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As I wrote in a recent paper, I believe we are witnessing a convergence between public and private markets that is creating a more integrated “ecosystem” of public and private companies and broadly altering the investment landscape. Case in point: A growing number of hedge funds are looking across not just the public market but the private market as well, to understand industry dynamics more fully and to identify potential winners and losers. In fact, hedge funds accounted for 15% of total private market deployment in 2021.1
For those evaluating hybrid or crossover strategies, one of the key questions is where they should reside within an asset allocation. Allocators with a specialist model, for example, must determine whether hybrid strategies are best overseen by the hedge fund, private investment, or public market team. In this brief note, I’ll share my views on this important portfolio construction decision, which asset owners may want to look at as a multiple-choice exercise with one or more correct answers depending on the institution’s liquidity needs and governance structures.
Long/short directional strategies play an important role in many allocators’ tool kits. For example, they may help enhance performance in a volatile market, which is generally conducive to long/short alpha generation, and their ability to modulate beta exposure may contribute to overall portfolio resilience. Given their unique attributes, hybrid strategies may warrant a stand-alone category within a diversified hedge fund allocation. These strategies may have the flexibility to benefit from arbitrage opportunities across structural winners and losers, both via long/short and public/private positions. Additionally, hybrid strategies typically have the ability to be opportunistic and take into account relative valuations when deploying capital into public or private investments. Thus, they may have a higher level of idiosyncratic risk versus other directional long/short strategies.
From a governance perspective, the evergreen nature of hybrid strategies may lessen the due diligence and resource requirements, allowing staffs to lean into private markets without needing to manage capital calls and fundraising cycles. Importantly, allocators need to consider the liquidity profile of hybrid strategies, which may use “side pockets” to segregate the less-liquid private investments from the more-liquid public investments. There should be a clear understanding of the expected steady-state level between public and private exposures, to help assess whether there will be sufficient liquidity to support liabilities and spending needs. Allocators should also consider tracking liquidity at the total portfolio level, monitoring aggregate private market exposure no matter where the allocation resides.
Managers of hybrid strategies typically seek to apply the breadth of their public market acumen to private opportunities and to identify superior growth prospects across the public and private competitive landscape. While hybrid strategies may at times not reap the same illiquidity premium as fully private investments, the enhanced liquidity may alleviate certain governance challenges facing private investment staffs. The liquidity profile of open-end vehicles may, for example, facilitate more frequent rebalancing than closed-end vehicles while still allowing for a strong foothold in innovative sectors. In addition, the evergreen structure may offer the ability to recycle capital back into the portfolio as realizations occur and thereby reduce the due diligence burden (especially valuable in periods of condensed fundraising such as 2021). Hybrid managers may also benefit from having access to capital during equity market drawdowns, when private market managers may not be calling capital. Lastly, hybrid strategies allow investors to be fully exposed at inception, potentially minimizing J-curve drag in the portfolio.2 This may be valuable for allocators building out their private market programs.
Allocators must think holistically about how they pursue growth across their portfolios. With so much disruption, dislocation, and innovation affecting markets today, I think investors with significant public market programs should review their public portfolio’s exposure to sectors, geographies, market caps, and factors to identify potential risks and opportunities. This may also be an opportune time to carefully review portfolio liquidity and how it could be affected by various stress scenarios.
Depending on the outcome of the exposure and liquidity analysis, allocators may consider using specialized hybrid strategies to amplify exposure to innovative areas or to fill in gaps created by the changing market landscape. For example, allocators may want to put more capital behind structural megatrends impacting sectors such as technology, biopharma, fintech, or consumer. They may also find that traditional public market small-cap allocations are missing out on an important phase of growth potential in companies that opt to stay private longer — a topic I discussed in my recent paper. Regardless of the gap being addressed, allocations should be made with clear expectations for liquidity sourcing and strong conviction in manager selection skill and access. I believe manager research should focus on strategies committed to a presence in both public and private markets (no “tourist capital”) and emphasize diligence, selectivity, and caution in underwriting activities.
Allocators may also consider a cross-functional approach in which a group comprised of hedge fund, private, and public market team members can collaboratively research hybrid strategies and make a recommendation to the investment committee or other decision-making group. It may streamline the process for one team member to serve as the lead for each strategy, with responsibility for incorporating each stakeholder’s views into the due diligence and oversight process. While a collaborative approach may be a challenge for some governance structures, I think it warrants consideration given my strong expectation that the public/private equity convergence trend will persist.
1Morgan Stanley, 2022
2In private equity, the J curve is a phenomenon in which a period of unfavorable returns is followed by a period of increasing returns in later years when the investments mature.
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