Hybrid Funds: New Buzz or Combo Basket?
April 16, 2021
By Nevil Thakkar
With a growing private equity market, more and more traditional hedge fund managers are allocating a portion of their capital to illiquid investment opportunities, while still managing a liquid portfolio. For an investor, it’s a combination of exposure from both sides – it may still allow the manager to exit positions in a liquid portfolio while committing a portion of its investments for the long term. Unlike a golf course with only one sport, the hybrid structure resembles an Olympic stadium where two or more sports are conducted in parallel under one roof.
On Thursday, April 8, EisnerAmper hosted a webcast titled “The Latest Trends & Concerns for Hybrid Funds” to discuss this topic and address challenges and considerations.
- David Goldstein, Director, EisnerAmper (moderator)
- Tim Eberle, Senior Vice President, Citco Fund Services (USA) Inc.
- Keith Miller, Partner, EisnerAmper
- Kevin Neubauer, Partner, Seward & Kissel
Each hybrid fund structure can be different. How the fund works will depend on the individual terms defined in the offering documents. It is important to avoid ambiguity as much as possible in the offering documents and clearly explain how the mechanics of the fund, including fees, classes of capital, and the interaction of different classes of capital (e.g., transfers between liquid and illiquid capital) will work. This will eliminate subjectivity and hopefully help avoid potential errors in the financial records. Offering documents should seek to eliminate differing interpretations of key terms and should be as mechanical as possible. An investment manager should leverage the expertise of its fund formation attorney to the fullest while completing the process of drafting the offering documents.
In a hybrid structure, capital can be called and deployed for mixed use (such as to acquire both liquid and illiquid investments). There is not necessarily a single identification method as to what proportion of the capital subscribed into the fund will be deployed between liquid assets or illiquid assets.
The investment manager may invest idle cash from capital subscriptions into the capital markets, following an open-ended trading setup, as opposed to a PE structure wherein capital is called to invest in illiquid deals.
As capital moves from a main (or liquid) capital account into side pocket (or illiquid) capital accounts at different points in time, the waterfall calculation (if any) can become quite challenging to account for. Due to this complexity, it is necessary for the fund’s administrator to possess both experienced staff and correct technology to be able to handle the complexities of a hybrid fund’s capital structure and waterfall. Using a standard spreadsheet for allocations and the waterfall carried interest calculation is not advised as a best practice for such a fund structure.
There are many ways to structure a hybrid fund. The fund’s structure will likely ultimately be based on the investor group’s level of interest in a particular asset class (or classes) and the intersection between different asset groups. There are various ways of bifurcating a hybrid fund’s capital structure, including using side pockets, special purpose vehicles, or specific classes/series. The auditor will want to ascertain whether the capital structure works as it was intended and that capital and net income allocations are fair and equitable. Again, it is important the fund structure has a clearly defined mechanical process for handling allocations between different investors and groups of capital, and also transfers between these different buckets. It is not advisable for a manager to attempt to handle this in a subjective way or make decisions as issues arise in real-time. For example, when a new investor joins the fund and the manager wants to allocate a share of previously acquired illiquid assets to the new investor, the manager should refer to the clearly defined process, rather than considering the allocation in the moment.
Other audit considerations include calculating the fair value of illiquid investments. For a manager from a more open-ended fund background, it may be advisable to utilize the help of external valuation service providers in this process.
An evergreen closed-end fund structure may be a suitable choice for IRR disclosures. However, in a hybrid scenario where the timing of redemptions may not be aligned with the disposition of private investments, a time-weighted return may be a more meaningful statistic for the investor.
The best way to approach a hybrid fund structure is to have a robust plan in place at each stage of the fund’s design and development, and to use service providers experienced in hybrid fund structures. The complexity and flexibility of the hybrid structure will continue to grow and will continue to attract investors who are looking for more flexibility than can be offered in a single traditional hedge fund structure.