The global hedge fund indus-try continues to be a growth engine in financial services. The sector as a whole has increased by more than 10% per year since the global

financial crisis, according to Aima figures. But how can managers sustain this growth

amid increasing competition for investor capital? Today, managers need to seek many paths to growth, including looking at new products. In fact, launching new products was the top priority for nearly one-third of man-agers (more so than issues such as expanding into new markets and adding new strategies) in EY’s 2014 Global Hedge Fund Survey.

Investors, meanwhile, continue to demand higher returns, lower fees and customised portfolios in the form of separately managed accounts (SMAs) or so-called 'funds of one'. According to Aima, nearly two-thirds of managers say they see increased demand for custom solutions from their investors. In fact, almost half say they already offer a fund of one

or managed fund solution, with an additional 21% saying they intend to offer these solutions within the next five years.

Some of the most intriguing types of new products are funds focused on illiquid assets, such as distressed debt, mezzanine financ-ing, CLOs, bank debt and real estate. These products represent a departure for many traditional hedge fund managers. The illiquid nature of these investments requires a closed-end capital structure that is more similar to that of a private equity or real estate (PE/RE) fund. But these hedge funds are different from traditional PE/RE because of the nature of their investments and the frequency of their trades.

The operational challenges of hybrid funds

EY examines the growth of hybrid vehicles and the issues that managers looking to tap into positive

investor sentiment in this space need to watch out for

Because of their dual-faceted nature, these funds have become known as hybrid funds. Investors are increasingly allocating to hybrid funds because they offer the potential for pri-vate equity-like returns, but with the shorter lock-ups and greater liquidity of a hedge fund.

Operational challenges of a hybrid fundFund managers must take great care when operating these types of hybrid funds because they present many operational, accounting and tax planning challenges. Many typical hedge funds, administrators and investment operations outsourcing firms do not have the functionality to support hybrid funds that are focused on strategies such as illiquid credit.

What can make these funds so complex from an operational standpoint is that these credit instruments can have different levels of liquidity, funding sources, valuation processes, custody arrangements and settlement pro-cesses – all within one investment portfolio.

Fortunately, the ever-adaptive hedge fund industry is rising to meet the changing needs of managers. This trend is driving fund administrators who support hedge funds that are expanding into alternative credit strategies and privately held investments to leverage capabilities initially developed for the PE industry. For instance, leading admin-istrators with PE experience that are familiar with different categories of credit assets can quickly settle these types of trades, which can provide many benefits – not the least of which is speeding up the compensation process for managers.

With the help of these and other service providers, hybrid fund managers can plan for and overcome these challenges if they are to continue to attract clients and grow AuM.

Accounting and financial statement implicationsThe process for investing in credit funds is very different from the process of investing in a typical hedge fund. Whereas a tradi-tional hedge fund accepts capital and invests it according to its strategy and the current market environment, a hybrid fund functions more like a private equity fund. Investors make a capital commitment to invest a certain amount, from which the manager can then

Hybrid funds present many operational, accounting and tax planning challenges" Samer Ojjeh and Jun Li

draw capital (capital call) or return capital (distribution) to investors.

This sort of structure requires a different set of operational standards whereby these hybrid funds have to support the allocation of fund expenses, calculation of fees and accounting for the investments of both lim-ited partners and general partners.

Tax planning: avoiding potential pitfallsIn many cases, operating a hybrid fund will require proactive tax planning to avoid potential pitfalls. At a high level, managers must establish processes for having periodic discussions and reviews with the CFO, the director of tax and portfolio managers, as well as outside advisors, to minimise the risk of unexpected tax surprises at year-end.

For example, managers must pay careful attention to the timing of realising capital gains and losses from a tax perspective, as well as closely monitor cash flows from the underlying investments because short-term gains (12 months or less) are taxed at a sig-nificantly higher rate than long-term gains. In certain instances, managers could be faced with income from distressed debt invest-ments on an accrued basis that is subject to tax, without receiving the proper matching cash flow from the issuer. This is sometimes called phantom income.

There is another potential pitfall. Gen-erally, an offshore hedge fund is treated as trading in stocks and securities for its own account under IRC Section 864(b)(2) (trading safe harbour). Participation in certain loan investments may be considered as lending for an offshore fund which would not meet the trading safe harbour.

The consequence for failure to meet the trading safe harbor would result in the off-shore fund being subject to US federal income tax and branch profits tax. The requirements for meeting safe harbour rules for syndicated debt, loan modifications and workouts, DIP financing, mezzanine debt and fee income are complex, and therefore require upfront plan-ning and robust internal guidelines for both the investment team and finance team.

Moreover, cross-border taxation issues can arise as alternative funds continue to

increase asset allocation outside of the US by buying equity and debt interest in Europe, Asia and emerging markets. In addition to monitoring their local markets, managers must also have a clear understanding of local tax and regulatory requirements to minimize tax leakage upon exit. Managers must also be alert to the various global tax initiatives from the Organization for Eco-nomic Cooperation and Development and tax authorities around the world designed to increase transparency between taxpayers and tax authorities. These emerging man-dates can increase the costs of compliance and investing internationally.

In general, by staying ahead of the issues mentioned above and actively projecting and monitoring potential tax obligations, a hybrid fund manager will be better informed about

the complete risk-return profile of a potential alternative credit investment.

Building a world-class hybrid fundIn today’s increasingly competitive environ-ment, best-in-class investment management is about more than just Internal Rate of Return and performance. Hedge fund managers must be prepared to meet investor demands for stronger operational capabilities, increased transparency and more accurate reporting. Particularly for hybrid fund managers, the

quality, accuracy and consistency of their data is critical as they lead their organisations through the regulatory, tax and reporting landscapes.

The evolution of hybrid funds creates a significant opportunity for fund administra-tors who can combine their hedge fund and PE capabilities to develop an operating model to support these investment structures. For the managers of these funds, creating an open dialogue between the front and back office and making investments in solid operational processes, best-of-breed systems and tools can help achieve optimum performance. ¤

Managers must have a clear understanding of local tax and regulatory requirements" Samer Ojjeh and Jun Li

Jun Li:Jun.Li@ey.com, 212-773-6522Samer Ojjeh:samer.ojjeh@ey.com, 212-773-6486

Samer Ojjeh (left) is principal, financial services office, and Jun Li (right) is partner financial services office tax at Ernst & Young LLP