Historically, there have been clear lines between the monthly-traded liquidity offered by hedge funds and the 10-year, locked-in nature of the private equity industry. However, the growth in size of the alternatives sector, combined with a new level of investor sophistication, has led to a blurring of these lines. Increasingly, investors are looking to blend products and the benefits of different structures to suit evolving needs, whether that be to manage risk or liquidity.
Around a decade ago, the industry saw a raft of new hybrid products being launched by hedge fund managers. In these products, a trading strategy that was hedge fund-like was wrapped in a fixed-term, closed-ended structure. This gave significant advantages to the manager, as they were able to deploy capital to investment opportunities that could not have been unwound on a quarterly cycle if investor redemptions were requested.
For some longer-term investors, this was a useful offering, as it increased yield due to a broader opportunity set for the manager. To some extent, this structure also reduces risk. The investor liquidity is lower than the asset liquidity, so managers are able to ride out a storm. There is also less likely to be a run on a fund causing a huge spike in selling and an asset price drop.
Operationally, though, closed-ended actively traded products can be complex, as they require managers and administrators to combine operational models that span hedge and private equity. For example, private equity-style waterfall calculations can be complex enough on slowly traded private assets; but combine the complex calculations and higher asset trading volume and you see an exponential growth in complexity.
The continuous evolution of investor needs has more recently resulted in the growth of the opposite form of hybrids: private assets in semi-liquid wrappers. This has been led by investors who want to make a significant commitment to private assets but need to maintain control over how they withdraw their money due to their own liabilities. Typically, these investors are large enough and take a long-enough view that private assets are appropriate for them, but also want more control over the redemption cycle. At first glance, this would seem to be a case of ‘have your cake and eat it’: gaining the illiquidity premium by investing in assets that have no active market, but also being able to redeem from the fund.
But taking a slightly deeper look suggests it is reasonable. Firstly, these types of funds have very clear and long-dated redemption periods, normally of a year or more. Secondly, they typically allow new investors to join to replace investors who wish to leave, thus avoiding a need to reduce fund capital.
As an example, these funds work very well for private debt instruments where there is a regular return of capital to the fund from the target assets. This capital could be redeployed to new assets; or, if an investor has given notice that they wish to redeem, the manager has a long period of time to build up the capital repayments from underlying assets sufficient to meet the redemption request.
These semi-liquid wrappers are useful for investors, as they permit more money to be deployed into higher-yielding assets – whereas before, an investor’s own liabilities would have limited their ability to invest.
But as with the first wave of hybrids, these funds bring operational challenges for all parties. Allowing investors in and out of a fund is not typical for the processes and systems in the private equity industry. To be able to navigate these challenges, managers, administrators and transfer agents must work carefully together before the launch of the fund to ensure that all processes are clear and workable.
Fund managers must continually innovate to meet investor’s needs. Hybrid products are a great example of this as they can be a win-win for investors and managers. But with innovation comes risk, and so managers would do well to work with operational experts to ensure their operating models are up to the challenge.
Sam Metland is the head of private equity product at Citco