Liquid gold?

Investors and fund managers are increasingly looking to hybrid funds as a route to stability, liquidity and higher yields in these times of economic uncertainty

Economic and social uncertainty arising from the pandemic and the war in Ukraine is helping drive investor interest in one particular investment strategy – hybrid alternative asset funds. 

Amid the uncertain outlook and the growing external pressures, hybrid funds – which are a combination of hedge funds and private equity – are providing investors with the stability they need during these times of crisis. 

Mirek Gruna, IQ-EQ’s Chief Commercial Officer for Jersey, says “going hybrid” with a mix of liquid and illiquid investments can offer the “best of both worlds” for institutional investors previously glued to separate investment vehicles for each strategy. 

Investing solely in closed-ended private equity (PE) funds locks up these investors’ capital for the long term. However, through a hybrid structure – either open or partially open-ended – investors can redeem (take out their capital) or add more cash at specified intervals.

For an open-ended investor, the attraction of gaining more exposure to traditionally higher-return PE funds and more deal-hungry businesses post-pandemic is also obvious. 

Equally, hedge fund-focused managers can be less exposed to potentially disorderly redemption rates by investing in more illiquid assets.

“Hybrid funds started their rise in the 2008 financial crisis, as the chase for yields increased. When the macro situation gets tougher, as we are seeing now post-pandemic and with the Ukraine war, PE investors get more open-minded about hybrid funds,” says Gruna. “They want something they can liquidate without being locked up for a number of years.”

Indeed, a key driver behind the rise of hybrid funds is investors wanting access to the higher risk-adjusted returns generated by private market assets in a time of inflation, rising interest rates and the less attractive fixed bond market.

Managers of open-ended and closed-ended funds have also continued to turn to hybrid funds as a way of tapping into a growing investor base looking for more diversity and flexibility than hedge or private equity funds can offer by themselves. 

“When I first started seeing the hedge fund and PE combination back in 2005, it was often driven by hedge fund strategies that had topped out,” explains Tim Clipstone, Partner at Ogier in Guernsey. 

“They had reached maximum capacity but had more people wanting to invest with them. If they wanted to carry on raising money, an option was to go into less liquid investments. Managers want to provide the liquidity of open-ended funds and the longer-term higher returns you get from PE. 

“We could be seeing those factors arise again, especially with a limited pool of closed-ended assets on the market. Perhaps a hybrid combination makes sense again as a deliberate strategy.”

Added flexibility

In terms of flexibility, Gruna says hybrid funds also offer customised risk exposure, varying liquidity and a range of fee terms that can be adjusted to meet investor needs and the pool of available investors.

Fund managers also benefit from this flexibility, being able to “customise their products and better align with the fund’s underlying investments and their LPs’ preferences”, he says. 
 
Despite this rising trend, there are challenges. Having a hybrid fund means holding different types of assets with their differing fee structures and custodians. 

That in turn means complexity and calls for a level of expertise needed to manage them that is not often found in open-ended or closed-ended focused fund managers. 

Hedge fund managers, for example, need to be au fait with how to value PE investments and assets, while PE fund managers will have to get used to the trading of listed assets.

The managers must also comply with the additional accounting and reporting requirements of the different investments, while still consolidating at the fund or portfolio level.

In a report for the Alternative Investment Management Association (AIMA) last March, Ian Holden, Head of European Hedge Fund Services at fund administrator SS&C, wrote: “With a mix of publicly listed securities and private, illiquid or hard-to-value assets, hybrids entail complex accounting methods. 

“Striking a reliable and accurate monthly NAV can be an arduous undertaking. Investor accounting and profit and loss allocations are also more complex than with a straightforward hedge or private equity fund.”

Clipstone believes there are inherent conflicts in a hybrid fund. “You can see the attraction of a hybrid fund. You can redeem your cash out if you don’t like the change in strategy or direction,” he says. 

“But how do you give people the chance to realise their liquid assets without causing such a run on the fund that you have to also realise those longer-term and higher-return PE investments?”

IQ-EQ’s Gruna agrees, warning that matching cash flows from new and existing investors with underlying cash flows from investments can be a “delicate operation”. 

One answer to that delicate challenge is to ensure that distribution options can be tailored to the liquidity profiles of the underlying investments. 

In addition, Gruna says, expenses and fund overheads must be carefully allocated between different classes, side pockets and entities. As an example, costs attached to specific portfolios should be allocated only to participating investors. All allocations must be clearly documented.

Use of side pockets

Clipstone expands on the potential benefits of side pockets. “Side pockets – or designated investments – in the structure mean that some of the return would be locked up and you limit your redemptions to the liquid portion,” he says. 

“You could also limit redemptions to 50% of the holdings. There are many ways to skin it by creating separate cells within the same entity.”

These side pockets would hold illiquid or hard-to-value assets. It has been reported that they could be abused by fund managers hiving off their poorly performing assets to make the overall performance of the fund look better. But others believe it is a fair solution to having illiquid assets in a supposedly liquid fund.

Gruna says the complexity around these funds is why many fund managers are looking to Jersey and Guernsey for structural solutions. 

“It needs fund administration expertise to get these funds right. It needs strong administration and auditing, and a rigorous reporting environment. You need expert legal advice and tax advisers,” he states. 

“The Channel Islands gives fund managers a good opportunity to structure these funds well. Such funds fit the excellent compliance and regulatory environment here.”  

What they are probably not willing to give a green light to are hybrid funds for retail investors. 

Clipstone says he has not seen such a fund and believes it is unlikely. “It would be quite difficult as these are specialist fund structures,” he explains. “The regulators in Guernsey and Jersey would have some difficulty saying yes to a retail hybrid strategy as they would want to categorise it as open-ended or closed-ended.” 

Handling hybrids

Institutional investors, he argues, are big, tough and experienced enough to understand and live with the risks of a hybrid fund, as long as these are properly disclosed to them and the regulator.

Indeed, the offering documents of these funds should be clear and concise, explaining how the funds work, the side pockets, fees, redemptions – and how the different classes will function together. 

With more traditional funds, interested investors can easily follow the performance of, say, Japanese equities or real-estate-focused vehicles before making a decision on whether it is right for them or not.

But it can be hard for investors to track hedge funds in action in the same way. 

Industry analyst Preqin, according to a recent AIMA report, is tracking 186 hybrid funds and 261 hybrid hedge funds. This means they are classified as either PE or hedge fund depending on the strategy used or the previous experience and background of the manager.

Even when invested in a hybrid fund, it can also be difficult to find the clarity that most investors take for granted nowadays.

Gruna says hybrid fund managers need to respond to the increased expectations of service from investors resulting from the digital revolution. 

In short, they need real-time reporting technologies, which they are used to with their liquid investments, to also better keep track of their illiquid investments.

“If you have an ETF fund, you can look up on your phone any time to see how it is performing. It is difficult to do that with a PE fund,” he says. 

“But investors are now demanding a similar user experience with hybrid funds. As long as providers can offer these AI-driven solutions on reporting and consolidation, then the rise of and appetite for hybrid funds will only increase.”