Ishita Shah speaks to HFM Week's Jennifer Banzaca on the evolution of Hybrid Funds
Facing lacklustre performance and significant redemptions, hedge funds have had to adapt to attract capital.
To do so, and offer investments with more favourable terms while still allowing managers to invest according to their expertise, hedge funds are adopting more private equity-style terms and making more private investments to respond to investors’ demands.
And allocators are interested in these hybrid funds. According to JP Morgan’s 2019 Institutional Investor survey, 38% of respondents expect more capital to be allocated to less liquid hybrid vehicles, which are typically seen as uncorrelated return streams that complement investors’ hedge fund portfolios.
The JP Morgan survey also found that 46% of respondents had investments in longer-lock hybrid funds in 2018, the highest level since 2013. Outside this group, 8% of respondents plan to make an investment to a hybrid fund this year.
Similarly, Deutsche Bank’s 2019 Alternative Investment Survey found that 36% of respondents invest in longer-dated, hybrid private equity/hedge fund vehicles, up from a third two years ago.
Furthermore, the study found 41% of those investors who allocate are planning to increase their investment in such opportunities over the next 12 months. A further 10% are considering allocating to them for the first time this year.
Generally, hybrid hedge fund/private equity vehicles focus on a niche opportunity set where the returns are realised over a multi-year period.
According to the Deutsche Bank survey: “Institutional investors with longer-term investment horizons and an appetite for uncorrelated, higher-yielding products are likely to find hybrid private equity/hedge fund products attractive.”
“You will see a lot of credit-focused or private company investments with hybrid funds,” notes the general counsel of a $7bn multi-strategy hedge fund. “These tend to be longer-term investments so they are a good fit for some of the private equity-like terms hedge fund managers have been adopting.”
Optima consulting partner Alan Halfenger explains that the trend for these hybrid products has risen in line with growth in private equity.
“As we have seen more growth in the credit space, and there is more of a natural movement from doing public credit to doing high-yield bonds to doing private placement originations, there is a trend for more private equity-like structures,” he says.
Halfenger has seen several start-ups in the last two years where there is “almost a 50/50 blend of hedge and private equity terms”.
Steven Nadel, a partner at Seward and Kissel, says employing a hybrid strategy helps managers raise more assets and have more committed capital. In adopting private equity-like terms, Nadel notes he has seen a number of hedge funds offering a drawdown capital commitment concept.
“You will see managers who periodically raise money through a capital commitment,” he says. “These structures are more for opportunistic investments and when managers need quick access to capital in order to take advantage.”
The drawdown feature is also used by restructuring and distressed funds. Nadel notes that some firms, especially those that have a longer duration buy-and-hold strategy, have been adopting a multi-year incentive allocation.
“In this multi-year structure, managers will take the incentive every year but the rate is recalculated annually and looks back over the previous two years. If there was an overpayment in fees, then the GP has to pay back the overpayment, like a clawback in private equity,” he says.
Nadel explains that because of tax considerations associated with the recalculation and potential clawbacks, three years is the longest a multi-year incentive fee will go.
In a standard clawback provision, where investors have paid a performance fee and have lost money, they can receive compensation from the manager for that loss.
The multi-strategy general counsel has also seen more peers offering multi-year incentive allocations: “These structures really better align the manager’s interests with those of the investors. Instead of charging a flat performance every year, the fee is adjusted every year to reflect returns over that period of time.”
Another fee option being adopted by managers is to determine and pay the performance allocation on an annual basis, but place a portion of the performance allocation in an escrow that would only be released after a set period if there are no future losses, observes Henry Bregstein, a partner at Katten Muchin Rosenman.
Hybrid funds are not a new trend; hedge funds have been adopting private equity terms for years. However, as this trend has continued, a new one has emerged, Ishita Shah, head of private equity North America at Citco, says.
“With the first generation of hybrid funds, we saw hedge funds keeping traditional trading strategies and applying more closed-ended structures. We are still seeing a number of these funds today,” Shah notes.
“Most recently, we’re seeing a new generation of hybrids that look like PE-style trading in an open-ended structure. The private equity managers are adopting ongoing fundraising similar to the traditional open-ended structure of a hedge fund.”
Bregstein adds he has also seen the trend. “Where we now have these private equity funds becoming open-ended structures, essentially the fund becomes evergreen with long notice periods. The private equity investors are now able to redeem at certain points in the life of the fund but the managers are able to continuously raise capital.”
Shah explains that some of these next-generation hybrid funds being launched by private equity managers are offering redemptions or the option for investors to come out after four or five years. Typically, private equity managers would either keep cash on hand as a way to manage liquidity needs or would take lines of credit to pay redemption requests, Shah says.
“For the first four or five years, the fund will operate as a traditional private equity fund to help manage liquidity. The managers then allow different stages of redemptions after that.
“For example, investors would be able to redeem up to 25% after year five and up to 50% after year six, and so on. This basically marries investor needs for liquidity with the liquidity of the underlying investments.”
As for fees in this new generation of hybrid funds, Shah says there has been a convergence of the carry calculation, common to private equity funds, with the incentive fee/high water mark calculation standard in hedge funds.
In private equity, the carry is a percentage of a fund’s profits that managers charge on top of their management fees. However, in the hybrid structure, if the manager loses money over a period, the fund must get above the high-water mark before receiving the carry.
“Whether you’re running a hedge fund or a private equity fund, you’ve felt the pressure on fees,” observes the multi-strategy hedge fund GC.
“As managers have adopted different fund terms to attract and retain capital, fees have definitely evolved. These hybrid funds are able to take the best of hedge and private equity fee terms and marry them into something that is good for the managers and investors.”