In this second article in our series on convergence trends, we explore the dynamic world of hybrid (also known as semi-liquid) funds and how to manage them.
By bringing together liquid and private market strategies in the same investment structure, hybrid funds seek to deliver the best of both worlds. Combining the illiquid investment exposures associated with closed-ended private market funds with the liquidity terms and trading strategies of open-ended funds offers managers a way to mitigate risk and access alpha in the hunt for improved performance. Managers can also widen their target investor base by tapping into asset owners’ growing interest in illiquid strategies – a trend well established in North America and northern Europe, and now spreading to southern Europe and Asia-Pacific.
Taking the hype out of hybrid funds
Cost-effective access to both liquid and illiquid investment strategies through a single vehicle in turn provides investors with more choice, flexibility and portfolio diversification, bringing the prospect of both enhanced returns and periodic income streams from a range of asset classes. That prospect has led to a surge in investor allocations into hybrid funds, with Barclays research pointing to a 35% rise in assets under management between 2016 and 2021. 
Institutional investors have led the way but new regulation could promote further retail inflows. The European Commission is reviewing the European long-term investment funds (ELTIF) regulation  – which aims to channel retail savings into long-term investments to help drive economic development and the green economy. In the UK, Long Term Asset Funds (LTAFs) have been introduced to promote more investment in less liquid asset classes . And with volatility in public markets playing havoc with traditional 60/40 allocation mixes, hybrid funds’ appeal seems set to grow.
European long-term investment funds (ELTIFs) are a hybrid product by design, as each fund is required to hold long-term, usually private investments, with up to 30% in liquid instruments. ELTIFs aim to channel retail savings into long-term investments to help drive economic development. To date, the product has not experienced a huge amount of take up.
What is a hybrid fund?
Hybrid funds – or semi-liquid funds – are a broad category, with no single model. At Securities Services, BNP Paribas, we are seeing increasing demand for and incidence of multiple hybrid fund types. Examples include:
- Hedge fund managers that add side-pocketed illiquid positions alongside the liquid fund structure, or launch dedicated illiquid position vehicles with a capital call structure.
- Hybrid vehicles combining portfolios of liquid and illiquid exposures. These may take the form of a blended capital structure, where a closed-ended fund with private capital investments sits alongside more liquid investments with a daily NAV requirement.
- Asset owners investing in a mixed portfolio of liquid and illiquid assets within the same fund structure. Larger asset owners often create their own vehicles. Medium-sized firms are more likely to end up in hybrid funds as they may not have the scale for the additional costs associated with setting up and maintaining separate vehicles.
- Private investors using hybrid vehicles to get exposure to private equity investments, which ordinarily have high minimums and low diversification. Via retail distribution channels associated with open-ended funds, they can access vehicles investing in private capital funds and that can cope with commitments and relatively unpredictable drawdown patterns.
Operational challenges for hybrid / semi-liquid funds
Combining closed-ended and open-ended investments in the same fund though brings multiple structure, pricing and sales complexities. Solving those complexities in an efficient and scalable manner is a major challenge.
Liquidity mismatch of hybrid funds
Hybrid funds have an inherent friction, risking a mismatch between the investor liquidity terms and liquidity profile of the underlying portfolio.
For example, an investor in a liquid alternative fund may be able to request a redemption every 30, 60 or 90 days due to the liquidity of the underlying investments in the portfolio. However, if a private investment is purchased, the investor liquidity terms need to change. Hybrid funds can use various techniques to “align” the liquidity of the asset with the liability to the investor. Mechanisms such as lock-up periods, gates and side pockets are nothing new in the asset management industry, but any mix of these creates operational complexity.
Any liquidity mismatch, and the terms offered in response, needs to be carefully managed. Investors must be treated fairly and information properly disclosed. The language in the offer documents has to be clear, to guard against a wave of redemption demands that cannot be met.
