Multi-manager platform funds, which seek to generate superior risk-adjusted returns – or “alpha” – by allocating capital to multiple portfolio managers who trade independently across a broad spectrum of strategies, remain popular among hedge fund investors. These funds offer access to specialized talent, diversification against market or systemic risk, and centralized risk management. They also tend to be cash efficient and thus have significant amounts of available cash. As a result of these features, we are seeing a trend among multi-manager platform funds to supplement their core (“pure alpha”) strategies with “beta overlay” (sometimes also referred to as “beta one” or “portable alpha”) products that use available cash to add targeted overall market exposure – or “beta” – to their core strategies. In this article, we examine some of the structuring and legal considerations that fund managers should consider when offering these products.
In funds that use beta overlay strategies, investors receive both “alpha” exposure to the fund’s core investment strategies and “beta” exposure through investments in a market index (such as the S&P 500 or the MSCI World Index) or other beta benchmark via the use of swaps, derivatives, futures contracts, ETFs or otherwise. These strategies may take a number of forms, including by targeting a fixed ratio across the alpha and beta exposures (e.g., 50% exposure to the alpha strategy and 50% exposure to the beta strategy), targeting a fixed gross beta (e.g., pairing a 0.9 beta exposure to the target index with a 0.1 beta on the alpha strategy) or investing the cash savings from derivative exposure to the beta benchmark (as opposed to fully funded exposure) in an alpha-generating investment. In some cases, we are also seeing beta overlay strategies that create a new alpha portfolio by selecting a subset of the manager’s core fund strategy in order to dynamically adjust the beta of the alpha strategy.
We are seeing a trend among multi-manager platform funds to supplement their core (“pure alpha”) strategies with “beta overlay”.
Simon Saddleton, Zach Paterick and David Tang, Sidley Austin
Broadly speaking, managers looking to offer new beta overlay products to investors have three basic options: (i) creating a new investment vehicle that implements the beta overlay strategy in parallel with the manager’s core fund (“Parallel Fund Structures”); (ii) creating a new vehicle that implements the beta overlay strategy by investing in the manager’s core fund or in underlying portfolio funds through which the core fund implements its trading activities (“Feeder Fund Structures”); or (iii) adding beta overlay share classes to their existing funds without creating new vehicles (“Add-on Class Structures”). Each of these options has pros and cons, as further discussed below.
Parallel Fund Structures. In the Parallel Fund Structure, the manager forms a parallel fund that holds its own portfolio of both alpha- and beta-generating assets that it trades separately from the manager’s core fund. As a separate legal entity, the parallel fund may use its own assets as collateral for margin or other financing to support its beta portfolio, reducing “contagion” risk to the manager’s core fund. However, the need to maintain the parallel fund as a separate trading vehicle (with, for example, its own trading infrastructure and counterparty agreements) adds complexity and cost. In addition, because the parallel fund’s alpha portfolio, although held separately, will nevertheless overlap with the core fund’s portfolio, contagion risk cannot be completely eliminated – for example, rapid sales by the parallel fund to meet margin calls relating to the beta portfolio may depress the prices of assets held by the core fund. Managers must also allocate trading opportunities and expenses between funds (which may be especially challenging for multi-manager firms that pass through overhead expenses to their funds) and otherwise address inter-fund conflicts, including cross-trading, in a manner consistent with their duties to all of their funds.
Feeder Fund Structures. In the Feeder Fund Structure, a newly-created feeder fund holds the beta portfolio directly and obtains alpha exposure by investing in the core fund (rather than trading the alpha portfolio assets on its own). The Feeder Fund Structure thus leverages the core fund’s trading infrastructure (i.e., its existing trading and counterparty agreements) for the alpha portfolio, reducing some of the costs and complexities of Parallel Fund Structures. Because the beta portfolio is held in a separate legal entity (the feeder fund), counterparties to the beta portfolio, including counterparties who require margin, should have recourse only to the feeder fund’s assets, reducing contagion risk to the manager’s core fund. However, because the feeder fund’s principal (non-beta) asset is its investment in the core fund (which will generally be subject to liquidity restrictions), the feeder fund may face limitations on its ability to obtain margin financing on acceptable terms. In addition, if the feeder fund must pledge its interests in the core fund to counterparties in order to support the margin requirements of the beta portfolio, foreclosure and/or forced liquidation of those core fund interests also presents risks to both the core fund and the feeder fund that must be evaluated and managed. Care must also be taken to ensure that any tax differences between the feeder fund and the core fund are properly addressed (for example, the possibility that, unlike the core fund, the feeder may not be deemed to be a “trader” for US federal income tax purposes and thus subject to limitations on deductions for expenses).
Add-on Class Structures. In the Add-on Class Structure, no new vehicle is formed – instead, the beta portfolio is held by the core fund (in addition to the alpha portfolio), and the core fund specially allocates profit and loss from the beta portfolio to investors in a new “beta overlay” (or “beta one” or “portable alpha”) class (or series) of interest issued by the core fund. An Add-on Class Structure is simplest from an operational perspective, but because it does not involve the creation of a new vehicle, it presents significant contagion risk compared to the Parallel Fund or Feeder Fund Structures that must be carefully evaluated and managed.
In addition to the structuring challenges and considerations discussed above, managers should be mindful of the following issues when implementing beta overlay share classes:
Before introducing beta overlay strategies (especially through Add-on Class Structures), managers should carefully consider whether such strategies could present contagion or other risks to their existing core funds and/or investors in “pure alpha” strategies, and whether those risks can be mitigated structurally (for example, by limiting the size of the beta overlay strategy relative to the core fund, or by negotiating with trading counterparties to limit their recourse if the beta portfolio deteriorates). Where these risks cannot be structurally eliminated and/or are material, managers will need to ensure that they are adequately and effectively disclosed to both prospective and existing fund investors (and, with respect to existing investors, that any necessary consents have been properly obtained).