The prevalence of private markets hybrid funds has doubled over the past two years, revealing a significant shift in the types of funds being serviced by Citco, a global financial services company. According to Citco’s recent report, the client-base has moved from an 80/20 mix of private equity to private credit or hybrid funds in first half of 2021, to a 60/40 mix in H1 2023.
Citco, a leading global financial services company focused primarily on the alternative investment sector, recently highlighting the emergence of private markets hybrid funds. These are a mix of closed- and open-ended structures that have seen considerable growth over the last two years.
Rise of hybrid funds
According to Citco, these hybrid funds have doubled in prevalence as general partners (GPs) search for new capital sources. Notably, the mix of funds serviced by Citco’s private markets client-base has shifted considerably: it moved from approximately 80% private equity and 20% private credit or hybrid funds in H1 2021 to about 60% private equity and 40% private credit or hybrid funds in H1 2023.
Citco’s report identifies that traditional boundaries between hedge funds and private asset funds have been blurring over recent years. The ways assets are packaged into funds have diversified to meet new capital requirements and to create new solutions for limited partners (LPs).
Despite the clear rise in the numbers, the term ‘hybrid’ remains somewhat opaque, which Citco defined under two primary categories within hybrids based on their relative liquidity: ‘illiquid-asset’ and ‘liquid-asset’ hybrid funds.
Illiquid-asset versus liquid-asset hybrids
According to Citco, illiquid-asset (IA) hybrids are becoming increasingly popular as the private markets world aims to capture more private wealth capital. These funds often have between 5% to 25% cash or liquid assets in real assets funds, and slightly higher levels between 15% to 30% in fund of funds.
On the other hand, liquid-asset (LA) hybrids aim to provide investment flexibility by allowing a more diverse asset mix in the portfolio. For instance, the mix of assets in these structures can range from 5% to 70% liquid assets.
Citco reasoned that the rise in IA hybrids is largely due to lower minimum investments and some level of liquidity that attracts new pools of capital. The report also discussed the operational complexities entwined with hybrids.
For example, IA hybrids require more complex investor terms and performance fees, necessitating more robust investor servicing platforms. Meanwhile, LA hybrids face their own set of challenges, such as needing new integrations between previously separate hedge fund and private markets platforms to manage the higher volume and complexity.
Operational challenges and financial models
The Citco report delved into the evolution of financial models used for these types of funds. Initially, private equity assets were managed using closed-ended structures, which remained operationally manual due to the slow pace of activity. With the financial crisis of 2008, private credit funds emerged to replace bank lending, adding to the operational complexity due to more intricate accounting calculations.
By the early 2010s, the use of closed-ended funds for publicly traded assets increased, further complicating operational processes. This escalation was mainly due to the high volume of purchases and sales, which required more calculations for performance fee metrics based on internal rate of return.
Citco highlighted that these complexities have only grown with LPs and GPs now placing lower liquidity assets into higher liquidity funds. The report identified two changes to address liquidity concerns: the fund holds a portion of liquid assets or cash, often termed a ‘liquidity sleeve,’ and conditions are added to the redemption process to slow the rate of redemptions.