Crossover Funds, the artists formerly know as Hybrid
Moderated by Matthew Brown, Waystone’s Global Head of Business Development, topics will focus on what the structuring considerations are for new and existing funds, operational considerations and participation in illiquid opportunities.
Hello, everyone, and thank you for joining today’s webinar on “Crossover Funds, the artists formerly known as Hybrid.” I’m going to pass it over to my colleague, Matthew Brown. Thank you, Matthew.
Thank you, Allie. Welcome, all. Thank you for taking the time to join us today. First off, I’d like to introduce myself and my fellow panelists. My name is Matthew Brown. I’m global head of business development at Waystone. Waystone are a global governance risk and compliance provider, supporting both investment funds and management companies of our clients. We, to date, support over $1 trillion of our client assets from our global offices, and I would like to introduce my panelists.
About the Panelists
Thank you, Matt. I’ll start, Alaina Danley. Thank you for joining us. I’m a managing director with Waystone governance based in the Cayman Islands, serving as a business leader for the fund governance practice and a professional independent director.
Thanks for having me, Matt. My name’s Owen Schmidt. I’m a partner at Schulte, Roth, and Zabel, and the Investment Management Group, where my practice focuses on representing alternative asset managers, hedge funds, private equity fund, venture capital managers, and advising on all things regulatory and compliance related to alternative investment manager.
Matt, thanks again. Seth Factor, tax partner at KPMG, leading the charge on the Emerging Manager Platform on the tax side, and also working with a lot of middle market funds, PE funds, and fund of funds as well.
The Resurgence of Crossover Funds
Thank you, all, and thanks for taking the time to join us today. Why are we here today? We’re here to discuss crossover funds, their popularity, and the nuances of launching and operating such structures. But I guess why are we seeing a resurgence of the popularity of these structures? Like most trends in our industry, we’re seeing growth of these funds driven by investors as the blend of public and private assets offer the possibility of higher returns. And while public and private equity tap into the equity risk premium, private equity investors also expect to be compensated for other risks, including liquidity and manager risk. And given the continued invested demand for such assets, market returns, and Covid, we’ve seen a strong focus on technology in healthcare for such funds, although this doesn’t exclude other sectors.
What we’d like to cover in this discussion is an area that’s been widely reported as the increased competition for these private fields. Whilst hedge funds have dabbled in venture since the dot-com bubble, their presence in this asset class was never as prominent as it has been over the last year. I think this has led to bidding wars for private deals in some instances [inaudible 00:02:48] the established venture capital specialists. This leads to questions around valuation, sort of, being paid for such assets. So a few of my thoughts on the crossover structures to date, maybe if we can put some questions to the panelists, and this is to everyone on the panel. Quite simple, I guess, but we’ll see from the responses,
What is a crossover fund, and why have we seen a resurgence in this fund structure?
Sure, so I can try and take a crack at that first one, Matt. So a crossover fund, a hybrid fund, these are just, sort of, terminology that’s thrown out there, generally speaking, to mean a product that invests in both public and private assets. And typically you hear about this in an open-end fund context, so not your true closed-end private equity fun with no voluntary withdrawals or liquidity. But in an open-end fund, this would be a fund whose investment mandate covers both public and privates. And you touched a little bit on some of the host of issues that can arise on this, and I know we’ll probably touch on some of those additionally later, but at its core, it is a fund designed to invest in both kinds of assets. And what that often means is things like side-pocket mechanics, although there are some other iterations of things with fast pay, and slow pay, and other ways to do it, but side pockets are certainly the most common way of structuring funds around this.
And again, I think you briefly touched on it, but this has certainly been a trend among alternative asset managers, particularly those who have historically focused on public and liquid markets. And you don’t need to go much farther than the front page of “The Financial Press” to see that there is tremendous value being created in private markets, in private companies. And those companies are staying private longer at higher and higher valuations.
