During the past decade, an increasing volume of hedge fund dollars has poured into traditional liquid strategies. As a result, market inefficiencies have narrowed or vanished, and opportunities for arbitrage – and the alpha it can generate – have grown fewer and farther between. In response, some hedge fund managers that traditionally focused on liquid strategies started investing at least part of their funds’ capital in private equity and other illiquid securities and assets. However, using liquid fund vehicles to invest in illiquid assets has presented a variety of problems, including those relating to: taxation, liquidity, valuation, manager compensation, strategy drift, due diligence, expectations regarding returns and regulatory scrutiny. While there has been considerable discussion
regarding the convergence of hedge funds and private equity funds, the experience and aftermath of the credit crisis indicate that the convergence discussion should be more refined. Convergence at the fund level is problematic because illiquids do not fit naturally into a liquid fund. Convergence at the manager level – for example, the same manager managing both private equity funds and hedge funds – is marginally more palatable, but by and large, institutional investors have demonstrated a preference for managers who stick to their knitting. In a guest article, Philippe Simoens, Senior Manager in Tax and Strategic Business Services for Weaver, an independent certified public accounting firm, addresses some of the reasons why illiquid assets present problems when housed in liquid funds – even liquid funds purportedly structured to accommodate illiquid investments via mechanisms such as side pockets. In the course of doing so, this article explains traditional liquid fund structuring and taxation; characteristics and taxation of marketable securities versus private equity; and structures employed by liquid funds to accommodate illiquid assets (including side pockets, lock-ups, gates and redemption suspensions). The article concludes with thoughts on structuring for managers who traditionally have focused on liquid strategies, but who are exploring illiquid opportunities.