Astute investors are constantly looking for greater diversification with the goal of achieving exceptional returns uncorrelated to the global equity markets. To satisfy this demand, alternative investment managers coming from either the closed-end or open-end school have become increasingly innovative. A prime example is the emergence of hybrid fund structures. Designed to focus primarily but not exclusively on illiquid investments, these vehicles combine the longer-term investment strategies, investor commitments and capital calls of closed-end private equity funds with trading and hedging strategies associated with open-end hedge funds.

Hybrid funds offer investors exposure to a wide variety of asset types, including both publicly listed and private companies, private credit, real estate and infrastructure, as well as derivatives and illiquid investments such as bank debt, distressed debt and CLOs. While they are closer in structure to closed-end private equity funds, hybrids allow investors a greater measure of flexibility in liquidity options due to the mix of assets and duration periods. Managers seek to deliver both predictable income streams for the investor as well as the potential for long-term gains.

An evolving model

Although hybrid funds have reportedly grown in popularity, gauging the market opportunity for hybrid funds is difficult. Alternative industry analyst Preqin, for instance, says it is tracking “186 hybrid PE funds and 261 hybrid hedge funds.” These low numbers relative to the fund universe suggest that, for tracking purposes, most hybrid funds may be classified as either private equity or hedge funds depending on the strategy or the manager’s background. This further suggests that the hybrid model is still evolving and maturing even after a decade of expansion. (Analyst reports on the global alternatives market generally do not break out hybrids as a separate fund type.)

Perhaps more compelling than fund inflow statistics and AUMs is the opportunity to offer investors an innovative product with greater diversification, current income and long-term alpha-generating potential. Not surprisingly, that opportunity has attracted participants from both the hedge fund and private equity worlds. For private equity managers, the hybrid approach frees them from focusing exclusively on private companies that require lengthy investor lock-ups. For the hedge fund firm, it provides some protection against “disorderly” redemption rates.

Making the marriage work

Regardless of the manager’s origins, however, setting up and launching a hybrid fund is no easy feat. The marriage of two distinct investment disciplines calls for a combination of closed-end and open-end expertise that few firms have to begin with. A private equity firm looking to create a hybrid fund needs to acquire hedge fund skillsets and vice versa, typically by hiring people with the requisite backgrounds. And even then, there are the different cultural nuances to consider. Few hedge fund managers are likely to be familiar with the rigorous and deliberative valuation process that goes into private equity investments, or with capital call procedures. Conversely, private equity firms aren’t steeped in the everyday trading mentality that characterizes hedge funds.

Simply developing the fund documents has proven to be challenging for many firms. Defining terms and conditions, capital allocations, expense allocations and distribution of proceeds requires agreement on a common “language” that effectively bridges the public and private aspects of the fund. Manager compensation methods can also be extremely complex, combining the performance-based incentives of hedge funds with private equity waterfall fee calculations.

Removing operational impediments

From an operational perspective, there are significant challenges. With a mix of publicly listed securities and private, illiquid or hard-to-value assets, hybrids entail complex accounting methods. Striking a reliable and accurate monthly NAV can be an arduous undertaking. Investor accounting and profit and loss allocations are also more complex than with a straightforward hedge or private equity fund.

The enormous influx of institutional capital into the alternative investment arena over the last decade has put pressure on fund managers to provide greater transparency into holdings and meet rigorous operational due diligence standards. Combined with more stringent regulatory reporting and disclosure requirements imposed on private funds since the 2008 financial crisis, fund managers must be able to demonstrate that they have the controls in place to mitigate operational risks. This is especially true with hybrid funds, in which added complexity elevates the risk of errors in fund accounting, investor allocations and fee calculations.