So as we’ve seen that, particularly in the tech, and life sciences, and healthcare space, albeit we do see it in other spaces as well, traditionally public markets focused, open-ended fund managers have tried to go to where they see the alpha creation potential. And that largely has been in private markets. And so we are seeing this crossover, again, for lack of a better word, of traditional public market investors getting into private markets, and vice versa, traditional private market PE managers getting into funds that can take a company through its full life cycle, from venture stage, all the way to post IPO.
Seth: And to add onto what Owen was mentioning, along with setting up the fund in a hybrid structure, or side pockets, making sure that from a tax perspective the taxable income is being allocated, a similar way to the economics that are taking place. So making sure that if people are investing in a side pocket or there’s an illiquid investment, that the tax is specifically allocated to the investors the way that the PM wanted it to flow.
Alaina: Matt, I think Owen and Seth covered the core elements here of where these structures are, you know, coming from in the interest. And I do think one thing Owen started with is the ability for asset managers to offer a more diversified allocation. I think we’re seeing the interests and the appetite from investors, particularly institutional investors, to seek diversification, both across their allocations and within the mandates that they’re invested. So I think this is a bit of evolution, and certainly a market opportunity for alpha presenting itself, particularly after a period of dislocation, is seeing a resurgence in the issuance.
And maybe a quick side question to you, Owen:
Are these crossover structures being launched by established managers, or are these new entrants into the market? What are you seeing?
The short answer is both. We are seeing long-term existing managers who maybe have done a few private investments in their fund, co-mingled it with their liquid investments, now want to dedicate a slice of their portfolio to private, and in a more formalized way, and they’re restructuring their funds to do that. We are also seeing a lot of interest among new and emerging managers that want to go out to market with this strategy right from day one, that this is part of their offering. You are going to get public and private exposure, maybe enhanced or additional co-investment exposure to some of these assets, and it’s really all part and parcel of their day-one marketing pitch.
And I guess that leads onto my next question to the panelists, and bear with me, this is a long question but we will work through it.
What are the considerations for existing structures looking to add a liquid investment versus establishing and launching a new vehicle? And where have we seen fund sponsors concentrate in their considerations?
And I’m specifically thinking about items which would be relevant to a public-private hybrid in valuation, operational, accounting, and investor considerations.
Sure, Matt, I’m happy to start there. I think it goes without saying, but to start with the basics is the offering itself. So for an existing manager versus a new manager, we need to really give first consideration around what our existing offering document and offering strategy is and how that needs to alter to bring in the private or liquid investments into the overall strategy. So not only what flexibility there is in the mandate and discretion of the governing body and the investment manager to make allocations to private or liquid investments, or introducing this for the first time. What are the relevant mechanics? We’ll get to the details around that, and Owen started a bit, talking about co-mingling versus side pockets.
But what consents and discretion is needed to get us there? Do we need to provide investors who may not have appetite for the allocation, the opportunity to redeem concurrent or ahead of the allocation to the privates? And how much exposure to the asset class are we thinking to introduce into the strategy itself? So it may sound like a basic consideration but there’s a lot to think about. I’m sure Owen and Seth, in particular, from the tax perspective, will have lots to add there.
I may just touch on a few other things high level before I hand off, and the next would be just operations, operations, operations. I think it often goes under-appreciated as to how many elements of the business overall in operating the fund are impacted by introducing a different asset class into a public market’s strategy. Everything from basic day-to-day reconciliations, thinking of key risks such as pricing and existence, to how the decision making process record keeping of those processes. We’ll get to some of the other core risks. And in particular, the service providers to the fund, what are their capabilities for handling the asset class?
Do our SLA and our terms of our procedural and policy elements take into account the factors particularly around transactional processing, valuation, and existence to accommodate the asset class and our calculation of our NAV on an ongoing frequency, as well as what the implications are for the reporting and transparency to investors post the decision to introduce the private investments into the allocation? I won’t steal Seth’s thunder, but valuation and existence will remain key risks and priorities for fund managers and from the governance oversight in particular. So thinking about valuation, are we establishing a new committee or relevant team of experts to give input into the modeling and the type of valuation approach we’re going to utilize for these investments?
