On-Demand Webcast: The Latest Trends & Concerns for Hybrid Funds

April 08, 2021

Our panelists discussed hybrid funds, recent trends in hybrids, liquidity issues associated with managing a hybrid fund, distribution strategies and more.

 


Transcript

Thank you all for joining this afternoon or this morning, depending on where you're calling in from. I'm David Goldstein, I'm a Director of business development within the financial services vertical of EisnerAmper.

David Goldstein:The financial services vertical includes, hedge and private equity funds, as well as banks, broker dealers, and insurance companies. For those not familiar with Eisner, we are a 2000 person strong firm with approximately 300 partners. We have 17 global offices and we have received accolades and awards from such firms as clearly rated Hedge weak, HFM and institutional investor. We're one of the largest audit and tax firms servicing Hedge and private equity funds today.

We've decided to discuss this topic today because Hybrid Funds is something that I frequently hear from our clients and our prospects and it generally, so I thought we would further explore that. And with that, I would like to ask Kevin to introduce himself and his firm. And then I'm going to ask the term Hybrid Fund has been around for many years and has meant different things to different people. Can you please give us a definition of what a Hybrid Fund means to you today? Advising your clients on such structures.

Kevin Neubauer:Thanks, David, I appreciate it. And it's great to be here with everyone. Again, my name's Kevin Neubauer. I'm a partner in the investment management group at Seward and Kissel in New York. We work with private fund managers, forming various types of alternative funds and also provide associated regulatory advice. So thanks again for having us great to be here, but to your question, David, and I think it's a good one. What do people mean when they say Hybrid Fund?

And I think the term means different things to different people. The way that I think about it is, there's really sort of three flavors of them that we see most commonly. And, but before I get to that, just in general, a Hybrid Fund, I think combines both components of an open-end liquid fund as well as a closed end illiquid fund. And so there's various structures within that spectrum that we see. And the three flavors, I would say, one something that looks awfully similar to a private equity fund, but operates in a different way. We see this on the credit side sometimes.

So you'll have investors make a capital commitment. That's drawn down by the GP to make investments. And then, one of those investments are disposed of. The cash is distributed out through a Waterfall. The difference though, for some of our particularly credit fund clients is that they'll call all the capital on day one, unlike in a traditional private equity fund where it's drawn down on an as needed basis and they'll invest the assets very quickly and then have a broad ability to recycle capital throughout the investment period, much more so than you'd see in a traditional private equity fund.

The other distinction we sometimes see with this sort of flavor is that given that the assets tend to be relatively liquid vis-a-vis or at least compared to a private equity fund, sometimes you'll see the management fee being charged at net asset value, like a hedge fund. And sometimes you'll see the subsequent closing mechanic work like it would it a hedge fund where if an investor comes into the fund at a subsequent closing, rather than buying in at cost like in a traditional private equity fund, they buy into their pro-rata portion of the portfolio based on the current value at the time of the closing. So that's sort of the first flavor.

The second which is sort of in the middle, is a fund that is generally speaking an open-end fund, but has a significant ability to make illiquid investments. And they're structured in a couple of different ways to start a classic model is for, a fund manager to have the ability to side-pocket investments into designated accounts that hold their liquid assets. Investors can redeem from the side-pocket accounts they're held until the fund manager decides to liquidate the assets. Oftentimes the P and L from those investments is then, shifted back over to the main account of the fondant. Then it's included within the annual incentive allocation that's charged at the end of every year, that'd be sort of a typical side-pocket model.

But a sort of permutation on that or a development in that area is we're seeing some funds rather than saying we're going to opportunistically make side-pocket investments. From day one, each investor really has two capital accounts, liquid capital account and illiquid capital account. And the Fund Manager maybe initially invest in the public portfolio, but then is able to draw from it and make investments in the private portfolio throughout the investors' investment in the fund. It's very similar to a suicide pocket in a lot of ways. Sometimes you'll see, in those funds that rather than the P and L from the private investments being included within the annual incentive allocation on the public side, you'll actually see a Waterfall just like you would in a traditional private equity fund, where the manager gets a portion of the realized gains from those illiquid investments are sold. So that's our category two

And then category three, which I think is something we're seeing more and more of recently. We see it a lot in the credit space, but it's what we'd call sort of an evergreen fund where the Fund Manager, the fund structure a lot like a hedge fund where investors can invest either monthly or quarterly. There's typically an annual incentive fee or allocation, but the assets of the fund tend to be illiquid. And so when an investor submits a redemption request, be it on a quarterly or semi-annual basis, rather than the investor receiving cash redemption proceeds shortly after the redemption date. Instead, the Fund Managers segregates the assets that are attributable to that redeeming investor into a separate account. And then as those investments roll off, the proceeds are distributed to the redeeming investor. And we would call that separate account would be a liquidating account.

