Traditional long-only public market investments are facing pressure from multiple forces ranging from rising interest rates and asset class correlations to inflation and economic slowdown, following years of success amid relatively liberal capital markets and suppressed volatility. The shift has prompted investors to reconsider how to rebalance and optimize portfolios and examine a variety of new approaches from asset type utilization to reviewing strategic and tactical allocations. This trend is causing a transition from liquid public markets to alternative private investments. Public equity markets have been offering increasingly narrow exposure across fewer long-standing names. Private markets supplement and complement that contraction. To a lesser degree, credit investors are entering private markets to achieve a truly diversified portfolio of yield, a migration that started with the zero interest rate policies during the global financial crisis and that has continued into the current rising rate environment, which favors shorter duration and floating rate instruments, among other investments. Investors who have preferred neatly categorized formal portfolio allocations are now questioning whether they should consider broadening their investment options, and in this paper we examine some of the opportunities offered through private hybrid/ opportunistic funds to lessen the impact of current market challenges.

Key Takeaways

• Current environment forcing a reconsideration of traditional asset allocation
• Hybrid funds may provide differentiated sources of return taking advantage of supply-demand imbalances
• Post-GFC specialized hybrid funds are benefitting from the flow of investments which historically may have been owned by the proprietary investment teams at investment banks
• Various market conditions may be favoring this type of investment style

Understanding Hybrid/ Opportunistic Funds
Hybrid/opportunistic funds encompass a wide range of asset classes and instruments aimed at decreasing portfolio volatility and reducing market beta. In general, these funds have more liberal mandates to invest across asset classes and to utilize specific instruments that may not fit into a current investment category or traditional investment mandate. While traditional investing may simplify portfolio allocations, the undercapitalized, underrecognized, un-catalogued, and under-pursued investment opportunities can offer the highest risk-adjusted returns. Hybrid/ opportunistic funds act as customized capital solutions providers to companies with unique liquidity needs. These funds are advantageous because they can invest across the capital structure and use a variety and combination of investment instruments to create unique risk-reward profiles.

Historically, these types of capital solutions were provided by proprietary desks at investment banks, which were able to offer flexible solutions and capital efficiently because their mandates were so broad. The banks themselves ultimately benefitted from these investments. Capital provision by proprietary desks ceased after the global financial crisis, when the banks reverted to their core banking businesses. Subsequently, these bespoke capital solutions are now offered to those with capital or liquidity needs by private funds, which enable their investors to benefit from this flexible investing style.

Rare Opportunity
Hybrid/opportunistic strategies seek to achieve their objectives through nuanced investments that are often difficult to source, highly customized, bilaterally negotiated, and time sensitive. Many deals require differentiated analysis, detailed expertise of the industry or markets, and/or specialized structuring capabilities. Some are too small to attract attention from larger institutions, while other deals are limited to smaller communities of investors who know the niche markets and businesses involved. Specialized funds can earn a premium because so few capital sources offer mandates flexible enough to provide this capital or liquidity. Moreover, the expertise to create these investment solutions is rarified.

It is prudent for investors to seek areas of the market where the supply-demand balance is in their favor. Finding these supply gaps has historically driven enhanced risk-adjusted returns, especially when investments contain combinations of liquidity, complexity, and scarcity/ structuring premiums. Returns consequently tend to be alpha-oriented and less correlated to traditional assets, complementing portfolios by providing excess returns over traditional markets, and other times providing differentiated returns and downside risk protection. There are always strategic opportunities for those with the skills and talent to see what others don’t. In this case, investors are outsourcing this capability to dedicated, specialized teams with liberal mandates that are intentionally opportunistic.

Windows of opportunity open and close without warning and having a dedicated hybrid strategy allocation could be extremely valuable, reducing the risk of mistiming or lacking available capital. Often, the advantage of the hybrid model is flexibility accompanied by execution expertise. Consider it a complexity premium with a willingness and capacity to structure and tailor a deal to alleviate risk without sacrificing premium. Hybrid funds tend to be very bottom-up focused and less disrupted by traditional market movements. Hybrid/opportunistic strategies respond dynamically, moving with conviction, judgment, and discipline to capture opportunities that less-equipped investors miss.

Why Now?
Currently, investors are evaluating portfolio allocations in the light of changing markets dynamics that impact their mix of alpha (specific or idiosyncratic risk) and beta (market risk, volatility, and shifts in supply and demand). Our colleague at Morgan Stanley Wealth Management¹ wrote presciently about considerations around directional-only passive beta risk at the start of 2022 and the need to take a more considerate approach to identifying differentiated active sources of return. By design and objective, hybrid/opportunistic investing falls squarely into this camp.