Accounting and administration support of hybrid funds
Investment commitments, capital calls and drawdowns must be tracked and accounted for. Assets need to be valued accurately and regularly, a task that is especially tricky for Level 3 assets such as private equity. Investment holdings across the liquidity spectrum need different pricing sources and methods to comply with Generally Accepted Accounting Principles, which can be costly to implement.
Level 1 assets require integration of multiple market data feeds.
Level 2 assets demand the operational capacity to deal with OTC instruments via broker pricing and more specialist pricing sources.
Level 3 assets are infrequently traded and so cannot be valued using readily available market information. Instead, Level 3 asset valuations integrate managers’ marks and are based on external valuation models and assumptions.
Profits, losses and expenses must be allocated accurately among investors across the fund structure and over its lifetime. The distribution waterfalls for how capital gains are allocated between different investors are often highly customised, making the calculations extremely complex.
Management and performance fees typically involve multi-tiered calculations that can cross the normal liquid alternatives mechanics of “2 and 20”, with carve-outs for side pockets or capital commitments. This can be combined with waterfall schedules that may need to be customised to take into account return of capital, preferred returns or distribution to sponsor performed on a deal-by-deal basis.
The industry’s growth has also elicited greater regulatory scrutiny and pressure for more transparency. The investor influx – especially from highly demanding institutional asset owners – has added to the calls for more frequent, accurate and granular reporting on the fund’s activities and returns generated.
Managing the solution
The diversity of hybrid/semi-liquid fund structures means a one-size-fits-all service model won’t work.
Supporting hybrid funds requires an integrated, cross-discipline approach that brings together the specialist knowledge and expertise found across a service organisation.
Service scope is crucial, to have the breadth and flexibility of capabilities needed to create bespoke solutions that match the specific requirements of each hybrid fund. Asset and structuring expertise spanning both the liquid and illiquid worlds is vital. Teams must have the knowledge and technology infrastructure to meet, and automate, the operational challenges.
Meeting the potential of hybrid funds
Hybrid funds’ growing popularity is further evidence of the convergence taking place in asset management markets around the world, between traditional and alternative sectors, and liquid and illiquid assets. But with the convergence trend comes demand for an accompanying breadth and flexibility of service provision. Hybrid fund managers need to ensure their service provider has the expertise to support a combined portfolio of liquid and illiquid investments, along with an industrial scale model, and the capacity and vision to bring the different service components together.
How the Securities Services business of BNP Paribas can help
We offer our clients a complete product suite able to cope with all types of alternative assets, with a single relationship manager that can oversee the full scope of those support services for the hybrid fund. Leveraging industry-leading platforms, our expert staff can support any hybrid fund type. In addition to our core administration services, custody and prime brokerage, ancillary capabilities such as flexible financing solutions provide an important value add to any hybrid manager.
How to meet the operational and liquidity challenges
A hybrid – or semi-liquid – fund brings together liquid and private market strategies in the same investment structure
For managers, it offers a way to mitigate risk and access improved performance
But combining closed-ended and open-ended investments in the same fund brings multiple complexities, such as
- Liquidity mismatch between the investor liquidity terms and liquidity profile of the portfolio
- Various pricing and accounting methods of investment holdings
Supporting hybrid funds requires an integrated approach that brings together the specialist knowledge and expertise
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This article was first published in April 2023
 For the $1bn+ hedge fund managers, Marching On: 2022 Global Hedge Fund Industry Outlook, Barclays, February 2022
 European long-term investment funds: Council adopts its position, Council of the EU, 24 May 2022, https://www.consilium.europa.eu/en/press/press-releases/2022/05/24/european-long-term-investment-funds-council-adopts-its-position/
 CP22/14: Broadening retail access to the long-term asset fund, Financial Conduct Authority, 1 August 2022, https://www.fca.org.uk/publications/consultation-papers/cp22-14-broadening-retail-access-long-term-asset-fund