These aren’t Bloomberg prices. Coming out of a traditional pricing source, are we going to consider costs and procedure to integrate third-party pricing providers? And then what are our obligations around safe keep and custodial aspects for private investments in those issuance? I’ll pause there. I know Owen and Seth probably have items to add, particularly around fee mechanics and tax, but they’re the experts, so I’ll hand it off.
Fee Mechanics and Tax
Sure. So that was a tremendous list of some of the issues faced, and I think it speaks to the fact that I have, particularly when you deal with an emerging manager, a new manager that hasn’t done this before, but also existing managers, if they don’t have in-house experience with side pockets. It is always more complicated than they think on its face. And I guess just to zoom out for a moment to explain, I assume most of the audience tuning into this will understand what side pockets are, but just on its most basic level, a portion of your investment in an otherwise open-ended liquid fund will be allocated to a class of shares or class of interests that cannot be voluntarily withdrawn until the underlying assets are redeemed.
So you make an investment in a private company, you put it in a side pocket. A portion of the investment gets moved over to that class corresponding to that asset, and it stays there forever until the asset gets redeemed. So that mechanism, while it’s very elegant from a legal perspective, creates the litany of operational challenges that you just heard about. And I think managers tend to underestimate just how complex some of those challenges can be. We’ve also watched an evolution in side-pocket terms over the past, say, 10 years.
Pre-financial crisis, firms with side pockets had maybe a paragraph that said, “We can make illiquid investments and we can do side pockets.” It may have literally been that basic. Post-financial crisis, after a few years when side pockets came in vogue again, the mechanics maybe spilled out to a couple of pages and we got into some of the more details about how they’re going work, and how allocations are going work, and valuations, and all those things. If you look at a modern fund with side pockets, the side-pocket mechanics can easily spill to eight pages or more. And it covers a lot of this nuance and a lot of this complexity because of all the potential conflicts.
Valuations for purposes of subscriptions or redemptions as well as fee calculations are real, and the side pocket, while is intended to address that, really does create a lot, a lot of operational complexity. Seth’s going speak about some of the tax and valuation challenges specifically, but managers do need to think about both their internal capability to handle all this complexity, and as well as their service provider’s expertise and experience in this space who can really advise them both from an operational and day-to-day challenges of how this is going impact all parts of their business.
And I’ll say one more thing on this, which is, on the legal docs specifically you will get people that say, “Oh, let’s just go ahead and build in side pockets,” without appreciating that it trickles through all the sections of all of your governing documents of your funds. It touches on fees, on allocations, on risk factors, on conflicts. The mechanics, the nuts and bolts of the fund are all touched by these adding side-pocket terms to your products.
Now those are great points, and Alaina and Owen, I think you guys hit it on the head. The complexities and the amount of administrative burden that gets put onto the back office and the service providers is tremendous. So the question is, whether or not, are we buying initially into the side pocket or are we transferring an asset over to the side pocket? Is that a taxable event or non-taxable event? Ideally we want a non-taxable event going over any unrealized appreciation if we are doing an opt-in type of situation or whatever it is. We’ll talk about that next, but we want to make sure we understand what the tax ramification is.
We also want to understand whether or not we’re going to be putting our self in the position of owning a pass-through entity or a C-corp stock, whether or not we’re triggering any thresholds on FIRPTA or [inaudible 00:15:04] property holding companies by really boosting up our investment. In addition to that, one of the other things that has really been something is understanding whether or not, is it a SPAC? Is it a foreign SPAC? Is it a PFIC? What does that mean for us in terms of reporting requirements? A lot of times these are causing a tremendous amount of administrative burden, and even in addition to that, some tax nuances that could affect your economic and after-tax returns as well.
