There has been in recent years a marked convergence of the traditionally separate asset classes of "hedge" and "private equity", a trend that recently has dramatically accelerated as hedge fund managers scramble to manage liquidity by side pocketing illiquid or difficult-to-value assets, often in return for restructured upside fees that are paid only on realisation of the underlying assets. Indeed, a significant number of funds that started life as hedge funds are beginning to resemble private equity funds.
Illiquidity in the equity markets and the rising chorus of criticism of the hedge fund model (particularly with regard to returns and manager remuneration), combined with increased cost of stock borrowing and higher margin requirements at brokerage houses, together with increases in middle- and back- office overheads, are woes compounded by the legal risks and general hassle associated with running existing funds that will not meet their high watermarks for significant periods of time to come. Faced with these troubles, some hedge fund managers are seeking either to diversify their existing fund portfolios into more illiquid, private equity-style investments, or to launch new funds pursuing investment opportunities in illiquid or distressed assets. And it is no secret that private equity returns have recently outperformed those afforded by hedge funds, particularly over 2008, a fact of which hedge fund managers can scarcely be ignorant. It is these dynamics that are driving the restructuring of existing funds and the establishment of new funds in the Cayman Islands as 2009 gets underway.
Against this backdrop, the trend towards hybrid funds (or "crossover" funds) has gathered momentum, with the ground separating conventional hedge and private equity products narrowing dramatically and, potentially, disappearing over time altogether. What is incontrovertible is that hedge funds are already major players in the private equity industry.
Mourant du Feu & Jeune's Cayman funds advisory team, based in London and the Cayman Islands, is well versed in hedge and private equity funds established in the Cayman Islands and can advise managers on the establishment of hybrid funds in that jurisdiction. This briefing note considers the top level characteristics of Cayman Islands hybrid funds, and should be read in conjunction with our paper entitled "Managing Liquidity in Cayman Islands Funds: Options for Managers" which explains terms such as side pockets, gates and lock-ins.
Hybrid Funds: Key Features
With stock market volatility and continuing market illiquidity, and the failure of many short-term investment strategies, more managers may make greater use of an analytical or value-driven approach to longer term holdings in companies or sectors, commonly associated with traditional private equity styles, and blended with an overlay of different strategies such as high yield or distressed debt, special situations, risk arbitrage and other forms of hybrid public and private investing.
These relatively illiquid investments may either form part of a fund's portfolio and be held in a side pocket, or comprise the fund's core strategy. Available evidence suggests that managers of hedge funds with side pockets tend to restrict the side pocket to between 10% and 30% of the fund's total portfolio. Given the average AUMs of medium to large hedge funds registered in the Cayman Islands (as disclosed by the Cayman Islands Monetary Authority in its yearly statistical digest of hedge funds registered with it) some side pockets can constitute sizeable private equity funds in their own right.
A side pocket, whilst not a separate legal entity, exhibits some of the salient characteristics of a traditional private equity fund, namely:
- A longer term investment holding period, usually a component of the illiquid nature of the assets
- The locking-in of investor capital, with a prohibition on withdrawals and redemptions of shares referencing the side pocket until the assets are realised
- The charging of management fees based on cost (although some managers may mark the assets to market)
- The crystallization of upside fees only upon realisation of assets, sometimes subject to a hurdle (around the traditional 8%) or a high watermark.
There are differences between a side pocket and a private equity fund, however, for example:
- Losses on side pocketed assets do not result in any claw back of upside fees paid to the fund
- There is no date by which the side pocketed assets must be liquidated or otherwise exited
- There are no limitations on the number of investors in a side pocket, and the fund, being a hedge fund (or at least having started out as such) will generally be subject to fewer regulatory restrictions.
There are signs of a growing willingness on the part of hedge fund managers to contemplate the notion of a performance fee calculated and paid only on realised gains. Whilst this is a cultural transition that has been made by most managers who find themselves managing side pocketed assets until their disposal, liquidation or exit (often with the standard performance fee continuing to apply to the liquid portfolio), its application to performance fees in general will be controversial in the hedge fund community. It may be that some pressure is brought to bear on managers by their onshore regulators (for example, the FSA in the United Kingdom and the SEC in the US) that causes upside remuneration in hedge funds to move towards the private equity model.
