Alternative asset managers have traditionally been classified under distinct groups: hedge fund, private equity, real estate, infrastructure and debt/credit managers, each specialising in specific products and structures. Now that hybrid funds are growing in popularity, some of those once-separate groups are starting to merge.
Hybrid funds are nothing new; in fact, they’ve been steadily gaining popularity since the 2008 financial crisis. Since then, managers of both closed-ended and open-ended funds have been seeking new ways to tap into the growing investor base with more diversity and flexibility than hedge or private equity offerings.
The search for new sources of capital and a broader investor base has led to a growing interest in the hybrid fund; a structure that combines benefits native to several asset classes under a single umbrella. Global leaders like Apollo and BlackRock have adopted hybrid strategies, and this is only the beginning.
In this post, our aim is to demystify hybrid funds and outline how interested managers can engage in the growing action.
What are hybrid funds?
As the name implies, hybrid alternative asset funds are investment vehicles that include attributes of more than one asset class or fund structure—in this case, hedge funds and private equity. A hybrid fund is, by nature, often difficult to track as they are frequently classified as direct private equity or hedge funds, but demand for investor and investment flexibility continues to grow.
Hybrid funds vary in their goals and structure, but they share certain characteristics:
- Liquidity: Hybrid funds are open or partially open fund structures that don’t lock up investor capital for the long-term. Investors can redeem or add capital at specified intervals, a feature that is especially attractive to investors during uncertain economic periods—like a global pandemic.
- Diversity: Increasing the breadth of potential investments open to a fund manager gives hybrid funds an advantage in generating alpha. Because of their built-in diversification, hybrid funds can offer exposure to a wide variety of asset types, including:
- Publicly listed, unlisted, or OTC equities
- Private equity and venture capital
- Real estate
- Infrastructure
- Derivatives including swaps, options & futures
- Distressed debt
- Private debt/credit
- CLOs
- Flexibility: Customised risk exposure, varying liquidity, and a range of fee terms within the same fund can be adjusted to meet investor needs and the pool of available investors.
Put simply, hybrid funds are not subject to the strict terms or “one size fits all” nature of traditional alternative investment assets. Investors gain the potential for higher returns alongside greater stability and liquidity, while managers also benefit from more flexible structuring and a broader investment universe.
Advantages of hybrid funds
The core benefit of hybrid funds can be summarised in a single word: flexibility.
Hybrid structures enable fund managers to customise their products and better align with the fund’s underlying investments and their LPs’ preferences. Because they combine elements from multiple investment vehicles, hybrid funds offer several distinct advantages for investors and managers.
Flexibility
Yield
Flexible holding periods
Efficiency
Non-traditional funds = non-traditional results
The Conversus StepStone Private Market Fund (CPRIM) is a perfect example of the potential that is inherent in hybrid fund structures. CPRIM offers investors access to a portfolio including private equity, real estate, infrastructure, and private debt. The fund returned 52% in its first 10 months, enabling it to live up to its executive chairman’s assertion: “This is not your grandfathers’ type of fund management.”
Challenges of hybrid funds
Unsurprisingly, managing hybrid funds involves additional complexity and requires more expertise than traditional funds.
Prominent challenges include:
- Complex accounting: A competent fund administrator is critical to the success of a hybrid fund. They should engage in pre-launch planning to minimise compliance errors and corrections following an audit. Accounting and reporting requirements can place a significant burden on administrative resources that are already stretched or lack relevant expertise.
- Cash flows: Matching cash flows from new and existing investors with underlying cash flows from investments can be a delicate operation. The liquidity offered to investors should be matched as nearly as possible to the cash flow profiles of the underlying assets, managed to ensure that redemptions don’t cascade into a run on the fund.
- Structuring: More flexibility means more opportunity—but things are also more likely to slip through the cracks. Capital allocations, share classes, and other mechanisms must be carefully defined to ensure no anomalies.
- Compliance: Regulatory issues, compliance issues, and conflicts of interest concern any fund, but hybrid funds offer elevated risk due to their complexity.
- Expense allocations: Expenses and fund overhead must be carefully allocated between different classes, side pockets, and entities. For example, costs attached to specific portfolios should be allocated only to participating investors. All allocations must be clearly documented.
Speak to IQ-EQ
The challenges of launching a hybrid fund are easily overcome with a strong partner by your side. IQ-EQ has the tools and expertise to administer funds across asset classes, whether liquid or illiquid. Our dedicated technology platform responds to the needs of both hedge and private equity markets for maximum flexibility.
Contact our Hybrid Fund Services Desk to learn more.