I’ll chime in. We see people stumble into some of those tax problems without even knowing it, that they think they’re going to make a venture investment. They’ve made five of them before, very simple U.S. venture investment. And then all of a sudden, deal number six comes along and it’s such an early stage company that it’s set up as an LLC or a pass through. And they’ve backed themselves into ECI problems that they never saw coming, and you really need to be aware of that stuff up front before you get the call from Seth at the end of the year during the audit and he says, “You’ve got a problem here.”
Yeah, and one of the…go on, Alaina.
No, and one thing I was going to say, well, you guys already helped take the wind out of the excitement of getting into the investment, is something to add and from the governance add is thinking about the end of the investment, right? So Seth, this just triggered. You bring up a good point around the ultimate redemption, right? Are we having investors seeking to leave the private investment vehicle before these illiquids are harvested, right? What does that mean? Are we thinking about provisions to in-kind, tax implications of that? There may be favorable treatment, and have we built in? Have we measured twice and built in the relevant mechanics so if the opportunity to accommodate and be able to be flexible when those decisions need to be made at the ultimate redemption period?
Distribution to the PM & Investor Base
No, that’s perfect. And the two hot topics that I always like to talk about, especially as it relates to private and side pockets are, one, Alaina, like you mentioned, distribution in-kind, both to the PM and to the investor base. It could be a tremendous charitable donation potential, depending if it’s going public and the like. Two, based on carried interest regime, it could also give the PM the opportunity, as it currently stands, to age a position to long term, even if a conviction on the investment is shorter for that side pocket.
The other item that is really popping up a lot more now, especially in early venture type funds, is whether or not the investment is QSBS eligible. And that could be one of the last but extremely enticing tax benefits to an early stage is the fact that there is some flexibility, depending if it meets all the criteria, to have a significant portion of the gain, if not all the gain, to be exempt from federal tax. So there’s definitely a lot going on there. Owen, you seem like you’re ready to chime in on something.
Crossover Strategies Are Not Venture Capital or Traditional Hedge Strategies
No, it’s so true. And one of the things, the first point you just made is something that I see people struggling with all the time, and it goes to the nature of some of the conflicts inherent in this crossover strategy. It’s not a traditional venture capital strategy. It’s not a traditional hedge strategy. It’s somewhere in between. And what you see, when you mention things like picking out, distributing out securities instead of cash, well, in the crossover fund model, by and large, that’s not the end game. The end game is to take the cash from the realization and move it back into the liquid fund, or take the securities and move it back into the liquid fund and sell them eventually when you want.
And so it is not, while in venture capital, very, very, very common for firms to distribute out to appreciated securities, and your U.S. taxable investors will all want that, or even demand that, quite frankly. In these crossover funds, they’re intended to be evergreen. They’re intended to keep recycling that capital permanently. So even though you might have an investor or GPR principal who says, “I would love to get that appreciated stock,” the answer is, well, we’re not paying out withdrawals from realization. It goes right back into the fund and we get to recycle and redeploy that capital.
And you see people, because there is no long history of these crossover funds, you see these concepts from VC creep into the fund structures, and quite frankly, into what the managers want to do. And you see the concepts and the mind sets from hedge funds creep in, and you say, “Well, no, guys, this is a very early stage investment. It might take me six, seven, eight years to realize it. You’re not going to be able to get your money back right away. We can’t market accurately.” And it really speaks to some of the inherent struggles and conflicts in the crossover fund structure.
And that raises an interesting question, Owen, you might be able to answer it, is that with a traditional public equity fund you’re obviously going to have very different liquidity terms than you will with a fund with illiquid assets.
So how do you see managers adjusting to that? Do you see them giving different liquidity terms to those investors that might opt into those private assets? Or are they extending the liquidity terms of the fund overall?
So the answer is it depends. It depends on if you’re going to put illiquid assets in an otherwise liquid pool, or if you were going to have something like side-pocket mechanics, which provides for, basically, I hate to say it, but permanent illiquidity until an asset gets realized. The tradeoff you tend to give investors for agreeing or going into side pockets is a very, very common market term is on management fees. You will not charge management fees on unrealized gains on those assets. Your management fee will typically be based on something like lower of cost and fair value, so you can mark it down but you won’t mark it up, and incentive compensation.