And so you could look at it an investor has the right to redeem on a quarterly or semi-annual basis, but put another way, an investor has the ability to cause the manager to no longer re-invest the assets attributable to it. And again, we're seeing sort of more and more of that. I think from the Fund Managers perspective, it's attractive as compared to a traditional closed-end model, because the Fund Manager can continue to raise capital on an ongoing basis. And this is restricted to only raising capital during the fundraising period. So that's very attractive.

On the other hand, those liquidating accounts, depending on the assets that the fund invest in can get really complicated. Particularly when the Fund Manager, maybe let's say it's a loan origination fund, and it has the ability, the borrowers from the fund have the ability to draw down on revolvers. How do you handle that? If you're somebody who's only redeemed from the fund, do you participate? And the additional capital necessary to satisfy the borrower's requests or do you not? And it leads to some difficult accounting and disclosure issues that need to be thought of upfront. So it is very attractive in so far as you can raise capital on an ongoing basis, but a lot of those complications need to be thought through upfront. So there's a plan when they come up as to how to handle.

David Goldstein:Great, thank you very much. That is definitely something that investors and managers have to pay special attention to. And I think we're going to touch on that a bit later in this hour, but with that Lexi, I'd like to put forth our first polling question, which is pretty simple. Do you currently run a Hybrid Fund or anticipating launching one in the next year? Going to give about 30 seconds for people to answer. Just a couple more seconds. Thank you. And I think we're good.

Kind of about what I expected. Although actually I think that the 68% is a little bit higher, but I do know that there's a number of service providers that are on the phone, so they would probably not be launching a fund regardless. But pretty interesting results are evenly split outside of the 68%. So Keith, I'm going to ask you now to introduce yourself and also ask you, a Hybrid Fund, we'll definitely have some complexity associated with it from an accounting standpoint. Can you talk a bit about what that means from an audit and tax perspective?

Keith Miller:Sure. Hello everyone. Good morning. Good afternoon. Good evening. Depending on where you are today. I'm a partner in the financial services group of EisnerAmper, based in San Francisco, California, San Francisco office. Working with really all flavors of private funds from open-ended hedge fund type of structures through close ended, private equity, venture capital type of structures through structures really in the middle, which I guess the Hybrid Fund concept comes under. And really just kind of adding to Kevin's comments that Hybrid Funds obviously all mean different things to different people and folks come out and from different angles as well. Whether they come at it from the more liquid side or more the illiquid side and really what it is that they're trying to achieve, what they feel that investors, a solution that investor is looking for.

And so in terms of the audit challenges and a little bit less on the tax challenges as I'm an audit partner, but I'll talk about them a little bit. I mean, certainly the obvious challenges that mixing up what could be, five or six different funds of the worst case and the best case, could it be two different types of funds that you're kind of putting together under one umbrella. And so certainly there's a lot of all of the usual audit issues that come with that, whether it's an illiquid. An illiquid portfolio with some valuation challenges or even if you're moving to more of a liquid portfolio, and you've got all operational challenges to keep good records that will clearly show what the fund has been doing, what its activity is.

But I think just adding to what Kevin said, the major audit challenge that we really have is the kind of the intersection between the different buckets, the liquid, the illiquid, the different groups of assets that make up the Hybrid Funds. And so one major challenge that we have on the audit side is really a kind of a subjectivity concern. We have a fund, investors put money into the funds. And then really one concern we have is this kind of equity or fairness as to what happens from there. And obviously how capital moves between those two buckets and/or more buckets and really making sure that the economics of what the investors receive is really consistent with the capital that they had at risk and the time that they were in the fund when it was doing those things that caused those results.

And certainly from a fund that's more open-ended in nature, that's an even greater concern. And so one of the major audit challenges we really have is when things start to go off script. So maybe a large investor comes along that we want to get into the funds, maybe there's an investor that wants to contribute more capital, or contribute capital on a more frequent basis. Certainly, there'll be liquid and illiquid opportunities. And that may move over time as to really where the great opportunity is for the fund and managing how capital is deployed between those two buckets.

And the problem on the audit side and the console on the audit side, I've always found is when things get subjective and the manager has to start to determine, what the fair treatment is, and then kind of backing into kind of justification for why we're doing what we're doing. And that gets problematic because for a hybrid structure and the capital structure is complicated, as Kevin also said that you can have multiple classes of capital. You can have side pockets, you can have a lot of different ways of the breaking up those different groups of assets.

