Liquidity Has to Come From Somewhere

Private market fund structures continue to evolve. While traditional closed-end funds remain the dominant model for many alternative strategies, managers and investors are increasingly exploring hybrid funds to deal with investor liquidity.  Those structures combine characteristics of open-ended funds with investments in private assets. 

Often described as evergreen or semi-liquid funds, these vehicles may offer: 

• Periodic subscriptions and redemptions; 

• Regular NAV calculations; and 

• An indefinite or extended fund life. 

For managers, they can provide a more permanent source of capital and reduce reliance on traditional fundraising cycles. For investors, they can provide greater flexibility over when they invest and exit. 

But these benefits raise an important question: How much liquidity can a fund investing primarily in illiquid assets realistically provide? 

A hybrid structure can change how investors access private markets. It cannot make an illiquid asset liquid. Ultimately, liquidity has to come from somewhere. 

Private Assets Remain Private Assets 

A traditional closed-end fund largely addresses the liquidity question by matching long-term investor capital with long-term investments. A hybrid vehicle changes that equation by providing investors with some ability to request redemptions. 

An investor may, for example, have the opportunity to redeem quarterly, subject to a fund-level limit. But quarterly redemption opportunities should not be confused with the liquidity available from publicly traded investments. 

A private company cannot necessarily be sold in 30 days. A real estate asset cannot always be sold at its reported value. Private equity portfolios can go through extended periods with few realizations. 

No fund structure changes those underlying economic realities. 

Where Does the Liquidity Come From? 

A hybrid fund has several potential sources of cash to meet redemptions: 

• Portfolio cash flows: Interest, dividends, loan repayments and other distributions. 

• Investment realizations: Asset sales and exits. 

• Liquidity reserves: Cash or liquid securities maintained for anticipated redemptions. 

• Borrowing: Credit facilities used to bridge temporary cash requirements. 

• New subscriptions: Incoming capital that can offset outgoing redemptions. 

Each can play an important role. But they are not interchangeable. 

Holding significant cash can create a drag on returns. Borrowing can address a timing difference but does not create permanent liquidity. New subscriptions can offset normal redemption activity, but continued inflows do not change the liquidity characteristics of the portfolio. 

Ultimately, sustainable liquidity has to come from the assets themselves—through cash flows, realizations or the manager’s ability to sell them. 

The underlying strategy therefore matters. Private credit may generate regular interest and principal repayments. Private equity typically generates less predictable cash flows and may require larger liquidity reserves or more restrictive redemption terms. 

When Liquidity Is Tested 

Liquidity can appear relatively straightforward while a fund is growing. The real test comes when several conditions occur together: 

• Redemption requests increase; 

• New subscriptions decline; 

• Portfolio realizations slow; and 

• Private assets become more difficult to sell. 

The manager may then need to use cash reserves, increase borrowing or sell investments. The assets that are easiest to sell, however, may not be the investments the manager would otherwise choose to sell. 

This is why many hybrid structures include notice periods, redemption limits or gates. These provisions can reduce the risk of forced asset sales, give managers time to generate liquidity and protect remaining investors from bearing disproportionate costs associated with redemptions. 

A gate should therefore not necessarily be viewed as evidence that a liquidity structure has failed. It may be the mechanism that allows the structure to work as intended. 

Periodic liquidity is not the same as guaranteed liquidity. 

Finding the Right Balance 

Hybrid funds can provide greater investor flexibility while giving managers access to a more permanent capital base. But managers need to design liquidity terms around the portfolio—not the other way around. 

That requires balancing: 

• Expected portfolio cash flows and realization timelines; 

• Cash and liquid investment reserves; 

• Borrowing capacity; 

• Subscription and redemption patterns; and 

• Appropriate notice periods and redemption limits. 

Clear communication is equally important. Investors need to understand the difference between having an opportunity to request liquidity and holding a liquid investment. 

For managers operating or considering a hybrid structure, the starting point should be the portfolio itself. The question is not simply how much liquidity investors want—it is how much liquidity the portfolio can sustainably support. 

Managers should regularly stress-test their assumptions under different scenarios, including higher redemptions, lower subscriptions and slower realizations. Fund administrators can play an important role by providing the underlying data, reporting and scenario analysis needed to understand the fund’s liquidity position. 

In Summary 

Hybrid funds can provide investors with greater flexibility while allowing managers to maintain a long-term private markets strategy. However, the liquidity offered to investors must remain aligned with the liquidity of the underlying portfolio. Effective liquidity management requires realistic assumptions, appropriate redemption terms, regular stress testing and clear communication with investors. 

The objective is not to maximize liquidity, but to provide a level of liquidity that the fund can sustainably support without compromising its investment strategy or disadvantaging remaining investors. 

Contact Alex Chapman at achapman@pinnaclefundservices.com to see how Pinnacle can help with your hybrid fund liquidity concerns.