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Alternative Investment

Hybrid funds: how to address problems before they start

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

With global economies stretched and markets volatile, many alternative investors are rethinking their strategies and shifting more towards illiquid investments. According to research by EY, of those expecting to increase their alternative asset exposure over the next three years, over half said they plan on adding on private credit.

This suggests that many investors believe the current climate of rising interest rates and deteriorating economic conditions will create interesting and lucrative investment opportunities.

The runners-up in the alternative investment stakes are real estate (29%) and private equity (28%), according to the research. Only 9% of investors planned to increase their allocations to hedge funds.

The research found that managers are expecting to increase investor mandates by launching new fund structures to capture retail inflows. In this area, crossover funds are a major focus: 32% of hedge fund managers have 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.

Natalie Deak Jaros, EY global hedge fund co-leader and EY Americas Wealth & Asset Management co-leader, says: “The asset management industry is facing a multitude of headwinds and managers are finding themselves shifting and modernising, both in terms of internal processes and front-office decision-making.”

More hedge funds are considering raising hybrid funds, which share elements of both hedge and private equity fund strategies. These include a lower threshold for investment, increased investments into more stable sectors in inflationary times, plus the added flexibility to target a range of higher-risk assets based on investor risk appetite.

Managers not only need to contend with the shift of working with more retail investors; they also face the newfound administrative complexities 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.

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

Fund managers entering hybrid fund territory for the first time may start to ask post-launch: are the complexities and subsequent headaches worth it?

Fund managers and their teams soon find out that they may need help to alleviate the technical and fundamental challenges of running a hybrid entity, which are much more complicated than your typical private equity fund.

Before a manager’s operational reputation is tarnished among investors, teams must be one step ahead – and that may necessitate acquiring expertise.

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

  • A fund does not engage with competent international fund administration until after pre-launch. It is then overwhelmed with 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, plus all the accounting and reporting required for different asset classes due to their investment cycles.
  • One of the most common challenges with 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. The last thing a manager wants is for redemptions to come all at once. Balance is crucial.
  • 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, 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 to react to client demands, mitigate and manage risks and create value.

As fund managers handle ever-increasing assets and invest in larger deals, they are diversifying across asset classes such as private debt, real estate and infrastructure, and across regions.

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

Add in rising competition and investors’ desire for lower fees and you have something of 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 an asset class’s longevity – especially once inflation subsides.

Why Intertrust Group?

Intertrust Group has built automated systems with the support of nearly 300 programmers. It has already created 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 all asset strategies, including private equity, real estate, private debt/credit, infrastructure, venture capital and fund of funds
  • Fund accounting and bookkeeping
  • Fund performance and 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

Intertrust Group has 70 years’ experience providing world-class trust and corporate services to clients around the world. Intertrust Group has been acquired by CSC, the world’s leading provider of business, legal, tax and digital brand services, worldwide.

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