Lock-ups at hybrid hedge funds could be up to seven years

02 May, 2014

The growing convergence between hedge funds and private equity could potentially see some managers imposing lock-ups of three years, or even seven in the near future.

"It is possible that some hedge funds running hybrid vehicles could impose longer lock-ups, potentially in line with standard practice at private equity firms in the future. We have seen a growing number of hedge funds investing in private equity investments and this is a trend that is likely to continue," said Chris Franzek, managing director at Duff & Phelps in New York.

A study in February 2014 by New York-based law firm Seward & Kissel found newly launched US hedge funds were imposing tougher redemption terms on investors. Eighty-nine per-cent of new funds restricted redemptions to a quarterly or longer-term basis in 2013 compared with 64% in 2012, added the Seward & Kissel report. The number of funds employing a hard lock up, usually of one year, rose dramatically from 8% in 2012 to 27% in 2013, indicating a growing convergence between hedge funds and private equity.

"The line is becoming increasingly blurred between hedge funds and private equity funds. Interest rates today are obviously very low and investors are looking for new sources of yield, and illiquid investments, potentially held in hybrid structures,  may provide that incremental yield," said Franzek.

A report by J.P. Morgan’s prime brokerage business in March 2013 highlighted the main catalyst for the growth in hybrid fund structures was the growing investment opportunities in less liquid distressed debt assets. 

Basel III and various national regulations are forcing banks to deleverage and restructure their balance sheets by devolving themselves of illiquid, non-core assets such as collateralised loan obligations and residential mortgage backed securities.  Managers scooping up these high-yield illiquid securities are also generating quality returns. Nonetheless, investor interest has remained static, said the J.P. Morgan study.

The illiquid nature of the underlying investments in these hybrid structures does cause trepidation among some allocators and the J.P. Morgan study said investors were not rushing into these vehicles. The same study added that hybrid vehicles were attracting capital from funds of hedge funds, family offices, foundations and endowments. While pension funds have expressed a slight interest in these products, many prefer to invest in hybrid funds through single-LP vehicles or funds of one. 

Others are not wholly convinced. “We have not seen many hybrid hedge funds on our platform with the exception of some distressed managers. Prior to 2008, like many other investors, we had some illiquid positions so as part of our operational due diligence, we like to ensure our managers’ portfolios are matched with their liquidity terms and we have a preference for liquidity in hedge funds,” said Gavin Rankin, head of managed investments for Europe, Middle East and Africa (EMEA) at Citi Private Bank in London.

Duff & PhelpsCiti Private WealthJ.P. MorganBasel III