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Hybridization At Warp Speed Ahead

Historically, making a firm distinction between hedge funds and private equity was a reasonably unambiguous exercise. Whereas the latter almost unanimously engaged in leveraged buyouts (LBOs), the former typically adopted long/short or global macro investment strategies. The 2008 financial crisis – and more recently COVID-19 – has underlined the importance of strategy diversification. As a result, we have seen a significant increase in convergence across alternative asset managers – including hedge funds, private equity, and private debt - over the last twelve plus years. Although strategy diversification is incredibly positive and can help generate returns, it is not entirely a risk-free process.

Global changes accelerate convergence

Convergence across alternative asset classes has been a recurrent theme since the financial crisis, and it has been driven by several different variables. The first is global regulation. To strengthen risk management practices at banks, Basel III imposed tough leverage rules and balance sheet capital requirements on financial institutions forcing them to scale back their lending activities. This meant it was much harder for SMEs to obtain loans, prompting several hedge funds and private equity managers to launch their own direct lending funds. More recently, COVID-19 has precipitated a rise in distressed companies in sectors such as retail, travel and hospitality. Again, this has led to several private equity and hedge funds launching distressed or private debt strategies. Preqin analysis found that private debt funds are expected to grow 11.4% annually, corresponding to an increase in AuM  from $848 billion at the end of 2020 to $1.46 trillion by 2025.

Post-08 performance blues prompts a strategy rethink

Secondly, the 2008 crisis had long-term performance ramifications, especially hedge funds. As institutional money exited equities and bonds and moved into alternatives, the hedge fund market became too crowded, subsequently drowning out investment returns. This has led to fee compression and, in some instances, outflows. In contrast, private equity has flourished since 2008. As a result, we are now seeing more hedge funds launch their own private equity or illiquid asset funds. According to the American Investment Council (AIC), private equity has outperformed all other asset classes. The AIC also noted that private equity’s median 10-year annualized net return was 10.2% versus 8.5% for public equities. Consequently, this has resulted in massive inflows heading into private equity, often to the detriment of hedge funds. Preqin highlighted private equity AuM is projected to increase from $4.41 trillion in 2020 to $9.11 trillion in 2025, a CAGR of 15.6%, making it the fastest-growing asset class over the next five years. Meanwhile, Preqin anticipates hedge fund AuM will grow at a much slower rate, increasing from $3.58 trillion in 2020 to $4.28 trillion by 2025.

Growing market share and mitigating risk

At the heart of this convergence trend is the need for return and investor diversification. To mitigate the risk of losses during downturns, fund managers mustn't be wholly dependent on a single strategy or asset class. This rings true for both liquid and illiquid alternative asset management strategies. Moreover, diversification also allows asset managers to market funds to institutional investors they normally would not have been able to access, thereby further growing their AuM. Furthermore, by launching a closed-ended private equity or debt vehicle with a long lock-in period, closed-ended hedge funds can shield themselves against redemptions during bouts of short-term volatility. Having gone through two black swan events in a little over a decade, alternative asset managers are likely to continue pursuing a policy of diversification.

Ensuring operational integrity in a new asset class

Irrespective of whether an asset manager is running a private equity vehicle or hedge fund, repositioning into new asset classes such as credit or private debt carries with it some new risks and challenges. Take private debt, for instance. If firms are to launch private debt products, they need to have a deep pool of in-house talent with expert knowledge about how credit and asset backed securitizations (ABS) and collateralized loan obligation (CLO)s work, for example. Managers also need to come to terms with covenant construction and have in place processes to make sure that they are sufficiently protected from capital losses should borrowers' default on their obligation. This requires specialists and a lot of internal resources.  A failure to appoint the right people or service providers when transitioning into these illiquid debt strategies could have profound risk management implications.

Hybrid managers need to think carefully about the vendors they appoint. In the case of a fund administrator, hybrid managers will require a competent provider who can support multiple asset classes. As hybrid managers increase in numbers, competition for investors will simultaneously grow too. To win institutional mandates and pass operational due diligence reviews, hybrid managers need to demonstrate that their internal processes and ability to handle debt instruments are robust.

Understanding the risk-reward

Hybridization is advantageous for asset managers as it can open up new sources of returns and investment. The volume of distressed debt floating around post-COVID-19 means an excellent opportunity for investment firms to acquire some desirable assets at low prices. Launching a credit or private debt vehicle is not straightforward. Leveraging existing processes that work well-supporting LBOs or trading strategies will not be suitable for private debt. In response, it is vital firms make serious investments in their operational processes before making a transition into illiquid credit. A failure to do so opens asset managers up to the risk of losses or even disinvestment.

Jeremy Siegel is CEO at Portfolio BI

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