So carried interest incentive allocation typically will not be paid on those assets until realization. So the tradeoff for the illiquidity that the investor is getting is arguably a lower management fee base and a delayed calculation of any incentive compensation. It is not calculating incentive on unrealized gains on those private assets while they’re held in a side pocket.
Seth: And Owen, to top onto that, one of the things that I’ve seen, too, which always throws something off is if you had this investment in your, and you were going to move it over to a side pocket, if your cost basis is extremely low and it appreciated dramatically and then you’re moving it over, is the PM now all of a sudden charging management fees on the initial cost because that’s the cost of the asset, and they’re actually losing money just by moving it over into the side pocket based on the valuation of appreciating asset?
It’s a great question and it does come up. And that question presupposes a term that not every fund even has, which is the ability to designate an asset as a side pocket after acquisition. We will frequently see investors push back and ask for only the right to side pocket assets when you make the investment. There are a lot of firms that can successfully defend the ability to side pocket an asset later on, and the classic example would be you make a small investment. Depending on. your fund size, of course, but you make a 10, 25, 50-basis point investment and it’s a huge home run. It’s a 10x investment, and now that 50-basis point investment is a 500-basis point investment.
And you say, “Whoa, this is actually impacting the liquidity of my overall fund. I now wanna move it to a side pocket.” Seth, you hit the nail on the head. What happens? Do you then move it to a side pocket, have to start charging management fees as though it was a 50-basis point position? Conflicts. It just speaks to some of the conflicts, and your disclosure documents should absolutely disclose the inherent conflicts in this way, and you should speak to your advisors and your counselors about just what the ramifications of those decisions are. Ultimately our clients are fiduciaries and they have to do what’s in the best interests of their clients and their investors, and that may mean taking a hit on management fees if that’s what’s right to manage the overall liquidity of the book. And that’s where, you know, you consult with your directors, and your governance board, and your legal counsel, and your tax advisors, and you consult with those folks to figure out the best course of action.
And I think, Owen and Seth, I don’t know if you see anything to the contrary, but most commonly we will see the offering and governing docs get to a specified threshold of how much of the book they’re looking to have allocated on a cost basis at investment to the illiquids, being pretty transparent of that up front. Perhaps flexible in how that threshold may vary over time, and where the discretion falls for that, and then obviously establishing policy and transparency mechanisms there. But we often see something in the 20% to 30% range. I don’t know if you’re seeing things differently but pretty consistent in terms of coming up with a mechanism and clarity on that for investors at the start.
Yeah, I think that’s right. I probably would’ve ticked it down just a little bit and said 15 to 25, but exactly same ball park. And then the devil is in the details. How are you calculating that limit? When are you calculating it? Are you basing it on the cost of all investments? Are you basing it on the fair value of investments? If you later designate investment as a side pocket, is that at cost? Is that a fair value?
I mean, there are so many iterations and nuances that you really, really…it goes to what I said before about why your disclosure went from a paragraph to potentially eight pages. We sit with clients and we talk them through all of this up front, all of these terms, and this nuance, and this minutia. But ultimately you need to think about that stuff up front because you’re exactly right. You could agree to a 25% limit and not have given thought to about how or when that’s calculated, and either have too much capacity or too little capacity for what you want to do with your investment program based on that.
Sorry, Alaina, I was just going to get to my final question here.
Do all investors have to participate in these illiquid opportunities, or is there specific opt-in, opt-out language that can be utilized in offering documentation?
Very briefly, the opt-in, opt-out mechanics are very common. We see them both in new funds but also from an existing fund perspective where they want to add in side-pocket mechanics. One of the ways to address the issue with requiring investor consent, and again, you have to look at the underlying fund documents and see what your amendment provisions are. But just imposing side pockets unilaterally would almost certainly be an investor consent requirement because you are reducing people’s liquidity. But if you offer it on a purely opt-in, opt-out, you can stay the course and continue the fund with no side pocket exposure and your same liquidity, I think in many times you can get comfortable that that can be one without getting affirmative.
