of equity investments. Underlying funds are utilising partly-called capital to undertake new investments and fund existing investments with an investment horizon of 5 years to 10 years in order to realise significant gains."