Comment and Analysis: Hybrid funds - converging alternative asset management strategies

Traditionally, alternative asset managers have been classified by distinct types: hedge fund, private equity, credit or real estate managers, each having products and structures designed to coincide with the nature of their investment activities.

Although many well-known fund managers have over the years set up structures in which a portion of the assets was set aside to invest in less liquid assets, such as side pockets, hybrid funds are the latest evolution in fund structures that seek to align the desire of managers to establish a greater degree of certainty in the capital invested, while at the same time fulfilling the investors’ desire to pay fees over the entire investment horizon.

Given the capital flows into hybrid funds, the investor community is obviously embracing this concept. The irony is that during the financial crisis many hedge fund investors found their moneys unexpectedly locked up in side pockets, so this latest trend of seeking more illiquid products is clearly perceived in quite a different light. The primary reason is most likely that the ways in which hybrid funds are structures create greater certainty in the anticipated outcomes associated with their investment activities.

Investors also understand that expanding the pool of investable assets beyond pure real assets provides managers with greater scope and flexibility. Hybrid funds trade both cash and liquid securities, such as distressed debt, bank loans, mortgage backed securities and swaps, alongside illiquid real assets, all within one portfolio.

Moreover many of the managers who are becoming active in this space have until now been equity or credit experts with hedge fund backgrounds, so they are equipped to trade the very products that are critical to contributing overlay and performance.

So what should managers and investors be cognizant of when contemplating hybrid funds?

Hybrids can be defined as closed-end vehicles with specific investor return profiles, such as preferred return baselines and incentive fee structures that are tied to actual realization. Hybrids also introduce certain operational and administrative complexities which are challenging to navigate.

For the managers, the challenges all depend on their background. Traditional hedge fund managers entering the hybrid space will have to build the requisite valuation expertise for real assets. In addition, it will be necessary for them to prepare complex models for waterfall fee calculations and implement operational procedures to deal with capital calls and distributions. They will also have to adjust their internal economics to account for the delayed payment of performance fees that are driven by asset realisations. Furthermore, they will need to create cross-asset reporting functionality that incorporates ROR and IRR measures.

For investors, convergence brings a new set of products to understand; and while the idea of investing in a hybrid structure may be attractive, they will want to ascertain their investor experience; i.e. the level of transparency, attribution and return measures, and they will have to adjust their due diligence accordingly.

Hedge fund managers getting into this space see the outsourced service provider model as a natural extension to their business as they launch new products and add new asset classes.

Published in HFM Week

4th June 2015