Hybrid Hedge Fund Structures and Longer-Biased Strategies
In today’s low yield environment, a number of hedge funds are targeting investments in less liquid assets as they search for alpha. In an effort to more closely align structure with strategy, such managers are introducing fund structures with longer lock-ups that share characteristics of both hedge funds and private equity funds. Investors, in turn, are showing increased interest in hybrid fund structures. However, there is trepidation among allocators about such structures since these vehicles do not fit easily into traditional hedge fund or private equity portfolios. Accordingly, the availability of investor capital for hybrid fund structures remains limited.
Certain trends are driving hedge fund managers to introduce such vehicles with greater frequency, and as a result, there are benefits and drawbacks for investors.
"Increasingly, managers are coming to market with hybrid vehicles in response to changing market conditions."
Catalysts for hybrid fund structures
Hybrid hedge fund vehicles combine elements of the traditional hedge fund model with private equity-like features. These structures tend to have longer lock-up periods and, sometimes, modified compensation arrangements.
Such vehicles are not new per se. A number of larger credit-oriented managers have long offered such products. Increasingly, however, managers are coming to market with hybrid vehicles in response to changing market conditions.
The distressed/credit opportunity
Major changes in global credit markets along with regulatory pressures are creating attractive opportunities for distressed investors. As a result of Basel III, European banks face pressure to deleverage and restructure their balance sheets. Those changes are likely to result in large sales of capital intensive assets including corporate bonds and dollar-denominated securitized Hybrid Hedge Fund Structures and Longer-Biased Strategies products. Similarly, U.S. banks also are shrinking their inventories of such securities. These conditions are creating opportunities for distressed investors and credit-oriented strategies such as direct lending.
Seeking to capitalize on such opportunities, hedge fund managers increasingly are targeting investments in affected asset classes such as commercial real estate loans, distressed corporate credits and second lien loans. Investments in such assets offer the prospect of higher yields. A number of managers surveyed believe that the current liquidity premium for investing in less liquid assets can range from 300 to 500 basis points. As shown in figure 1, prices for less-liquid, non-agency RMBS appreciated steadily throughout 2012 whereas yields on high-yield liquid credits gradually decreased, ultimately falling to historic lows.
Consequently, recent performance among managers who concentrate on such assets has been strong. During 2012, the HFRI Fixed Income-Asset Backed Index posted gains of +16.72 percent, significantly outperforming other hedge fund indices. Similarly, the HFRI Distressed/Restructuring Index increased +10.40 percent in 2012 compared with +7.42 percent for the HFRI Equity Hedge Index.
Investments in the above-mentioned asset types often are quite illiquid. For instance, special situation strategies such as direct lending require longer holding periods. Accordingly, such investment strategies may not be well suited to the traditional open-ended hedge fund model.
Liquid securities, longer durations
Certain managers who invest in liquid securities also are starting to pursue longer-biased strategies that may be ill-suited to the traditional hedge fund structure.
Activist investors are the most prominent example of such managers. Activist hedge fund managers frequently invest in highly liquid securities to impose changes through corporate boards. Such funds may not be well-positioned to offer redemptions at regular intervals.
Sector-focused funds that concentrate on earlier-stage companies are another example of managers who are pursuing longer investment horizons where the underlying securities are liquid. Such investments often require patient capital and, therefore, extended holding periods.
Because these strategies have longer investment horizons and require a stable capital base, they are not aligned naturally with the traditional hedge fund model.
"Hybrid hedge fund structures enable investors to access both liquid and illiquid investments in a single fund without the constraints of the private equity model."
Hybrid structures: a prospective solution
Hybrid hedge fund structures have emerged as a direct response to the misalignment between the abovementioned strategies and the traditional hedge fund structure.
The hybrid vehicles that are coming to market have various permutations but tend to fall into two primary categories, which we refer to as “fixed-term hybrid structures” and “evergreen hybrid structures.”
Fixed-term hybrid structures—The first category is comprised of funds with truncated private equity structures. As with private equity vehicles, fixed-term hybrids have the following features:
- Finite subscription periods
- Closed-end terms
- Specified investment periods
- Distribution waterfall profit allocations
These vehicles do not permit redemptions. As compared with private equity funds, the terms of such vehicles tend to be relatively short. Whereas a private equity fund might have a term of up to 10 years or even longer, a one and a half to three-year term would be typical for a fixed-term hybrid vehicle. The vehicle might then have a one-year investment period during which recycling of committed capital would be allowed.
Because fixed-term hybrid structures do not provide hedge-fund style liquidity, they tend to charge lower fees: for example, a management fee of 1.25 percent based only on invested, not committed, capital during the life of the fund.
With regard to capital distributions, fixed-term hybrid funds provide a preferred return for limited partners followed by a profit split for the sponsor and the limited partners. The preferred return is dependent on the fund’s return profile. Carried interest percentages for fixed-term hybrid fund vehicles tend to range from 16 percent to 20 percent.
Evergreen hybrid structures—Evergreen hybrid structures combine rolling lock-ups and rolling subscriptions with limited liquidity. These structures typically have initial lock-ups ranging from one to three years during which redemptions are not permitted. The initial lock-up period may be followed by a soft lock-up during which redemptions are allowed subject to a penalty. Subsequent to the various lock-ups, investors can redeem capital subject to notice requirements.