And so the key audit issue, and therefore the key advice I would always give on this is, you want the capital structure to be as mechanical as it can possibly be. So you want to think through all the different scenarios that your fund could encounter things that could do, things you might want to do. Whether it is a consideration that you might want to let someone out early, consideration of, you might want to let someone in later that you didn't necessarily know was going to come along, but they're strategically important to you.

And as I say, really eliminating that subjectivity factor, so that it's clear both in your accounting methodology that you put together of how your structure is going to work, and that inflows into your legal documents as to actually how this fund's going to work. Make sure that's clear, make sure you're eliminating possible gray areas. So it does become a very mechanical process. And then as I say, that subjectivity element that really can cause a problem with the audit is removed.

And so one thing I always recommend is modeling the fund structure out in a spreadsheet and have two or three or four hypothetical investors, and work through some scenarios of what you might want to do. And how that plays out, that will help you identify a lot of the challenges where you're thinking about something that feels like a good idea that a hybrid fund can do that no one else is doing. But then when you put it in a model, in a spreadsheet, you realize that there's an issue there in terms of something you might want to do that you really don't have a good answer for yet. In terms of how the mechanics of the allocations will work.

Certainly in terms of planning, planning is extremely important. You get the various major service providers together that you're working with, obviously on the audit side, the admin, keeping the books, the attorney that's distracting the documents for you. Really to think through those issues, ask questions, kind of really plan how the structure's going to fit together? What everyone's going to do? Obviously the admin to think through how their system can cope with the structure that you want to implement.

So that's major audit issues and tips on how to mitigate and avoid some of those problems. And obviously, these structures need a lot more constant monitoring, just to watch the capital allocations to understand what's happening in your funds, how your capital may be shifting between the liquid and illiquid buckets. It is a lot more of a monitoring an emphasis on the CFO to make sure that the things are working as they should be, and in a way that you can defend, and you can articulate for why that's right. And why the fund is working as intended. And as I say, it's something that really the burden falls a lot on the CFO to make sure that that stays to be the case.

And then, really the other major audit issues, that you want to be mindful of, largely all the areas of your portfolio that are new to what you typically would do. So if you're a closed ended manager, that's adding a more liquid portfolio. As I said earlier to think about operationally how you're keeping the records, that you can capture maybe more transactions than you might typically have had in a more closed ended structure. If it's the other way you're coming at it from more of an open-ended world, and you're adding private investments, then valuation can be quite a sharp and quite a challenge to managers where I'm really having to put together a more detailed valuations thinking about calculations, inputs, assumptions.

Maybe whether you need to use an outside valuation service to help you, especially if you're putting together discounted cash flow models or thinking about multiples of revenue, whether that's something that you have capability in house, or you need some assistance on those types of assets. And just a couple of others, expense allocations that's something that's more complicated in a hybrid structure and can be a challenge at all at a time as well.

How you allocate your expenses between different buckets, different liquid, illiquid, different asset classes. In certain costs, obviously like the audit may be spread over really all of your funds, but certain other costs you might be research costs, travel costs that it might be really associated only with the illiquid bucket or one of the illiquid buckets. And to make sure that those costs and expenses are really being allocated to the bucket that is benefiting from those assets. And so again, there's an emphasis on record-keeping, keeping good records of what those costs are, why they were allocated to the bucket. They were keeping receipts, keeping playing travel records, not relying on your credit card statements to keep a clear record of your costs.

Then obviously, fresh statements are a little more complicated audit time when you're fusing together, maybe level three assets with more liquid assets. Certainly there's more disclosures and the various different types of disclosures that go with each of those broad categories of liquid and illiquid assets. So there's certainly more of a burden there in terms of making sure that the financial statements cover all of those areas, staying with that for a moment. Certainly the capital structure is going to have more of a description, more detailed in your financial statements than you might see in more of a traditional open or closed ended structure to really describe how the capital allocations work, as there's every reason that your fund may be more unique, because Hybrid Funds can be lots of different things.

So making sure that, that disclosure is robust. And it really finally thinking about taxes again, coming at it from the angle of what it is you don't currently do now? So if you're adding a more of a private investment structure, then you're thinking about the text issues and texts opportunities that come with those illiquid assets. Whether there are elections that can be made, with structuring the acquisition of the assets that you can use that maybe you're not familiar with in a liquid world, that it's not something you have to worry about now.

