A new partnership between Capital Group and KKR will launch a series of (so-called) hybrid funds investing in both public and private debt securities.

These are vehicles intentionally set up this way, rather than those adding public or private exposure to an existing strategy for tactical or financial engineering purposes – First, when a private equity fund (illiquid) decides to hold onto securities that have gone public to take advantage of favorable public market conditions, or because they don’t want to realize losses if the IPO hasn’t traded well post-listing;  Second, when hedge funds add exposure to private equity as a way of reducing volatility (while ironically actually increasing risk), something that has been affectionately called “volatility laundering” by some skeptics.  In both cases, the strategy starts out as exclusively private (private equity fund) or public (hedge fund) and morphs into something different over time.  Nothing wrong with that, just not purpose-built from my perspective.

Here’s what I like about this structure:

  • Research insights are agnostic to structure.  Why should insights be constrained to one liquidity construct?  In our world, inflection ideas can seamlessly be deployed across vehicles or formats to the most attractive asymmetric risk return opportunity for efficient implementation.
  • Tactically, timing matters.  There are times when illiquidity premiums are rewarding and times where they are not.  Having one foot in each camp provides the opportunity to take advantage of liquidity quirks and market disconnects.
  • Capital never lays fallow.  Private capital call structures suffer from the J-curve effect.  The initial years, or the investment period, are characterized by negative returns as the portfolio is built and management fees are paid.  After that, presumed realizations start to narrow the gap and eventually overall performance turns positive in the middle innings (if all goes well, of course).  Often, investors reserve capital in cash-equivalent instruments on the sidelines in anticipation of this capital being called.  Why not utilize hedged liquid strategies to earn meaningful returns in the meantime? 
  • Allows for orderly periodic liquidity.  With a meaningful allocation to liquid securities, managers are never forced sellers of illiquid securities at inopportune times (and likely at a near-term discount), allowing the investment theses to play out over longer holding periods to maximize returns.

Going forward, Hybrid-type strategies could be a more efficient way to allocate capital to opportunities, regardless of liquidity or structure.

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