Cayman Islands: Cayman Islands Hybrid Funds: The Convergence Of Hedge And Private Equity

Last Updated: 23 April 2009
Article by Matthew Feargrieve and Neal Lomax


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.

Side pockets

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.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.