And then obviously going the other way, if you're adding more of a liquid portfolio, then you're thinking about whether UBTI is going to be an issue for investors. If you're trading on margin whether the tax, the long-term versus short-term capital gains tax treatment might be more applicable to you. And it wouldn't have been so much before if you're holding assets for a number of years. And even on the carried interest side for more of a liquid portfolio, the kind of one year versus three year rule that concerns open-ended managers more in terms of getting long-term capital gains treatment.

And that bifurcation again, is something that the kind of more of a closed ended fund manager might not need to concern themselves about. So I think the message kind of in summary is planning is absolutely critical. And discussing with your trusted service providers in advance, just really to identify the things you're not aware of now that you need to know in bringing in the component of asset classes to your structure that maybe you didn't have before you launched a hybrid structure.

David Goldstein:It's funny, you just took away the comment I'd written down as you're speaking, which is a good planning, coordination where your service providers and infrastructure is obviously very important, which is a very good lead into our next speaker Tim with Citco. Now, and if I get it as well, and my question for you is there are many challenges from a back and middle office perspective, something I'm quite familiar with having been in the administration field for many years. Can you comment on what you see from an infrastructure standpoint and how service providers can help to minimize some of the challenges that Keith and Kevin have raised?

Tim Eberle:Yeah, absolutely. And thanks, David. And hi everyone. Thanks for taking the time to join this presentation today. My name is Tim Eberle. I'm a senior vice president with Citco Fund Services, a leading fund admin in the private and hybrid space. And I'm primarily focused on technology development initiatives, particularly in the area of carried interest in Waterfall calculations. So I think you'll hear the common theme of the day, the operational infrastructure and tech challenges associated with hybrid funds, particularly as it relates to the back and middle office.

They mainly come when you have a high volume open-ended trading structure, folded into a close ended private equity style capital structure. Is really the first example that Kevin was talking about at the top of this presentation. Meaning that you have high volume opportunistic trading and primarily liquid investments, but it's wrapped into a close ended capital framework. That is at least on the surface, theoretically better suited for buy and hold, long-Term investing funded by strategic draw downs on healthy capital commitments. Because from an operational standpoint, those two things are pretty diametrically opposed.

And in a closed end structure, particularly one that includes a distribution Waterfall and we'll touch on the challenges, Waterfall calculations, and Hybrid Funds. But the character of every dollar that is deployed in the fund or by the fund is paramount, because in close end fund, dollars that do different things are treated very differently. A dollar that's used to fund investments is different than a dollar that's used for CapEX, is different than a dollar that's used to pay management fees, is different than a dollar that's used to pay down a line of credit, so on and so forth. Because when you have a liquidation event, the capital that's recouped by the limited partners is recouped in very specific tronches in a very specific order of priority based on how that capital has been deployed, and on what specific date that capital was deployed.

Because things like IRR and preferred return, those are deals specific concepts and calculations in the incentive fees associated with close ended funds, are generally based on individual deal performance, which is usually measured as an IRR on the capital that has been contributed for those specific goals. As of the date of that specific capital contribution. And that's all something that's relatively easy to track and account for in a more traditional close end private equity structure, where you have relatively low volume trading, that's funded by capital calls that are drawn down for a very specific purpose.

But in the hybrid space, capital tends to be deployed very differently. Because in the hybrid space, particularly the high volume credit space, which seems to be the flavor of this month in the last 150 months. The use of capital tends to be completely agnostic as to the source of that capital, meaning that in the hybrid space, cash is generally treated as fungible. The fund is constantly taking in capital from multiple sources, sure from capital calls like in a more traditional PE fund, but also for sales proceeds from current income, from pick, from corporate actions, from margin, whatever it is.

And then, the fund is just as rapidly deploying that capital back into the market, which is an open-ended trading style that is very well suited for an incentive fee structure, that would be based on something like NAV, rather than IRR, where the capital performance associated with individual deals doesn't necessarily come into play, at least not in the same way. But this idea that cash is fungible and the idea that every dollar is the same as every dollar, and every dollar out is the same as every dollar out. It simply doesn't work in a close ended capital structure. I mean, depending on the LPA, but in general.

And that obviously presents a very significant operational challenge. And because it's sort of my area of expertise, let's walk through a Waterfall calculation as an example. So let's say that I'm a hybrid firm with a mixture of public, private and debt investments. In my LPA still need to meet quarterly with partners, through a deal by deal Waterfall structure. So in a deal by deal distribution, the first thing that my LPs are entitled to is a recoupment of their capital contributions that have been used to fund deals that have been subject to a disposition.

The reality is in a Hybrid Fund, I may not have technically used up capital contribution to fund those deals that I've sold, because I may have bought those deals using current income generated from a completely different investment or more likely I may have recycled sales proceeds from one deal into the purchase of another, or I may have funded multiple deals using PITTA proceeds from a deal that's paid down. And then we need to make a determination as to what actually counts as a disposition for the OTA definition. We're talking about pick is pick a realization event.

