Hedge funds typically invest in liquid, publicly-traded opportunities. However, during the investment process, it’s not uncommon for a manager to come across a less-liquid investment that is not appropriate for the hedge fund that might be of interest to clients. In these scenarios, hedge fund managers may take a number of different approaches to structure this type of investment:
- Sidepockets — If a manager wants to set up a separate carveout account within the main hedge fund to accommodate illiquid investments, it may wish to consider establishing a sidepocket (or designated investment) account. A sidepocket account usually has a management fee based on the cost of the illiquid position, with no incentive allocation or withdrawals permitted within the account until there’s a realization event. Moreover, usually only investors in the hedge fund at the time of the illiquid investment participate in the particular investment. Some managers build in sidepockets upon the fund’s launch and may want to consider whether participation in sidepockets is mandatory or elective and whether there will be a percentage cap on illiquid investments. In other cases, the manager may want to implement sidepockets after the fund launch — this is more complicated, as it will probably require eliciting investor consent, unless the fund documents had the built-in flexibility allowing the manager to implement sidepocket mechanics at a later date.
- Separately Managed Accounts — A much simpler way for purchasing illiquid investments for a particular client would be to buy the investments through a specially created separately managed account (SMA) for such client. SMAs can be created very quickly and inexpensively, since they simply require an investment management agreement and a trading account. However, going down the SMA path could trigger investment adviser registration issues for the manager, as well as, in the case of US pension clients, ERISA concerns. In addition, SMAs can only accommodate one client at a time, and thus aren’t ideal if targeting multiple investors. Depending on the structure of the SMA client, the client may wish to establish an LLC or similar vehicle for protection against any liability incurred in connection with the investment. Most importantly, generally the carry in an SMA is set up as an incentive fee and not as an incentive allocation – this means that all the income is ordinary and there would be no opportunity to receive three year long-terms gains flow-through, which could be a distinct possibility where an illiquid asset is involved; so, if the strategy is only aimed at illiquids, an SMA is likely not going to be the best option for the manager.
- Co-investment Special Purpose Vehicles — To the extent that the manager does not want the illiquid investments to be held in the main hedge fund, setting up a special purpose vehicle (SPV) that either will invest in the opportunity by itself or co-invest alongside the main hedge fund might be the preferred route. An SPV is a separately established fund vehicle that can typically be set up relatively quickly. It is meant to hold a very small number of investments (usually, just one to three) that often must be acquired within a very short time period. Generally, SPVs do not permit investor liquidity and the carried interest follows the private equity fund model (i.e., no annual incentive allocation and the carried interest to the general partner is made only upon final realization). SPVs do, however, present issues relating to expense allocations, conflicts of interest and raising capital, among other things, but they are useful in many instances. For a more detailed discussion about SPVs, please read: https://www.sewkis.com/publications/key-issues-when-establishing-a-co-investment-vehicle/.
- Standalone Funds — If the manager concludes that illiquid investments can become a much larger opportunity for the firm, the approaches described above may be insufficient, and the manager may instead opt to establish a standalone closed-end fund. A closed end private equity or private credit style fund provides the manager with a more permanent committed capital base to pursue numerous private investment opportunities over the length of the fund’s investment period (usually three to five years) without having to worry about raising new money. While there are many positives, these vehicles may create challenges and conflicts of interest for the hedge fund manager, including with respect to expense allocations, compensation schemes within the firm, concerns relating to MNPI and valuations, and other operational and compliance issues. Moreover, it may be challenging for the hedge fund manager to raise a sizeable fund without a historical track record in the illiquid investment strategy.
Each of the approaches outlined herein may be the proper solution for accessing the illiquid markets, however, one must carefully weigh the business and legal considerations before proceeding.