Hybrid funds: how to address problems before they start

Hybrid funds are complicated in nature yet growing in popularity. They are also putting hedge fund managers’ operational performance to the test.

With global economies stretched and markets volatile, many alternative investors are rethinking their strategies and shifting towards illiquid yet higher-return investments.

In an era of high inflation and sub-par global economic growth, hybrid strategies can provide the best of both worlds. For example, combining liquid assets (such as open-ended hedge funds) with less liquid yet more lucrative assets (such as private equity) in one portfolio.

When it comes to less liquid investments, one segment that is gaining popularity among investors is private credit. Funds dedicated to this alternative asset class will see increased allocations over the next three years.

That’s according to the EY 2022 Global Alternative Fund Survey, which found that 97% of investors surveyed have plans to invest in private credit.

These findings suggest that fund managers, notably hedge fund managers, over the course of 2023 will likely pivot in favour of new fund structures, namely hybrid or “cross-over” funds, keen to take advantage of the opportunities they bring.

EY says that when it comes to crossover funds, 32% of hedge fund managers have already increased their exposure to private market investing, while over half (53%) of investors are “not limiting their hedge fund managers’ exposure to PE and venture-capital-style investments”.

These funds, according to EY, are believed to offer multiple risk opportunities and investment thresholds to a more diversified investor pool to the extent of developing fund structures that welcome even retail investors.

This, however, will bring added complexity. Managers not only need to contend with the shift to working with more retail investors, but they also face the newfound administrative complications of running a hybrid fund.

Challenges primarily arise not during the hybrid fund structuring itself, but instead during capital calls and in administration such as accounting, compliance and reporting.

“The asset management industry is facing a multitude of headwinds,” says Natalie Deak Jaros, EY Global Hedge Fund Co-leader and EY Americas Wealth & Asset Management Co-leader.

Jaros says managers are finding themselves “shifting and modernising, both in terms of internal processes and front-office decision-making”.

What risks should I be aware of when launching a hybrid fund?

Hedge fund managers entering hybrid fund territory for the first time may find themselves asking post-launch: are the complexities and subsequent headaches worth it?

These managers and their teams may soon find that they may need help to alleviate the technical and fundamental challenges of running a hybrid entity, which is much more complicated than those associated with your typical hedge fund.

Avoiding risks to a manager’s operational reputation calls for its teams to stay one step ahead – which in turn calls for new expertise.

Below is a list of typical challenges hybrid fund managers face every day:

• A fund does not engage with competent international fund administration until after pre-launch. It is then overwhelmed by compliance mistakes and a long list of corrections post-audit (for example, regulatory issues or conflicts of interest).
• In-house teams find out too late that they do not have the time, resources or experience to deal with hybrid fund domain and custodial services, alongside all the accounting and reporting required for different asset classes due to their investment cycles.
• Balance is crucial. One of the most common challenges in running a hybrid fund is cash-flow recording for new and existing investors. Hybrid funds, by their nature, have assets with differing liquidity. That means cash-flow management processes and technology should be put in place so that cash flow truly matches each underlying asset. That means a hybrid fund manager must closely monitor and match fund liquidity with the liquidity of underlying investments.
• Expenses from running the fund and any fees must be transparent, especially if a manager is dealing with a retail investor base. That requires careful monitoring and reporting given that hybrid funds are handling different assets, asset classes, side pockets and portfolios. Investors should be liable only for expenses that are tied to the portfolios they are invested in. That must be recorded.
• Compliance with each asset and/or asset class must be in line with the asset’s jurisdiction. This requires bespoke knowledge of how filing with the relevant authorities and reporting to investors is carried out.
• Excel spreadsheets, still commonplace in administration across all asset classes, pose the risk of human error, especially when cash flows and risk analyses get complicated.

Hybrid funds: are they here to stay?

In September, equities and multi-strategy funds were the areas from which investors pulled the most, at net outflows of USD 5bn and USD 4.3bn respectively, according to Forbes. The appetite for diversification has shifted investors into newer strategies, indicating that product innovation is here to stay.

However, global macro and hybrid funds saw net inflows of USD 100m and USD 1.7bn respectively – a sure sign that hybrid funds are attracting investors.

The importance of a good operations framework cannot be underestimated. It can help managers react to client demands, mitigate and manage risks and create value.

As hedge fund managers handle growing volumes of assets and invest in larger deals, they are diversifying across regions and across asset classes such as private debt, real estate and infrastructure.

And as private capital takes on greater economic significance – with retail investors now gaining broader access to private markets through their pension contributions – there will only be more oversight from regulators.

Add in rising competition and investors’ desire for lower fees and you have a perfect storm. Funds want to scale amid increased complexity, growing cost pressures and greater demand.

How hybrid fund managers operate in this atmosphere could make or break the longevity of an asset class – especially once inflation subsides.

Why Intertrust Group?

CSC completed its acquisition of Intertrust Group in November 2022. Together we offer a global solution for subsidiary governance, fund strategies, and capital markets transactions, with tools to help fund managers navigate the ever-changing compliance and regulatory environment that they face. With capabilities in more than 140 jurisdictions, we are able to do business wherever our clients are—and we accomplish that by employing experts in every business we serve.

Intertrust Group has automated portfolio monitoring and reporting systems that can help hybrid fund managers get the data they need in a single click.

Here are just some of the fund accounting and administration services we provide:

• Expertise across asset classes, including hedge fund, private equity, real estate, private debt/credit, infrastructure, venture capital and fund of funds
• Fund accounting and bookkeeping
• Fund performance, financial reporting and consolidation
• Investor reporting, including portfolio analytics and data access
• Assistance with financial audit and internal control
• Bank account management​
• Monthly, quarterly and annual financial statements in line with relevant accounting standards (such as local GAAP, US GAAP and IFRS)
• Filing of accounts with local authorities and risk management
• Management reporting via our mobile-friendly platform – with summarised data sets, dashboards, workflows, document management, detailed reporting, capital activity monitoring and pre-set formats
• NAV calculations and valuation reviews
• Cash management
• Implementation of accounting systems