Because evergreen hybrid vehicles constrain liquidity, they tend to charge lower fees than standard, open-ended hedge funds. Management fees range from 1.00 percent to 1.75 percent for evergreen hybrid structures and typically are lower for lengthier longer lock-up periods.
Incentive compensation generally ranges from 15 percent to 20 percent and is subject to a high water mark. The carry percentage tends to decrease inversely to the length of the lock-up. Evergreen hybrid vehicles frequently use a hurdle rate above the high water mark to calculate the manager’s incentive fee. Those hurdle rates vary, ranging from a spread above LIBOR over the high water mark to 6 percent over the high water mark.
Benefits and drawbacks
Hybrid hedge fund structures enable investors to access both liquid and illiquid investments in a single fund without the constraints of the private equity model. Hybrid vehicles also provide greater transparency than side pockets and special purpose vehicles (SPVs), which hedge funds frequently used for less liquid investments prior to the financial crisis. In fact, aside from side pockets and SPVs, hybrid structures are the only means through which hedge fund investors can access certain potentially higher-yielding, less-liquid assets.
Evergreen hybrid structures provide many of the advantages of the traditional hedge fund model, including rolling subscriptions and redemptions as well as marked-to-market valuations. Although fixed-term hybrid structures do not offer those benefits, they deploy and return capital at a higher rate than private equity funds because they have a significantly shorter investment horizon.
Both fixed-term and evergreen hybrid fund structures provide other benefits, including the prospect of being part of a stable capital base. Longer lockup periods mitigate the risk for both managers and investors that a fund will be forced to liquidate positions in response to redemption requests when it is disadvantageous to do so. Additionally, hybrid fund structures in both categories provide investors with exposure to potentially higher-yielding asset classes with the prospect of reduced volatility because of lengthier holding periods.
Hybrid hedge fund vehicles also present certain drawbacks for investors, the most obvious of which is reduced liquidity. Investors should therefore consider whether prospective advantages such as decreased volatility are sufficiently beneficial to offset constraints on liquidity.
Investors weighing allocations to hybrid hedge funds should also consider whether the potential returns justify the limitations on their ability to redeem capital. With respect to strategies that provide current yield, investors should take into account that cash-on-cash returns result in shortened durations.
Hybrid hedge fund vehicles may pose a challenge for investors from an asset allocation perspective because they do not fit neatly into liquid hedge fund portfolios. Because of that challenge, the availability of capital among institutional investors for hybrid fund products remains limited.
Investors that have committed to longer duration hybrid funds have addressed that challenge in one of several ways. For commitments to credit-oriented hybrid funds, certain investors have created “opportunistic credit” silos, which may reside within an existing hedge fund portfolio or may be designated as a separate asset class within a broader alternatives portfolio. Other investors have invested in credit-oriented hybrid funds through their broader fixed income portfolios. For commitments to equity-biased hybrid funds, some investors have invested through their general equity portfolios while others have created bespoke sleeves for such commitments.
To date, hybrid hedge fund vehicles have received many of their commitments from hedge fund of funds seeking to differentiate themselves through niche product offerings, family offices (along with registered investment advisors) and endowments and foundations. Pension funds have sought exposure to hybrid structures, albeit to a lesser extent. In several instances, pensions have invested in hybrid funds through single-LP vehicles or “funds of one.” It should be noted that several larger managers with established track records have succeeded in attracting pension investments for hybrid fund vehicles.
Although hedge fund managers are identifying a growing number of investment opportunities that align with hybrid fund structures, the prevalence of such vehicles ultimately will be determined by demand for these products among allocators. Investor demand, in turn, will rest on the potential tradeoff between reduced liquidity and access to potentially higher returns in today’s low yield environment.
Hedge funds—The standard hedge fund model allows for ongoing investor subscriptions and regular disbursements of a management fee, typically based on assets under management (AUM). The general partner’s incentive fee is payable on a periodic basis subject to a high water mark. Valuations for a hedge fund’s positions are usually marked to market. Furthermore, hedge funds have traditionally offered investors the ability to redeem capital at regular intervals.
Private equity—Private equity funds do not allow for rolling subscriptions. Private equity funds offer a finite subscription period after which they are closed to new capital. Private equity funds generally have a fixed term, frequently around eight to 10 years. Within that term, there is a defined investment or “commitment” period, which often ranges from four to six years and during which the general partner calls capital to fund investments. The management fee is calculated based on limited partner capital commitments.
Unlike hedge fund incentive fees, private equity incentive fees are payable only upon the liquidation of an investment. The general partner’s incentive fee is subject to a distribution waterfall as follows:
Underlying assets—A fund’s underlying assets are a key determinant of its structure. Because hedge funds are typically open-ended, the assets in which they invest should be capable of accurate valuation when subscriptions and withdrawals are allowed. Any fund that permits redemptions must be able to generate cash to satisfy those withdrawals. The underlying assets in a traditional hedge fund must therefore be liquid. By contrast, the private equity fund structure is appropriate when the underlying investments cannot be marked to market and require lengthy holding period.