No, that makes a lot of sense. And we’ve spoken a lot about side pockets but we haven’t necessarily covered SPVs.
Are you more inclined with these crossover funds to mingle the public and private assets through side-pocket structures? Or do you see people using separate SPVs to hold these illiquid positions?
We see it both ways. Often times you’ll see the SPV structure to handle co-investments or overflow from capacity of a deal that may otherwise go in the main fund. And we always like to set up an extra SPV so Seth can have another box to audit.
I was going say, Seth will set us straight with the tax issuance but co-invest is what came to mind for me as well, and flexibility for that capacity.
Yeah. And the key questions to understand on the SPV side is, is it going to be an LLC or an LP entity? There might be some foreign investors that might prefer one versus the other based on their country and the jurisdiction that they’re in. The likelihood is a lot of times there’s little to no leverage at all on those assets. You might see more tax exempt investors and pensions in endowment to be more comfortable going in knowing that. Two, it’s a matter of also understanding the type of investment. Is there going to be ECI from trade or business, or just C-corp stock? So those items are key.
Understanding also, there’s additional administrative burden, right? So there’s an incremental additional tax return versus a side pocket which is more just an extra allocation, potentially an extra audit as well that has to get done, and maybe the administrative books and records as well on that. But with that said, it probably also does save you in terms of, though, if somebody’s out of the fund and out of the marketable and did not opt into the LLC, then they’re just done and they’re out. They’re going to get their K-1 and they’re out of the fund.
The fund’s audit and tax work are probably going be a little more streamlined and smoother because you don’t have to worry about valuation issues if it’s not the same investment in both funds. If it is the same investment, maybe you can piggyback a little of the valuation that was done on the master-feeder versus the SPV. I mean, I’ll let Owen and Alaina chime in on expense allocations and all that stuff, but those are some of the tax items that I’ve seen really pop up.
How much time do we have for this panel, Matt? We haven’t even talked about compliance. You could spend a whole panel on the compliance considerations with putting illiquids in an otherwise liquid structure.
I’m just trying to keep to a reasonable time. I appreciate people have other things to do with their days, so I think we’ve just got one question from the audience from a registrant is:
What’s the overall percentage of fund AUM that you would expect to have in private investments with a crossover fund?
Is that based on cost or value? I’m just kidding.
It’s a great question and it depends. We see it all over the map. If you do offer that zero percent option, in other words, that opt-out, there’s probably a little more latitude to potentially offer on a higher level because people are choosing. But if it’s a no choice, one option, I think that 15 to 30 range is probably about where we see it.
I completely agree, and I think something to not be underestimated is thinking about specific investor agreements that may be already in place before we’re navigating the introduction of a new asset class, so our favorite side letter provisions and how those alter over time. But again, I think that’s a completely different panel which we can table for the next one.
Yeah, I’d echo everything, and just understanding where is your business supposed to be focused, and what is your ultimate goal? But I’d echo Owen and Alaina.
Yeah, what do your investors expect and how wide of a latitude did you have in your investment mandate? You do have a future obligation to maximize returns for your investors within your mandate, and if that leads you to private markets, there’s solutions out there to make it work. It’s going to make your life a little more complicated but the returns may be worth it.
I want to thank you all for taking the time, especially to my panelists that gave such a detailed and thoughtful overview of crossover funds. I’ve certainly learned a lot more about this specific hybrid asset class today. We’ll be making the recording available on our respective media portals and perhaps even within the podcasts. And to our guests who are taking time out of their day to listen, thank you for taking the time. We hope you found the content useful, and should you have any questions, please don’t hesitate to reach out to any one of us. Alaina, Owen, Seth, thank you very much, and wishing everyone a great afternoon. And Seth, as you said, we could probably do a range of developments and subsequent podcasts on this exact topic, so that might be something that we would consider doing, and digging a little bit deeper into some of these individual elements.