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Are hybrid funds the future of private equity? Yes and no, say experts

IQ-EQ webinar outlines how PE managers are looking at hybrid funds to offer flexible products to an evolving investor base.

With the rising popularity of hybrid funds, PE managers are looking at how to offer flexible products to an evolving investor base.

Hybrid funds have become increasingly popular in recent years, as heated competition for both investors and investment opportunities causes asset managers to look for ways to add diversification and flexible liquidity terms to their offerings.

But panelists pointed out during global service provider IQ-EQ’s recent webinar “Are Hybrid funds the future of private equity?” that despite the rising popularity of these vehicles, hybrid funds will not replace traditional private equity funds.

Jeffrey Hall, head of international product at Nuveen, however, said hybrid structures will nonetheless be an important part of the private equity landscape going forward.

“These hybrid funds are filling a void that was in investors’ portfolios, and this has allowed the democratization of private funds to take place. Investors are gaining access to private equity and other elements of private markets through the innovation we’re seeing with hybrid funds,” he said.

“I don’t see them replacing traditional private equity, but if you look forward a few years you will see a disproportionate amount of growth in these structures,” added Philip Cuff, a partner and the head of the European hybrid value team at Apollo Management. “I think you’ll also see more variants of hybrid funds and how they are structured going forward.”

Specific investor segments will likely provide the heft of demand for hybrid funds, said Garvan McCarthy, a partner and international alternatives leader at Mercer. Those might include wealth management firms, private banks and defined benefit plans, whose own investors have different liquidity needs than traditional PE investors.

Using the right structure

But as more private equity managers jump on the hybrid funds bandwagon, they need to think about how best to structure these vehicles, whether in an open-ended or closed-ended vehicle, and decide on the fund’s jurisdiction – usually Delaware, Cayman or certain popular European fund domiciles, much like most traditional PE funds.

“Managers need to decide whether the hybrid fund will be an evergreen fund and have continuous contributions and permit some type of withdrawals or if it will be more of a closed-end vehicle like we’ve traditionally seen in the private equity or private credit space,” said Debra Franzese, a partner at Seward & Kissel.

Managers may prefer a closed-end structure, but the kinds of investors attracted to hybrid funds tend to prefer open-end vehicles, due to the aforementioned liquidity needs, said Josh Lerner, Jacob H. Schiff professor of investment banking at Harvard Business School.

“As this democratization is underway, more investors are entering the alternative investment space and they’re not necessarily used to signing subscription documents and having a commitment or subscription drawdown over three or four years,” he said. “They’re looking to get access to the asset class they’ve been craving as soon as possible and this gets addressed in open-ended formats.”

The jurisdiction will also affect the tax structure, so managers will have to think about which tax rules are best suited to their target investor base.

Managers need to decide whether the hybrid fund will be an evergreen fund and have continuous contributions and permit some type of withdrawals or if it will be more of a closed-end vehicle like we’ve traditionally seen in the private equity or private credit space, Franzese said. She added that many hybrid funds are structured as partnerships, like traditional funds, but call all their committed capital once, upfront, rather than piecemeal as deals draw close.

Apollo’s Cuff said his firm’s hybrid funds are primarily structured in closed-end format.

“The difference, from our perspective, is centered on the risk-reward, the type of investments and the type of risk profiles that investors try to do within the funds,” he said.

In setting up its hybrid funds, Cuff said, Apollo starts by thinking about the ultimate investment objective, then talks to investors about the investment mandate and what the appropriate risk/return is.

“You need to be very clear on exactly what the hybrid fund is, what it’s trying to do, and why it makes sense as an alternative,” Cuff noted. “Investors need the transparency so they are better able to figure out where to fit these hybrid funds on the risk/reward spectrum; where they fit in their portfolios.”

While panelists agreed that hybrid funds won’t replace private equity funds, they do believe that innovation will continue with these vehicles.

“There’s no shortage of innovation that’s coming from alternative investment fund managers, traditional managers, and regulators that are putting in the groundwork that would allow hybrid products to be sold to a broader array of investment channels,” Lerner noted.