Initial lock-in (or "lock-up") periods, during which newly subscribed shares cannot be redeemed, have long been a common feature of hedge funds established in the Cayman Islands. The "traditional" length of a lock-in was typically 12 months, but now the trend is towards multiyear lock-ins, usually of around two to three years but with an increasing number of funds demanding that investor capital be locked in for five, six or seven years (the average holding period of a conventional private equity fund).
The quid pro quo for lengthier lock up periods is normally lower fees: annual management fees of 1.5% rather than 2%, for example, combined with higher hurdle rates. Admittedly, relatively few of the managers of hedge funds established in the Cayman Islands have shown much willingness to reduce the 20% performance fee, but a significant number have been engaged in the process of resetting their high watermarks in favour of investors. Some notable new funds have replaced the traditional marked to market performance fee with an upside fee (calculated periodically, or at the end of the lock-in period or the life of the fund, or on each disposal of assets) paid only on realised gains.
Many institutional investors have shown themselves cognisant of the fact that hybrid funds with longer lock-ins are able to pursue longer term investment objectives, particularly attractive in times of market volatility and illiquidity. Hybrid funds also benefit in this way from committed capital enabling the implementation of unconventional investment and trading strategies, always appealing to investors seeking truly uncorrelated returns and wanting to avoid the closet passive managers.
Gates, Suspensions and Redemptions in Kind
Gates, suspensions of NAV and dealings, and the payment of redemption proceeds in kind (or "in specie"), are means of keeping investor money in the fund, or at least of placing limitations on the speed and the manner in which it exits the fund, and are very much in use by managers of hedge funds experiencing liquidity problems. Whilst not strictly means of replicating private equity-style styles per se, these techniques are critical to maintaining the stability of a fund's liquidity and, post-2008, will increasingly form part of the structural fabric of hedge and hybrid funds alike.
Hybrid Funds: Challenges for Managers
Side pockets and gates are bound to receive a mixed reception from investors, no matter how positive the rationale posited by the manager. Newly formed hybrid funds may suffer from the negative light in which side pockets are seen by some members of the investment community, regulators, governments and the public at large. It has been suggested in some quarters that side pockets are open to abuse by underperforming managers wishing to improve their balance sheets by effectively hiving out unsuccessful or substantially depreciated investments. Managers for their part may feel that investors may be disinclined to accept limitations on their means of accessing capital, particularly given market illiquidity and lacklustre investment performance.
There is bound to be some initial amount of concern by managers, investors and regulators alike, but recognition should be given to the fact the tools of managing liquidity have been in use for some years now and not solely by managers under liquidity pressure. The willingness of managers to maintain illiquid assets at cost until their realisation, in conjunction with the other investor-friendly techniques discussed herein, will undoubtedly help to assuage investors' concerns. Indeed, certain hedge funds have been complementing their staff for several years already with seasoned private equity managers, which will undoubtedly facilitate the implementation both of side pockets and investment policies in existing hedge funds and new hybrid funds.
It is fair to say that alternative managers wanting to diversify into more illiquid strategies will in most cases need to re-calibrate their investment skills and mindset to enable them to make the transition from short term active management to longer term management-to-exit of illiquid assets, using private equity-style investment strategies such as sectoral fundamental analysis, growth opportunities and strategic positioning of businesses.
The valuation techniques applicable to illiquid and difficult-to-value assets will also be new territory for alternative managers accustomed to trading and valuing highly liquid securities for which there is a readily available market price. It may be that US managers, having historically self-administered their funds and appointed valuation committees, will climb this curve more quickly than their European or Asian counterparts; and we can expect to see more managers in all demographics engaging independent third party valuation specialists given the prevailing illiquidity and reduced observability of market data.
The legal techniques of managing liquidity have always been available to managers of Cayman Islands funds, and we expect to see increasing use made of them as managers seek either to restructure their funds in order to survive the liquidity crisis or to establish hybrid funds that will blend hedge and private equity investment styles.
The Cayman Islands remain the jurisdiction of choice for offshore alternative funds, and Mourant du Feu & Jeune can advise managers or prospective managers on all aspects of Cayman Islands law and regulation applying to hedge funds, private equity funds and hybrid funds established in the jurisdiction.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.