Do I need to recoup capital for deals that have been waiting down and liquid investments, based purely on a daily fluctuation of a mark? Does current income need to recoup capital or in that current income flow to the next tier of the Waterfall based on the DOD Waterfall provisions? And the default answer, which is generally we'll just look to the LPA. But look, with all due respect to my good friend Kevin and all the other law firms out there, the LPA is generally not going to speak to the specifics that you need in order to fully account for all of that variability.

But let's say you didn't get beyond that hurdle. We understand what's going back to the LPAs as return of capital. How do we calculate a preferred return on all of that activity? How do we know what dates need to be included in that calculation? If we can't marry the use of capital back to its initial source, since that's what the IRR are based on. I mean in one step further, let's say we can get through that tier of the Waterfall and we are able to calculate carry, how do we accurately attribute carry back to individual investments, if that's what's required for the upper tier compensation or care plan allocation?

So complexity there, and that's where technology and third parties really come into play. Because look, I'm hitting on this a lot but I really do feel that the most significant challenge with hybrid funds from back office and operational perspective, is this idea of tracking the sources and uses of capital. Add a level of granularity required to accommodate high volume trading within a closed ended capital structure. And the unfortunate reality is at least today, there's no one system that does it perfectly. Instead, it really requires a best in breed technology stack that bridges very good portfolio accounting systems like an Admin Geneva, or an Aexio, which is something that my organization Citco uses into a capital allocation system.

Like an Invest tran or AltaReturn or any of the various capital allocation systems throughout there on the market. Because the portfolio system or the deals live, that needs to seamlessly feed into the capital allocation system, so that the character of every portfolio and income event is mapped to a specific capital event, that can then feed into the reporting and the distribution provisions established in the LPA. And the reality is that is not a simple technical task, especially when it comes to things like capital reinvestment and recycling of proceeds, where you need to track cash flows from this deal to that deal, to this expense payment to that follow on investment. Ultimately back to a single capital event on single bait.

And obviously things only get more complicated when you're dealing with leverage in lines of credit. And look, the reality is lines of credit, at least in the short term are going to continue to increase in usage. Especially if interest rates stay where they are. And that's when a fully flushed out service and technical solution really becomes paramount. You need a dedicated service team who fully understands and is able to account for all of the implications and the tracking, the processing of all of these data that's going to be flowing through your system.

I mean, excel in very real personal experience, it's just not a scalable solution. It doesn't matter how phenomenal your VBA team may be, the volume is too high and Excel's processes are just too slow. That system breaks, especially when you're dealing with all of this volume, but also things that keeps mentioning earlier, like subsequent closes and partner transfers. Where those things require an inception to date reallocation of what could ultimately amount to theoretically and practically hundreds of thousands of journal entries on inception to date basis.

And that's where the admin comes in, that's why establishing that relationship is so important. You really want to make sure that when you're partnering with a third party administrator these are the questions that you're asking, how do you track the portfolio? How do you track the capital? How do you marry those two things off? Because that's really in this space, what the administrator, the other third party admin model is for. And honestly, the continuing growth in the number of hybrid funds in the industry, that's been one of the most, if not the most significant driving factor behind what has been a rapid adoption of the third party outsourcing model in the PE space.

Because the admins, they do have the capacity, they do have the expertise to handle these requirements and calculations, but just as importantly, they've got the tech in place. It's not just, kind of a nice to have, like it used to be. It's really a requirement to fully automate these calculations and produce results that are accurate, timely and efficient. And any third party service provider, at least the ones who are SOX compliant. They're also going to have data governance policies and procedures built into that automation. And that requires the data is constantly booked consistently and a little level of granularity that's required to handle all that volume, all the different instrument types, all the different income streams, that really are the hallmark of hybrid investing.

And what you're seeing today in the market is that it really is the third party providers and the administrators who are leading the charge for technology development in the closed-ended space. For example, three or four years ago, the product team at any fund administrator was either tiny or non-existent. And today, every administrator who's worth their salt has a fully flushed out product team, who's really, in a lot of ways leading the business in terms of automating their policies and procedures. And then look, I'm certainly not here today to sell Citco, but as an example, the proprietary Waterfall Calculation Engine we've developed in-house, that we call Sickle Waterfall, because we're accountants and not creative people.