Efficient markets hypothesis (EMH) suggests that markets price in all available information to create accurate valuations. In a perfect market, there are no transaction costs, information is free, and investors are rational and share expectations, thereby creating efficient markets. Within the world of hybrid/ opportunistic investing, we see several factors at play that undermine market efficiency. With the growing range of available investments, increasing volatility, and constraints around information exchange, transparency, and access, certain areas of the market, particularly the private markets, offer an edge to skilled investment professionals. Especially during times of heightened stress or volatility, certain managers may achieve attractive differentiated results. Many traditional and alternative investments can provide a form of diversification, but correlations are abnormal and can spike in times of stress. Hybrid funds are diversified across asset classes, with some, such as royalties, remaining uncorrelated even among themselves. These true non-correlating properties, along with contractual protections in the structuring of some deals, may generate attractive true non-correlated returns.

Before we delve more deeply into some of the specific investments considered by hybrid/opportunistic funds, it's useful to provide some context for the current investing climate. Most significantly, the supply-demand dynamic between capital seeker and provider is shifting toward supplier.

Structuring Alpha
In the current environment, capital needs are at a premium and the capital provider may have heightened influence in their ability to negotiate pricing and structure optionality around the transaction to obtain enhanced contractual downside protections. Some of these structures result in differentiated returns, or structural alpha, for the capital provider.

Weakening M&A Cycle
The supply of capital is typically much tighter following a protracted period of robust mergers and acquisitions and deal activities. In a typical M&A cycle, deal volumes and values initially decrease in keeping with an economic downturn, often prompted by external events. In this environment, hybrid/opportunistic funds can be the provider of capital capable of plugging a liquidity gap at attractive terms for the capital provider.

Staying Private Longer
Less regulatory oversight, inflation, recession fears, and broad market volatility are among the many reasons why some companies delay initial public offerings. The IPO market has significantly slowed in 2022, and many companies that went public in recent years are now trading below IPO prices, suggesting that public markets are demanding more maturity for new issuers. Also, within private markets, there is heightened sensitivity around traditional private equity rounds of financing. Due to current market conditions, companies worry that a "down round" (financing in which a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier financing) will be perceived negatively. Companies are looking at different ways of structuring their financing to shore up capital. This opens significant opportunities for hybrid/ opportunistic investors with liberal mandate requirements enabling them to structure investments attractive to both parties. Moreover, many growth companies are pivoting hard from spending to bolster top line growth. Traditional private and public capital markets are unable to provide the capital they need.

Transaction Speed, Certainty, and Confidentiality
Sometimes companies prefer to transact privately, with a limited set of capital providers executing transactions quickly and efficiently. Hybrid/opportunistic funds offer the flexibility, access, and expertise to achieve these goals with certainty and speed regarding structure, terms, and rates.

Volatility
Capital needs are exacerbated in periods of heightened volatility, as supply-demand gaps widen. During moments of volatility and market disruption, several circumstances occur:

1. Issuers' need for capital may increase and/or accelerate through cash flow constraints, or the business plan requires additional capital
2. Sources of capital may become more expensive, harder to find, or dry up
3. Regulatory constraints are imposed (prop desks are restricted from participating)
4. Tourist investors (institutions that don't typically have roots in venture capital) re-focus on primary areas of investing or retrench as noted below
5. Liquidity constrained investors seek liquid assets

Retrenchment
During periods of market exuberance, investment firms may stretch beyond their comfort zones into other areas in a bid to boost returns through differentiation. Over the past few years traditional hedge funds have leaned into more private growth-orientated investments, but in times of stress, there is typical retrenchment back to core mandates. Pullback often creates opportunities for investors with flexible mandates who are dedicated to the space.

Conclusion
Hybrid/opportunistic funds are unconventional and invest in opportunities that require expertise and sourcing. These investments can be episodic, hard to access, and complex, but they can generate attractive differentiated risk-adjusted returns. Current market conditions create more opportunity for hybrid investing gains. Understanding the overall objective of hybrid/opportunistic funds requires evaluating the profiles of potential investments and why they may suit the current environment. Offerings include payment-in-kind (PIK) instruments, warrants, royalties, and tax receivable agreements (TRAs). Hybrid/opportunistic investments may provide a unique diversified return source with low correlation from traditional investments that investors cannot capture on their own.

¹ Passive Investing: The Right Strategy for 2022? | Morgan Stanley by Lisa Shalett, Chief Investment Officer, Wealth Management. January 4, 2022.