Insights on Hybridization for Hedge Funds: An Interview with BKD’s Sal Shah & Murat Yasanliel

Thoughtware Article Published: Sep 29, 2021
Insights on Hybridization for Hedge Funds

With an increasing number of hedge fund managers considering hybrid models, Partner Sal Shah and Managing Director Murat Yasanliel sat down with HFM to discuss what managers need to know before setting up a hybrid fund.

What is driving hybridization among hedge funds?

Sal Shah: Traditionally, this structure has been more popular for private equity funds simply because they’ve been able to find high returns and alpha for investors. A private equity fund typically is a closed-end fund where investors commit capital; they don’t get any returns until the investment unfolds. In a typical hedge fund structure, investors can come in and out of the fund after a specific notice period. But a private equity investment is a long-term investment, which is different from a typical hedge fund model. But, because of the success of private equity funds, hedge funds are now trying to get into private equity investments.

Murat Yasanliel: A hedge fund is very liquid, and they redeem on request because they can sell those liquid assets right away. And what happens when the economy goes down is that all the investors in a hedge fund structure rush to liquidate their holdings. You can see hedge funds’ assets go from $20bn to $10bn in the space of a couple of months because investors are scared and looking for a safer asset class. Consequently, the steep declines in the fund’s asset mean less management fee and much smaller performance allocation. When you go hybrid, you have a more stable asset. 

What are the benefits for hedge fund investors?

Sal Shah: If hedge funds start to get into private equity investment, it gives investors exposure to private equity or venture capital in a hedge fund structure. That’s the advantage to the investor.

Murat Yasanliel: If structured properly, a hybrid structure can be beneficial for private equity investors and hedge fund investors, as well as hedge fund managers. It gives the manager flexibility to raise capital on a permanent basis; it provides some liquidity for private equity investors and gives hedge fund investors exposure to benefit from long-term assets, which most hedge funds do not offer. Furthermore, it allows investors and managers to generate a mix of short- and long-term returns that are taxed at different rates.

What do hedge fund managers need to know about the hybrid model?

Sal Shah: When a hedge fund manager is marketing to the investors, you need to make sure you’ve created proper side pockets or other structures within the hedge fund so investors cannot redeem any capital that’s locked into relatively longer-term private equity-type investments. You don’t want any kind of a fire sale. You want to make sure that investment has gone through a proper seasoning process so all investors have equal benefit from it and the manager has had the opportunity to generate maximum alpha from the investment strategy.

Murat Yasanliel: In a hedge fund, usually your performance fee is very straightforward to calculate. But in a private equity-type investment, you may need to go through complicated waterfall allocations, which the hedge fund manager may not have experience with.

And then, as a manager, you have employees, so you need to set up their expectations as well. If it’s a long-term investment, they need to understand that their performance fee will be long term, too. Whereas traditionally, in hedge funds, you may get the benefit in a year, as you can buy and sell right away.

Also, with private equity investments, the investor usually has valuation requirements they need to go through for all their assets. And that may create more administrative work for the fund manager.

How can hedge funds make the transition to the hybrid model?

Sal Shah: It starts with marketing of the hedge fund. You need to explain to investors that it is a longer-term investment strategy and that capital will be deployed for a longer period. The next step is coming up with a strategy for managing the investment because most hedge fund managers typically try not to take control or ownership of the underlying asset. They tend to piggyback off of other majority owners, or they could be distressed investing—debt or equity—and buy low/sell high after the restructuring, which enhances the asset’s value. It takes a complete cycle of planning, from getting into the investment, selling the fund to investors, and exiting it.

And when you’re reporting on these investments, you need to also come up with a fair value determination process, which is very different from getting market quoted prices. So, you need to gear up and create controls and processes for fair valuing investments. The models that generate the fair value of these investments need to be appropriate and ensure they comply with U.S. GAAP and partnership agreements.

Murat Yasanliel: Ultimately, these are hedge fund managers and investing in private equity investments is truly different from other investment strategies, and they need to get that expertise. It could mean hiring experts or outsourcing it, but they still need to have experience in investing in private equities, which accomplishes your strategy. Hedge fund managers usually understand the economy or market trading activities well. But private equity is about understanding a specific business and the industry it operates in. A private equity investment is investing in different niches. For example, some invest in information technology because they have expertise in the area; others invest in biochemical companies and might have a doctor or scientist on board. They have specific industry knowledge and a good understanding and expectation as to how to season the investment to a higher exit value. 

Also, as a fund manager, your needs may change when you move to a hybrid model. So, the hedge fund manager needs to make sure they have appropriate infrastructure, including hiring the right service providers who understand their business and investment strategy like the law firm, fund administrator, and accountants.

For more information, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below. Visit our Asset Management page to learn about the services we provide hedge funds.

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