But it's really been a game changer because it's taken a process that can be complicated and convoluted enough, even in a traditional buy and hold LBO traditional PE fund forget about hybrid. And it just applies rules, logic, and transparency fully automates that component of the distribution process. And look, I really feel that that's the way of the future hybrid funds are only going to grow in number and third party technology and service providers will be there to meet the challenge.

David Goldstein:Tim, thank you very much. I have a quick follow-up question for you, something you mentioned, you talked about lines of credit, and I'm just curious as to how many not an exact number, obviously, but are your clients actually able to get lines?

Tim Eberle: Yeah, they are. I would say-

David Goldstein:The credit for these structures. It seems to me that they had trouble extending credit a lot of times to any alternative. Go ahead.

Tim Eberle:Yes, sir. I would say that 85% of our funds across it goes close ended space, and that includes real estate, that includes private equity, that certainly includes hybrid. Have been able to get a line of credit and are actively using it. Sometimes they have to go to different places. It's not always the big traditional guys were giving out LLCs like they used to. But in my personal experience, lines of credit are very very widely used. And the funds like interest is cheaper than PREF, You're able to get capital quickly and yet from what we're seeing, that's only going to become more of the norm.

David Goldstein:Thank you. Sorry folks, I think there's a bit of a delay but hopefully that'll catch up. Lexi, we go to our next polling question which is of the below, what is the most important element that a hybrid fund has to offer? Give everybody a couple seconds to answer that. And please, I would encourage anybody to submit your questions through the Q and A box. Because, we will definitely have time to answer those at the end. A few more seconds. Great. Thank you Lexi, I think we're good. That's exactly what I figured actually. Definitely fits into my experience. So Kevin, if I can go back to you, and it definitely is in response to that polling question, where have you seen the most investment dollars from hybrid funds actually being spent on public versus private markets?

Kevin Neubauer:Yeah, thanks David. It's interesting and not to sound too much like a lawyer, but it sort of depends. So I think if you're an open-end hedge fund manager, I think the attractiveness of setting up a fund like I described earlier, that has a component for private investments is that, maybe the manager's expertise is in public investments and that's why institutional investors selected that manager. But because they're sector focused and they're really integrated in a particular sector of market, they see everything and they see opportunities that aren't necessarily appropriate for their fund, but they don't want to pass them up. And so they want the flexibility to be able to allocate to private investments. And there's a few different ways to do that.

Obviously we talked about side pockets or funds with multiple portfolios. Other managers, instead of going that route, we'll, opportunistically set up single investment vehicles into which they sort of pass the hat around there, open-end fund investors and see who's interested in participating in a particular private investment. Maybe it's a Pre-IPO company or something like that. And set up a vehicle that invests on it. So I'm just in that particular investment. And that's been a very common story over the last, call it five years where you have public equities, particularly public equities manager. And just see so much that's attractive, that doesn't necessarily fit in the public portfolio. And so that's the sort of draw of adding the side-pocket ability or utilizing that flexibility to set up a separate fund.

So where's the most capital going private or public? It's sort of hard to say. I think what we're seeing and what we've been talking about today is, where institutional investors like what a manager is doing on the public side, but are willing to give the manager the flexibility to opportunistically take advantage of private investments that the manager sees. The other sort of way to answer this question is, when an institutional investor really buys into an investment manager and to its investment team. There are obviously the traditional institutional investor allocation model is to have public equities bucket, a private equities bucket, a credit bucket, et cetera.

But there are circumstances where, and this is true with respect to a lot of hybrid fund managers, where institutional investors really trust and have long standing relationships with an investment manager and are willing to defer to the investment manager to be able to choose how to invest its capital, rather than putting them in a particular bucket as they may do with the rest of their portfolio. And so we have a lot of hybrid fund managers that sort of fit that model that are longstanding, have long standing relationships with institutional investors.

And they're in a category of their own for those institutional investors in so far as the investors just trust them to deploy their capital within parameters obviously. But among both public and private opportunities, because there's a level of trust and a level of, the manager has proven itself over a number of years and the investors are willing to sort of defer to them as to what makes the most sense in a particular situation.

David Goldstein:Excellent. Thank you. I've gotten a couple of quick questions that I'm going to throw out just because I thought they were very interesting. One is, will lending be more difficult due to the, I'm not even sure how you pronounce it, Archer goes Debacle. I'm not sure it's really an applicable question because that Debacle was more about margin calls than it was lending, but would anybody like to comment on that on our side? Anybody? Maybe not. Kevin having some construction going on down there.

Kevin Neubauer:Sorry about that. It may be more difficult depending on-

David Goldstein:That's all right. Yeah, yes. Another one we have is what drives the use of a TWR versus IRR in an evergreen structure? Keith, that might be one for you or Tim.

