Since the early 2000s, hedge funds have focused heavily on traditional liquid strategies. As a result, market inefficiencies have narrowed or vanished, and opportunities for arbitrage 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. Using liquid fund vehicles to invest in illiquid assets, however, 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. Convergence at the fund level is problematic because illiquid assets do not fit naturally into a liquid fund. Convergence at the manager level is more palatable, but institutional investors have typically demonstrated a preference for managers that specialize in managing either private equity funds or hedge funds. This article
explains traditional liquid fund structuring and taxation; characteristics and taxation of marketable securities versus private equity; structures employed by liquid funds to accommodate illiquid assets (including side pockets, lock-ups, gates and redemption suspensions); and some of the reasons why illiquid assets present problems when housed in liquid funds. The article concludes with thoughts on structuring for managers that traditionally have focused on liquid strategies but are exploring illiquid opportunities. For more on hedge funds and illiquid assets, see “Co-Investments Enable Hedge Fund Managers to Pursue Illiquid Opportunities While Avoiding Style Drift
” (Jul. 6, 2017); “Credit Suisse Investor Survey Finds Steady Demand for Hedge Funds and Growing Demand for Less-Liquid Products
” (Apr. 13, 2017); and “Lock-Ups and Investor-Level Gates Prevalent in New Hedge Funds
” (Mar. 23, 2017).