Q3 2020 - Hybrid Funds
September 01, 2020
It is no secret that the COVID-19 pandemic prompted many hedge funds to shut down. Many of these funds had common characteristics, including a simple capital structure, an investment portfolio comprising a large number of varied exchange traded securities, and a consistent inability to outperform the S&P500. Some of these funds had only reached a first or second birthday.
Alongside this, there has been a rise of index tracking ETFs and increased interest among managers to offer “retail” products. These provide beta to investors at a fraction of the cost of a traditional hedge fund, with greater liquidity and transparency. Is the hedge fund dead? Or is it a case of waiting long enough and everything comes back into fashion?
However, despite the hard times faced by certain managers, many successful hedge funds have outperformed. Common themes include a focus on specific related investment sectors; the manager acquired deep expertise, practical knowledge and experience in its specialty industry focus area. Often the manager had obtained a related advanced formal education (such as an M.D. operating a biotech life-sciences fund). The fund didn’t seek to “offer all things to all people” and filled a specific gap in an investor’s overall strategy, holding concentrated positions in a smaller number of companies to generate alpha. Many funds also provided exposure to both public and private investments, holding around 20% of capital in non-marketable illiquid investments. Could this be the future of hedge funds?
By holding both publicly traded and private investments, these funds could nicely position themselves at the corner of “hedge fund street” and “private equity avenue.” These funds all have certain characteristics:
- Liquidity, through an open or partially open fund structure that, unlike true private equity funds, doesn’t lock up investor capital for ten or more years. Investors retain the flexibility to redeem capital as their own personal circumstances require. This may be especially attractive in uncertain times such as the current pandemic.
- Potential exposure to the widest spectrum of investment opportunities, including exchange listed securities, marketable and non-marketable debt, derivatives contracts, private equity and venture capital investments, and real estate. This breadth of possible target investments potentially gives the fund an advantage in being able to access the best of all possible worlds to generate alpha in a way index tracking ETFs cannot. Also, unlike private equity funds, the investment mandate is not limited to private investments that require many years to return capital to investors.
- A fairly sophisticated capital structure offering flexibility, customized risk exposure, differing liquidity and fee terms within the same fund on a relatively individual investor basis.
Such funds weren’t constrained by the “one size fits all” nature of a vanilla hedge fund; or saddled with the illiquid long-term nature of a closed-end private equity fund.
Flexibility considerations incorporated into these funds’ capital structures included:
- Giving investors the ability to opt into, be carved out of, or gain greater exposure to certain asset classes or specific investment opportunities.
- Certain funds used the above concept to help investors avoid potentially disastrous tax consequences, such as carving investors out of asset classes that presented an issue (e.g., investments generating UBTI or ECI); while the other investors in the fund enjoyed the full returns on such investments.
- For a standard hedge fund holding illiquid assets, liquidity can be a double-edged sword. Allowing an investor to fully redeem its entire capital balance can disproportionately expose the remaining investors to illiquid assets. A previously “liquid” fund could end up significantly comprising illiquid assets not sellable at fair value for an indeterminate time. Conversely, where the illiquid investment became the superstar in an otherwise liquid portfolio, the capital structure must remain equitable to all investors as the fund allows further capital activity. Investors must not feel “cheated” either as subsequent investors dilute current investor ownership; or former investors feel they weren’t provided with good information on the illiquid asset’s potentially significant future gains before fully redeeming capital.
- Providing a range of fee and liquidity choices; allowing investors to pick a combination that best met their preferences – a higher management fee for a lower performance allocation, a range of hurdle rate choices, a lower management fee/profit allocation for a longer capital lock-up.
- Allowing capital to be contributed and denominated in multiple currencies or allowing investors to manage or limit their own risk exposure to investment asset classes denominated in other currencies.
Such capital flexibility can be achieved through fund accounting concepts including:
- Multiple share or interest classes – these can bifurcate an investor’s capital into multiple sub-capital accounts to control exposure to a portion of the fund’s overall investment portfolio or illiquid assets. This concept can also be used to provide differing fee and investor liquidity arrangements without the need for side letters.
- Side pockets to house illiquid or other “special situation” investments. Side pockets can be created when an investment is acquired; or alternatively, individually as an investor fully redeems its liquid capital.
- Special allocations such as automated true-ups between investor liquid and illiquid sub-capital accounts. Such mechanisms can provide new investors with exposure to previously acquired illiquid assets, or “rebalance” investor relative exposure to the fund’s liquid and illiquid investment portfolios after subsequent fund capital activity.
- Multiple feeder or special purpose vehicles (SPVs) that feed into one or more Master Funds. This concept adds cost in terms of entity formation, audit, tax, and fund administration, but it partitions legal liability and can clean up a structure by formally housing different assets in different legal “buckets.”
- Series funds - this entity structure is similar to the concept of multiple share classes; however, a series fund should legally insulate assets and capital held in one series against legal liability or claims occurring due to events in other series. However, series funds generally require more work to prepare the fund accounting, annual audit and tax returns.
One or a combination of the above concepts might offer a more equitable or intriguing exposure to different asset classes and fee/liquidity terms under the same roof than otherwise possible in a simple comingled fund. A bespoke structure can be created applying the vision of the fund manager and the practical knowledge of the outside accounting firm and fund attorney.
The additional complexity in a hybrid fund does require increased expertise to operate it over a plain long/short fund.
Issues that must be addressed in managing the fund include:
- Complexity of accounting records. A competent third-party fund administrator is crucial and can bear most of the workload to strike the monthly net asset value (NAV). It is imperative that the fund administrator be involved in pre-launch planning alongside the auditor and attorney to ensure it understands all nuances of the structure. This will minimize later corrections during the year-end audit.
- Fund documents. The devil is in the details in articulating how the capital allocations, share classes, and other mechanisms will work; also, to ensure there are no asymmetries, mathematical anomalies or other side effects in the mechanics after these are “translated” into written words for the operating agreement.
- Potential regulatory and fiduciary issues, compliance issues and conflicts of interest. Fund counsel and outside compliance services can advise on the risks and management of such matters.
- Style drift. Also, as the fund builds out its investment portfolio, it is critical it remains compliant with any restrictions in its offering documents.
- A competent dedicated Chief Financial Officer/Chief Operating Officer (CFO/COO), either internal or outsourced, is necessary to effectively review the fund accounting NAV each month and ensure the capital allocations are computed correctly. The CFO must verify that all features of the fund’s capital structure are working as intended, for example ensuring side pockets are unwound equitably.
- Private investment valuations require significantly more attention than marketable securities. Competent personnel with sufficient expertise and capacity must oversee the ongoing valuation of the illiquid investments. Consideration should be given to the use of an outsourced valuation specialist if such expertise cannot be found in-house. The manager must ensure its valuation policy and methodologies remain sound; and that supporting documentation is prepared, retained and updated, along with the calculations for the valuation marks. The auditor will request to see this during each year-end audit (and a regulator will likely ask to see this during an examination).
- Expense allocations. Careful consideration must be given that expenses and fund overhead are allocated between different classes, side pockets and entities in an equitable manner. Costs identifiable to specific investment portfolios should generally be allocated only to investors participating in such assets. Expense allocations should be clearly documented and supported, both for the purposes of the monthly NAV and year-end financial statement audit, and also for a possible regulatory examination.
Obviously, no one fund structure can guarantee investment success any more than another. However, the flexibility and diversity that can be incorporated into the hybrid fund structure may allow a manager to offer a compelling investment solution for investors who are no longer excited by the traditional hedge fund.
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