Keith Miller:Actually I think it might be move on to Tim actually.

Tim Eberle:Yeah, sure. So I'll say you generally don't see IRR used as frequently in an evergreen structure. IRRs tend to work in a close ended structure where the fund is going to exist from point A to point B and the timing between point A and point B, and when you call down capital and when that capitalist gets returned to the limited partners, is very important. That's where IRR calculations work best. Although, I will say, even in the close end space, what we're seeing a strong tendency moving away from either one of those structures and starting to do these calculations based much more significantly on multiples.

And you'll see that in Waterfall calculations as well. Whereas, two years ago, you'd be hard pressed to find a preferred return calculation that wasn't an 8% IRR, from the day the capital was contributed to the day the capital's realized. What you're seeing now is the preferred returns tend to be structured as the higher of either 8% IRR or 1.5X or 2X on contributed capital. That's really being driven by the limited partners who, look, they like the time component of things, but they don't necessarily want to incentivize GP to sell early, to do something in IRR when they're only getting an 0.2X on their contributed capital.

So a little bit of a divergence there, but I would say in evergreen structures TWR is generally the way that we go, IRR doesn't come into play. I asked frequently, but in both of those structures, LPAs specifically are starting to look to a MOIC and the less time-based performance hurdles when they're doing their analysis.

David Goldstein:Great. Thank you. Keith, I've got another question for you. What are some of the practical ways that of fund can use to structure itself and its accounting records to actually incorporate a hybrid fund structure?

Keith Miller:Right. So this can run the whole gamut really. From one end, I guess you could say one extreme is that you just literally have one bucket and you just throw everything into it. And if you're allocating based on a commitment rate for more of a closed ended fund or a ownership ratio for an open-ended fund, then that's the way you're going to go. I'm not sure I recommend that, but that's one end of the extreme. And then from there, there's a bunch of other measures and we've mentioned some of these concepts already. So side pockets for illiquid assets is one commonly used measure to break out the different buckets and put the illiquid assets into a side pocket.

Another approach is to set up multiple share classes or interest classes. So to bifurcate between buckets based on that and investors will be in one or more of those classes or for interest groups depending on the structure of the fund and on what's being offered. And another idea that's kind of one level on from that, is to create a whole set per entities. So thinking along the master feeder idea of having multiple masters, multiple feeders that are used to bifurcate those buckets.

That idea obviously, the more entities you have on when you do have a separate entities, then obviously there's overhead that goes with that to be thinking about that audit's tax returns, fund accounting, maybe corporate services, if you have let's say Cayman vehicles as part of the mix. So that's a method that can be used and even on from that, I've seen this concept of a series fund used where, I guess technically everything is under one roof there.

But again, with that legal ring fencing that comes with each of the various classes or groups or buckets within the series funds. Then from a financial statement point of view and from a tax return points of view, it ends up normally looking like you've got six separate funds even though it's technically under one umbrella. So I don't see the use of series funds so much but I've certainly seen them, they're certainly not that popular in my experience.

And then, from there I've seen some fairly creative use of special allocations between different buckets, liquid and illiquid. Certainly I've seen some funds that try to use a mechanical rebalancing concept, be it when a new investor comes in and for certain structures that are more open ended, but investing in illiquid assets and trying to kind of fuse more of a hedge fund style allocation into illiquid structure that I've seen mechanisms to try to rebalance so that new investors are getting an allocation of assets that were required before they joined the funds.

And then similarly, but differently, that what happens when a subsequent investor comes in and there's a rebalance of four splits between liquid and illiquid capital, both of them and the other investors. And so that kind of more customized, special allocation system I've seen, that's obviously the most complicated one. And certainly, needs to be most carefully thought through to make sure it works and it does what you think it's doing and what it's supposed to be doing.

But, I think, obviously these ranging complexity from simple to absurdly complex, and obviously the more buckets you have, the more opposite absurdly complex you can get. So it really, I think, comes down to what it is that you're trying to do, thinking about the IUL that you have in different buckets and the overall structure. Thinking about time resources certainly, that kind of special allocations concept, is potentially very time-consuming.

You're thinking about the cost of the fund admin's time, the audit as well. The more complexity, the more time, the more costs and really thinking about what do you really need, what is it trying to do. And being realistic concerning all the bells and whistles out there. This is what we're trying to do. That does the structure do that? And you're not being tempted into perhaps creating something that might be relevant one day, but your fund may never get there. So such staying mindful of that. And as I said before, a combination of everything above I've seen, it depends. But they're the major types of process I've seen to have to handle this.

