The ABCs of Special Situations Funds

Also known as co-investment vehicles, special situations funds offer retirement plan sponsors several benefits. But, according to TeamCo Advisers, which manages the portfolios of some hedge funds and other opportunistic alternative investments, plan sponsors should get to know the basics.

Special situations funds can arise from any one of a number of occurrences. For instance, according to TeamCo’s white paper, “Special Situations Funds: A Private Party Worth Crashing,” a reeling Argentine bond market in 2013 presented the potential for previously untapped markets to a U.S. hedge fund manager. But the firm’s flagship fund was not the right place for this opportunity. Instead, the firm created a separate vehicle that matched the uncertain liquidity profile of the debt.

Kurt L. Braitberg, a portfolio manager with TeamCo, defines special situations funds as relatively illiquid hybrid investments launched periodically by hedge funds. “Structurally, they are very similar to private equity in that they have a commitment and drawdown structure,” he tells PLANADVISER. The funds are formed, usually, to take advantage of an opportunity that may not be suitable for the hedge fund’s underlying flagship fund, either because of the magnitude or the illiquidity of the opportunity.

Speed is a factor in their formation, Braitberg says. “These structures tend to be developed very quickly,” he explains. “Opportunities are identified, structures are created and often they are launched anywhere from two to four or five months.” The reason for the tightened time frame is that the managers want the fund up and capital invested quickly, with most funds typically in the $250 million to $500 million range. “These are not multi-billion-dollar, years-long efforts,” he notes.

The rapidity of the fund’s formation means that the plan sponsor must conduct due diligence quickly—and manager selection is critical, points out Jeremy Kish, managing director of TeamCo Advisers.

“Even knowing about these funds or getting the information that they exist or are being offered in the first place can be a challenge,” Kish tells PLANADVISER. Since relatively few consultants or private equity consultants review this space, plan sponsors could be without a due diligence partner.

For the most part, Kish explains, those firms launching special situations funds only offer the funds to their existing clients. The investments have appeared in the flagship fund in some capacity, he says, and limited partners will be familiar with the investment strategy before it becomes a special situations fund.

Others will need some time to learn about the vehicle and its strategy, Kish says, adding that advisers that work with hedge funds and know a team can accomplish this within a short period of time. “But a plan sponsor on its own would find it a tall task to get up to speed on the manager and the fund,” he believes.

That relationship with a hedge fund—either direct or indirect—is necessary for a plan sponsor even to learn about the special situations fund and be in a position to assess the opportunity, Braitberg says.

Braitberg says special situations funds share several characteristics. First, there are alignments of interest that exist between the fund’s general partners and the investors. “First and foremost,” he says, “the special situations fund is primarily created for the general partners. They see a great investment opportunity for the intermediate term that they want to take advantage of, and they want to do something beyond what they’ve allocated in their flagship hedge fund.”

In most of the special situations funds TeamCo has been in, the general partner has usually been the largest investor, Braitberg says, up to as much as 30%, instead of the usual 2%. The pricing is generally more favorable than typical private market funds.

Because the fund’s managers want to get it up and running quickly, they often do not charge management fees on committed capital, only on drawn capital. The funds have an inherent discipline, and if the opportunity dissipates the managers cancel the fund, bear the cost and release the investors from the commitment without charge.

One possible pitfall to be wary of, Kish says, is a fund being marketed over the course of eight months. “If they’re not a client of that hedge fund, the plan sponsor may well end up allocating capital to an asset-gathering firm,” he says. “There are some firms that we think are launching product to capture longer-duration capital, despite not having identified compelling opportunities.” The distinction between private equity and special situations funds is important, Kish says, with true special situations funds almost always being raised in response to an existing opportunity. In contrast, private equity funds are typically raised on the heels of the previous fund or in anticipation of an opportunity set.

One red flag to watch out for, Kish warns, is the sudden introduction of a product pitch in the middle of what was supposed to be an introductory conversation. Look for the partner’s own stake, lower fees and a short time frame, he advises. Special funds situations aren’t at eye level, so to speak, and Kish says they sometimes have to dig to find out a manager is creating one.

The top three benefits, Braitberg explains, are the attractive rates of return—12% to 25%—with significantly less liquidity. The listed fees are lower than those for private equity or hedge funds. Last, they will significantly diversify the defined benefit portfolio.

Kish explains the gaping chasm that exists between 1- and 10-year liquidity.

“Ultimately, there’s a need for capital between liquid and traditional private markets and few firms with the ability to supply it,” he says. A corporate DB plan sponsor that wants to capitalize on their ability to provide illiquid capital but does not want to take a 10- to 12-year risk could find this an attractive opportunity set.