The Rise of the Hybrid Fund Structure

Historically, alternative investment funds were classified as either “hedge” for liquid strategies or “private equity” for illiquid/private investment strategies. Over recent years, however, the line that marks the clear distinction between fund types has seemingly blurred. The hybrid fund model is not a new concept; however, it has recently increased in popularity as investors seek the best of both liquid and private investments. According to Citco’s publication in September 2023, its private market client base has significantly shifted in recent years from 80% private equity/20% hybrid funds in the first half of 2021 to 60% private equity/40% hybrid funds in the first half of 2023.

A hybrid model exposes investors to both illiquid investments traditionally associated with private equity funds (typically closed-ended) and the liquidity and trading opportunities of hedge and credit funds (typically open-ended). This diversification provides investors with a unique combination of stability and growth and greater flexibility as to how their money is invested and managed between asset classes in a single investment vehicle. Investors aren’t the only beneficiaries; hybrid fund managers can adjust asset allocations and fully customize the asset class, which in turn attracts a much broader investor audience. The benefits of a hybrid model are undoubtedly clear; however, there are considerations and risks fund managers must examine and mitigate to make informed decisions.

Liquidity Considerations: Hybrid fund models require significant consideration regarding how the portfolio’s liquidity affects an investor’s liquidity objective. For instance, an investor in a liquid fund would expect to be able to request and be granted redemptions on a periodic basis, typically monthly or quarterly; however, if the fund seeks to invest in illiquid investments, the investor’s ability to request redemptions should undoubtedly change or be restricted to allow for adequate time to liquidate any illiquid investments. Clear terms must be outlined in the fund’s offering documents to provide transparency into the potential illiquidity of certain investment holdings and how that may impact investor flexibility.

Operational Complexities: Introducing the functionality of traditional open-ended and closed-ended funds into one model requires significant operational capacity. Valuations of illiquid investments are complex and require considerable knowledge of valuation models, techniques and related assumptions, while liquid investments fluctuate in value regularly and require various reliable pricing sources. Expertise in both sets of asset classes is crucial, particularly to comply with U.S. GAAP and other regulatory requirements. There are numerous other factors to consider, including integrating the necessary systems and technology for accurate and efficient execution, recording and reporting of transactions, as well as the ability of the fund’s service providers to service the fund across both types of holdings.

Profit and Loss Allocations: Investor income and expense allocations in a hybrid fund structure are typically more complex than for a simple hedge or private equity fund. The returns generated from investments in hybrid funds can vary greatly, directly impacting the investor allocations. The timing differences between the two asset classes can affect the predictability and frequency of investor income distributions, if any. Ideally, separate allocations for the liquid vs illiquid strategies should be maintained, and further bifurcation for the illiquid investments should be based on the timing of each transaction. Most importantly, hybrid fund managers must fully understand the nuances of the hybrid fund’s diverse income sources and risk management strategies in order to provide and maintain transparent, ongoing communication with investors.

Management Fees & Performance-Based Compensation: Fund managers must also consider the implications of a hybrid model on management fees and performance-based compensation. Determining the terms and conditions of management fees varies based on factors such as expected investments, investor commitments and return expectations. The management fee basis can be based on capital commitments, capital invested or the fair value of the investments and can change depending on what phase the fund is in. Determining the appropriate management fee structure in a hybrid model requires consideration of all relevant factors. Further, open-ended funds typically carry an incentive fee/allocation based on the fund’s annual realized and unrealized appreciation, subject to a high-water mark. Private-equity or traditional closed-ended funds, on the other hand, typically bear carried interest distributions to the general partner based on fund performance and realization of fund investments. Consistent with the overall approach of the hybrid model, the performance-based compensation takes a blended approach. Hybrid funds typically determine a set period, referred to as the “Incentive Allocation Period,” in which the allocation is based on distributions and both realized and unrealized appreciation of investments. Depending on the investment strategy of the fund and investor needs, the incentive allocation can be based on inception-to-date performance or an annual basis and subject to a high-water mark and/or a claw-back. Fund managers must analyze all facts and circumstances to determine the best approach for these fees and compensation and thoroughly communicate it to prospective investors.

Constructing the Hybrid Fund

While there are many benefits to the hybrid model, the adoption and maintenance of this structure are not straightforward. The characteristics of closed-ended and open-ended funds fundamentally differ, and creating a blend that bridges the gap proves challenging. Managers of open-ended funds with liquid investments may not be well-versed in the valuation and compliance processes required by private equity investments. In contrast, managers of private equity funds are usually not privy to the complexities and compliance requirements when trading in active markets. When factoring in considerations such as fund administration support, accounting and reporting requirements, and liquidity expectations for investors, the adoption of a hybrid model requires significant fund intelligence, technological skills and clear communication. Creating a strong foundation of knowledge, technology and transparency will allow fund managers and investors alike to reap the benefits of a hybrid model.

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