David Goldstein:Thank you Keith. Tim, there's a question that popped up that I think is good for you. I'm going to paraphrase it a little bit. But the question is basic Glee Funds and a service providers are looking to hire people to work on hybrid fund structures. And again, this is a bit of a paraphrase of the question, which do you think is more valuable hedge fund accounting experience or private equity fund accounting experience?

Tim Eberle:At the risk of offending any hedge fund accountants, I would say that private equity fund accounting experience is probably where we would tend to lead, only because that's where we tend to find the complexity. You have concepts that just add so much complexity to hybrid funds, things like, "We're talking about sub clauses, subsequent clauses, or partner transfers, Waterfall calculations," things that don't necessarily exist in the hedge fund accounting space. They just add a lot of complexity.

Now, part of that is due to the fact that close into capital structures haven't necessarily evolved as quickly as hybrid funds have. So really what you're trying to do in a lot of these instances is take a square peg and jam it into a round hole the close ended the capital structure, but the reality is if that's what the capital structure is today, you need someone who really sort of understands that. And so I would say leaning slightly towards the private equity count of skillset, I would think that would be the more valuable if I had to choose between the two.

David Goldstein:Thank you very much. I have just a few more minutes here, I do have a question I'm going to put for Kevin, and then we're going to have two quick polling questions to close things out. But Kevin, the question is we run a closed NCRA Debt Fund, when fundraising we are walking the line between investors who want higher multiples versus those not wanting longer-term lockups, what's the best structure for a hybrid vehicle to serve both types of investors? Might be a tough question to answer.

Kevin Neubauer:It's a tough question because obviously, investors want the best of both worlds. I mean, I would say, the model that I mentioned earlier which we usually refer to as an evergreen fund, with illiquid assets can work well, particularly if it's a debt fund. So the way that it would work, it would look and feel a whole lot like a hedge fund, right? Where investors could invest on a monthly or quarterly basis, maybe there's an annual incentive compensation realized gains.

But when an investor wants out, they submit a redemption request, but the redemption terms, so there's a number of different levers to pull. The redemption terms are extremely restricted, such that the investor, when they submit a redemption requests can expect to be waiting a year or two or three, depending on the term of the investments in the fund to actually get all of its capital back.

Now, obviously that doesn't satisfy an investor who wants their capital sooner, but to the extent the investor wants exposure to these other assets, it's the best the manager can do. And as I said, it works well and we see it frequently in debt funds that have income generation. And put another way rather than investors submitting their redemption requests, maybe they're just sort of turning off the switch up reinvestment. But other ways to manage redemptions, other than using that liquidating account mechanism I mentioned, would be to impose fund level gates.

Stuff such that only X% of the fund can be paid out in redemptions on a given redemption date, and so maybe, there's semi-annual liquidity and there's a 25% fund level gate. So only 25% of the fund at max could be paid out on a semi-annual basis, or maybe it's quarterly at 12.5%, something like that. But there are mechanisms you can put in place to slow down the funds obligation to pay out redeeming investors, while still giving investors exposure to those illiquid assets that potentially have the higher multiples you mentioned.

David Goldstein:Excellent, thank you so much. So we do have two polling questions left in our last couple of minutes, which are actually not necessarily hybrid fund related, but are going to help the panelists and myself guide for some future webinars to see what people's interests are. So Lexi, can we put up the next one, which is select the two hedge fund strategies that you predict will have the highest returns for the remainder of the year? Give everybody a few seconds. Also going to add, there is one question that is still in our inbox, which I believe we will email out afterwards to somebody best positioned to answer it and they will get right back to you by email.

Few more seconds here. And I think that should do it Lexi. Long short equity, not event driven credit is basically what I've seen 0% for short only. That's surprising, especially given to me the inflated markets right now, but that's personal opinion. And the next question, has your company invested in or plan to invest in a spec in the next six months? Kevin, I see you rolling your eyes.

Kevin Neubauer:I'm not rolling my eyes, but It wouldn't be a panel these days without-

David Goldstein:Without specs?

Kevin Neubauer:Yeah.

David Goldstein:Absolutely. Just a few more seconds. And I think we're good. I'm actually very surprised at those results, to be honest with you. I thought for sure it was going to be heavily weighted to people looking to invest in spark. So that's actually really good to know for my own education. I show we have about a minute left, does anybody on the panel want to throw anything else in or Lexi, Would you like to do your closing comments? I think we're good. Thank you for joining us today.

About David A. Goldstein

David Goldstein, Director in the Financial Services Group, expertise includes fund structuring, jurisdictions, regulations, service models and strategies. He has worked with an array of financial services organizations including hedge funds, private equity funds and other alternative investment strategies.