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Demystifying hybrid funds

15 Feb 2022

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

Managers experience significant flexibility when structuring a fund tailored to specific investment goals and time horizons, enabling them to avoid the rigid structuring rules that traditional hedge funds or alternative investments often face.

Yield

As a lot can change in the global economy over the life of a private equity fund, having a more broad investable universe allows managers to invest across the cycle and diversify their returns. For example, the low interest rates have prevailed since 2008, meaning that options for investors in search of high yield have been relatively sparse. At the same time, managers are under significant pressure to offer access to opportunities with higher returns. Hybrid funds provide exposure to the high yield of alternative investment strategies with the added benefit of stable cash flows and more predictable liquidity.

Flexible holding periods

Closed-ended funds can face complex challenges when holding assets at the end of a fund’s life. Managers in this situation can either exercise extension periods (which are generally relatively short) or establish a continuation fund to house remaining assets. The latter option entails significant cost and effort to balance the needs of exiting LPs, those rolling over to the new fund, and new LPs.

Open-ended funds have also faced challenges when fund duration and liquidity are not well matched to their underlying assets. Managers have been forced to sell assets at fire-sale prices or implement solutions like side pockets or redemption suspensions to avoid heavy losses.

Hybrid funds, by contrast, can be structured to include flexibility around investor liquidity. Open-ended or evergreen hybrid funds involve no time pressure to sell assets, and investors can redeem their capital at any time (as allowed by the fund redemption terms). Managers can also raise additional capital for the fund or offer investors the option to redeem capital without being required to sell assets before the timing is right.

Efficiency

Hybrid funds aren’t just more flexible than traditional funds—they’re also more efficient. They can be structured to permit new capital contributions at specified intervals, allowing a sponsor to permanently market the fund instead of undergoing periods of focused fundraising. They also provide better features for enabling secondary sales, led by either LPs or GPs of either individual positions or commitments to parts of the fund, without significantly impacting investment performance or other investors.

Launching a single fund rather than a series of investment vehicles also allows sponsors to reduce their upfront effort and overall costs.

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.

Working with IQ-EQ has been seamless – you and your team understand our business, advise us appropriately, and handle your side of our collective partnership so that we can focus on making good investment decisions. Evan Gibson SVP, Merchants Capital

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