Times have changed – and markets with them. In the wake of the Great Financial Crisis of 2008 we are living in a low yield and deleveraging environment. This is playing itself out in all kinds of ways, not least in the alternative funds industry.
Hybrids
Convergence has been the overarching theme. First, it was the blurring of lines between traditional and hedge funds. Traditional long-only funds started investing in over-the-counter assets, while hedge funds started to mainstream into the more traditional space, with an added degree of transparency. The regulatory environment adapted to accommodate the shift and asset servicers invested in the systems necessary to accommodate the convergence.
Then, over the past five years or so we have witnessed a degree of convergence between hedge funds (open-ended) and private equity funds (closed-ended) as managers seek new strategies that are in effect a marriage of the two alternative investment approaches. The term ‘hybrid fund’ has crept into the vernacular with the dual nature of such funds offering the potential for a closed-ended fund structure with a liquid or semi-liquid portfolio, with a possible investor distribution element to the fund objectives.
The alternative investment arena has certainly entered into a new dimension. Who would have thought10 years ago of an income-bearing product wrapped up into a hedge fund?
Hybrids are becoming even more complex as the low yield environment continues and asset managers start to invest in illiquid assets such as structured credit or develop a debt origination strategy.
In a December 2015 Willis Towers Watson paper entitled Illiquid Credit – Playing the Role of a (Good) Bank, authors Greg Disdale and Chris Redmond say: ”We believe there is greater scope for investors to consider illiquid credit as a meaningful part of both low risk and return-seeking portfolios; indeed we view this as an excellent opportunity for clients with a tolerance for illiquidity and a desire to improve overall portfolio efficiency.
This increased move into illiquid assets has led to further blurring of the lines between traditional, hedge, private equity and credit/debt strategies, providing investors with the diversification they want across key assets that are potentially income bearing. The pressure is coming from investors themselves, with demand for higher returns, lower fees and a degree of fund term customization in order to get the best of all worlds.
Operational challenges
From an operational perspective, hybrid funds of course also introduce certain administrative complexities, often combining as they do the characteristics of both closed- and open-ended structures.
Not all fund administrators have moved with the times. Now administrators need additional functionality to support more sophisticated, complex hybrid funds that are focused on strategies such as illiquid credit too – a tall order as these instruments can have different levels of liquidity, funding sources, valuation processes, custody arrangement and settlement processes – all within one portfolio.
Add to this cross-border structures, multiple jurisdictions, all with their own regulations and the rise of global tax reporting, and you start to understand why many fund administrators are reeling.
Necessity – the Mother of Invention
If convergence of products is the direction we see, it’s no surprise that the fund administration operating model needs to do the same. Having just one ‘out of the box’ approach does not work as this new cross-breed of strategies will require a level of customization out of the gate. The evolution of hybrid funds may appear daunting and expensive, but this need creates an excellent opportunity for fund administrators that can combine their hedge fund and PERE capabilities to further develop an operating model to support the new generation of hybrid structures.
The call for transparency in the industry, boosted by high levels of due diligence to cover thorough investigation of a general partner’s (GP) operations and controls and the need for granular level of detail brings the discussion on technology in hybrid to the table. Indeed, one of the areas that limited partners (LP) and regulators are scrutinizing is the GP/administrator’s hybrid systems. Having a report straight out of a system to minimize potential human error and manipulation of data is a valid demand.
LPs are increasingly use more technology to meet their selective criteria in picking their investments, which makes it potentially difficult for GPs to be prepared to meet their needs. Options available to GPs are to implement an in-house system, buy one off the shelf, run a spreadsheet-based system, or outsource to an administrator.
Lenin Perumalsamy, product technology specialist at Maitland, can attest to how the rise of hybrids has turned the firm’s platform into a proverbial laboratory for re-engineering tools and integrating them to create a solution. “One of the biggest challenges managers faced early on was trying even to find an all-encompassing system that would be easy enough to set up – that is, be more “plug-and-play” – but at the same time would be quickly customizable based on the fund type needs that are specific to a portfolio holding a combination of close-ended and open-ended fund structures,” he says.
In essence, the challenge was to create a portfolio accounting system that could provide extensive liquid investment coverage for pre-defined investments that could also leverage standard interfaces. Maitland worked closely with SS&C Advent to marry their portfolio accounting and allocation functionality with Maitland’s proprietary CRM tool Avatar Fund Manager (AvatarFM) to allow the administration of hybrid structures off a single integrated platform providing an end-to-end solution.
Among the features that were critical in the design and building process:
- a standard interface construct so that debt investment structures could transfer over to the Maitland platform. Currently, most systems require users to setup all the debt investment features from scratch, then create a custom interface and then purchase and “add-on” applications to glue these pieces together. This requires too many steps for the user.
- extra diligence in designing a bigger, more powerful system that could withstand the load of both larger volume and a higher number of users,” advised Lenin.
- implementing the latest release of Geneva World Investor, Maitland to provide the support needed for hybrid funds through a new control environment with SOC1 best-in-class operational workflow.
Once created, the other layer of challenge was in transitioning the technology for managers operating hybrid funds. “We needed to create a technology set that would be scalable and customized from a reporting standpoint.”
The way this works is that the feature set provides reporting from fund to investor via extensive drill down capabilities delivering the transparency necessary to satisfy investor demands. Also included is support for flexible allocation rules, opt outs, cash source delineation, subsequent closes, waterfall calculations and a full suite of enhanced performance reporting.
This is just the start. As alternative investments continue to evolve, fund administrators will have to adopt a flexible infrastructure capable of creating ‘future-proofing’ solutions – it won’t be enough to boast of a robust platform – it must be backed by a strong integration model.
Article by Scott Price, Head of business Development and Client Management for Maitland North America
