Asset owners are skeptical yet open to investing in hedge funds that cross over into the private markets — as long as the conditions are right.
At the 2022 TRS/ERS Emerging Manager Conference on Wednesday, Lulu Llano, a director at the Teacher Retirement System of Texas, and Panayiotis Lambropoulos, a portfolio manager at the Employees Retirement System of Texas, shared their views on the topic alongside Amit Doshi, a founder at Harbor Spring Capital.
The subject is top of mind for many asset owners, because hedge funds are increasingly tapping into the private markets. Fewer companies are publicly traded, and hedge funds’ private equity peers outperform.
Lambropoulos approaches these hedge fund firms that start crossover funds with caution. “If my favorite public hedge fund came to me and said they’re going to have a separate share class and we’re doing private investments, my first yellow flag would be why?” Lambropoulos said. “Why now? Why you? What is the value proposition? And is this a strategy drift?”
He added that when limited partners invest in hedge funds, they are long call options, with the high-water mark being their exercise price. However, adding a private investment to a hedge fund, in his view, is like adding a call option within that structure — similar to a levered call option.
But there are benefits to investing in a crossover fund. “As companies stay private longer, they often become competitors to public companies,” Llano said. As a result, she added, hedge funds that have traditionally invested in the stock market now have to perform due diligence on private competitors, giving them more expertise in the private markets than one might expect at first glance.
Harbor Spring has found this to be the case, Doshi said. He recounted an investment his fund made alongside Amazon in More Retail, an “omnichannel” retail company in India that has its roots in the grocery business. Harbor Spring had been an investor in Amazon and spent time researching the company’s Whole Foods acquisition. When the opportunity to invest in More Retail arose, Harbor Spring was able to take it a step further, adding an eCommerce element to the deal.
“Our public equities portfolio helped us do the private deal,” Doshi said. Likewise, he added, an investment in a private cashback company called Ibotta has given the company access to data on consumers that can help it formulate short positions in its public markets portfolio.
Based on their positions at their funds, Llano and Lambropoulos have different investment mandates. Texas ERS views its main hedge fund allocation as a risk mitigator for the rest of the portfolio, which means that a “return-seeking” crossover fund is by definition counter to the program, Lambropoulos said. “Purely based on an investment perspective, it wouldn’t make sense for us to delve into crossover funds,” he added.
However, if he were to invest, Lambropoulos said that he’d be interested in activist investors who have more liquidity, as well as hedge funds who have private equity backgrounds. He added that this sort of crossover fund makes more sense for sector funds than it does for long-short investors who are investing in “everything under the sun.”
Meanwhile, the Teacher Retirement System of Texas is a bit more open to taking on hedge funds with private investments.
“From an investment perspective, we would consider the managers who have the necessary expertise, and [who] have a competitive advantage in the space,” Llano said. “Just as importantly, they need to have a robust operational structure that includes a strong valuation framework with a clear and repeatable pricing structure.”