In this series of articles, we take a look at two of the most common requests we see in terms of fund structuring options: Multi-category funds, and Hybrid funds. This second article in the series will look at hybrid funds. Multi-category funds will be discussed in a separate article, available here.
Many sponsors looking to start a new offshore fund will have well-defined ideas on common terms that should apply with regards to the pooling of investments and liquidity rights for investors. However, for clients looking for something more bespoke, two of the most common requests we see in terms of fund structuring options relate to:
These can be described as funds with a mandate that allows them to pursue two or more different strategies (or acquire two or more different investments or tranches of investments) within a single fund vehicle that should be treated as distinct and separate from each other, so that investors in a given strategy only participate economically in that particular strategy and in no other strategy (or participation) of the fund.
These are funds that hold both liquid and illiquid investments and seek to combine elements of the usual fund conditions for hedge funds (for liquid investments) and private equity funds (for illiquid investments) within the same fund vehicle.
Such alternative strategies may present some unique issues and challenges from a structuring point of view, but the British Virgin Islands (âBVIâ) fund industry is very well suited to address them given the flexible legal regime of the jurisdiction and the unique set of reputable, innovative instruments and fund products at competitive cost.
Historically, hedge funds and private equity funds were viewed as two entirely different alternative investment classes. More recently, however, the distinction has blurred somewhat, as evidenced by the growing prevalence of hybrid fund structures. Hybrid funds can be loosely described as funds that hold a mix of both liquid and illiquid (or otherwise difficult to value) investments and seek to combine elements of usual fund conditions for hedge funds (for liquid investments). ) and private equity funds (for illiquid investments) within a single fund vehicle. Hybrid funds that hold a large portion of their portfolio in liquid investments but look more like traditional private equity funds than hedge funds are often referred to as âlean private equity fundsâ.
Hybrid fund structures are most often used for activist investing, distressed investing and certain credit strategies, as well as by sponsors who believe they can achieve higher returns and / or significant costs or losses. Administrative efficiencies by executing a broad mandate encompassing both liquid and illiquid strategies with a single fund vehicle (rather than creating and operating two or more segregated funds).
For a hedge fund that is willing to cap its illiquid holdings at a relatively low percentage of total assets (often 10% to 30%), âside pocketsâ and / or multi-year lock-ups as part of a hedge otherwise conventional The fund structure can be a viable alternative to a more complete and complicated hybrid fund structure. However, for a fund with a significant portion of liquid and illiquid holdings, a more comprehensive set of hybrid conditions may be required.
There are many different potential permutations of hybrid fund structures. Some of the most salient issues that often arise in the practice of a dual liquid / illiquid investment portfolio include the following considerations:
- Management fees:
The conventional risk capital approach to management fees, with fees calculated on the basis of capital commitments during the commitment period and the cost of investments invested and not reimbursed after the commitment period, may not not be appropriate for a fund that holds a significant portion of its portfolio in liquid investments. with easily discernible market values.
Conversely, a typical hedge fund management fee structure based on prevailing net asset value would not be practical for a portfolio of illiquid or otherwise difficult to value investments.
- Performance allowances / incentives:
The conventional private equity approach to carried interest, based on realized returns (and potentially subject to a barrier and GP clawback provisions), would not be attractive to a fund sponsor. which holds a significant portion of its portfolio in cash. investments with easily discernible market values.
Conversely, a typical hedge fund structure of commission / incentive allowances calculated at periodic intervals throughout the life of the fund on the basis of realized and unrealized gains (on a market valuation basis) would not be attractive. for investors nor practicable for a portfolio. investments that are illiquid or difficult to value.
For hybrid funds that use a private equity approach to performance allocations, a European distribution cascade (with back-end carry of the entire fund) would be more common because the transaction-to-transaction carry characteristic of waterfalls American-style payout is difficult to calculate for actively traded funds.
- Subsequent closures:
The conventional private equity approach of allowing additional investors to be admitted to the fund on subsequent closings only during a limited supply period, at cost plus an interest factor (“accrued charges”) may not be appropriate for a fund which holds a significant portion of its portfolio in liquid investments with readily discernible market values ââand / or in investments which may generate significant income or realized gains prior to the final closing date.
Conversely, a typical hedge fund structure with subsequent closings at periodic intervals throughout the life of the fund at the prevailing net asset value (evergreen) would not be suitable for a portfolio of illiquid or difficult to value investments.
- Investment periods:
The conventional private equity approach of prohibiting or restricting reinvestments of capital after the defined investment period may not be appropriate for a portfolio of liquid investments that are actively traded with frequent rotations.
In addition, the lifecycle of many investment strategies that naturally lend themselves to hybrid fund structures tend to be significantly shorter than a traditional private equity buyout fund structure – often 3 to 5 years rather than the more usual 8 to 12 years old.
- Disclosures / investor transparency:
A fund that holds a significant portion of its portfolio in publicly traded investments will have to impose significant limitations and restrictions on the information it is required to disclose to its investors regarding its holdings in public investments.
- Other investor requests:
A sponsor should keep in mind that while the fund seems closer to a private equity structure, sophisticated investors may well demand the kinds of additional investor rights and protections typically associated with private equity funds. investments that are rarely offered by hedge funds (such as investment rights, key man provisions and minimum time commitments of principal principals, GP / sponsor capital commitments, restrictions on future / subsequent funds and investment opportunity allocations, and investor rights to replace the GP and / or terminate the fund).
Conversely, a hybrid fund which holds a significant portion of its portfolio in liquid investments may be faced with requests from investors for periodic redemption rights (at least with regard to liquid assets).
- Market value :
Marketing can be a potential challenge for funds pursuing dual liquid / illiquid strategies, as investors may be confused as to the fund’s core investment philosophy and whether it is more like a private equity fund. investment or hedge fund (which may be important for internal investor allocations and investment committee approval processes).
The sponsor may need to resist the temptation to try to select the most favorable aspects of the PE and hedge fund terms for the benefit of the sponsoring group, as this may not be acceptable to an investor base. warned.
- Regulatory treatment:
For the purposes of BVI regulation, an essential distinction is made between:
- Hedge funds and other open-ended funds (which give investors the right to withdraw capital at periodic intervals based on net asset value) – they are regulated as mutual fund in BVI.
- Closed-end funds (which do not provide periodic redemption / withdrawal rights to investors) – like a typical PE / VC fund structure, they are generally regulated as private investment funds BVI (subject to certain limited exemptions).
Regulatory regimes concerning mutual fund and private investment funds are largely segregated and segregated in IVBs, so for a fund that seeks to combine elements of the usual fund conditions for hedge funds and private equity funds within a single fund vehicle, special care should be taken should be given to the correct regulatory classification and treatment (which would almost certainly involve discussions between BVI’s legal counsel and BVI’s Financial Services Commission).
Hybrid funds are difficult to define and market practice has not developed anything that looks like a standard set of fund conditions for a hybrid fund structure. As noted above, a dual liquid / illiquid investment portfolio raises a number of unique issues and challenges in terms of fund structuring and marketability for investors. However, for sponsors who are established on a hybrid fund structure, BVI has proven to be very well suited to tackle such challenges with its flexible legal regime and reputable, innovative and competitive fund products.[View source.]