New private equity investment options offer increased access, flexibility and risks

The private equity (PE) and credit industry is undergoing a significant transformation as more investors seek exposure to the asset class, which has historically outperformed public markets and offered diversification benefits.

Investors are also looking for more flexibility and control over their PE investments, as well as the ability to exit or rebalance their PE exposures according to their preferences. At the same time, the development of digital platforms and data analytics has enabled more efficient PE transactions and operations.

A swath of innovative product structures has been introduced—many by large alternative asset managers—opening participation in private funds to individual retail and mass-affluent investors through open-ended evergreen and other semi-liquid vehicles. These investors may have previously been ineligible to participate or historically shied away from the longer-term lockups, fee structures, and high minimums of traditional private equity funds.

These innovative product structures also come with important drawbacks. Asset managers, as well as advisors and investors, face a steep learning curve in making them work at scale given the complexities that arise from managing a large group of investors with different goals, time horizons and liquidity expectations.

Comparing traditional and evergreen structures

Evergreen and traditional closed-end PE structures have different characteristics, advantages, and drawbacks, which may make them suitable for different scenarios. These structural differences span characteristics such as fund life, liquidity provision, fee structure, and alignment of interests.

While expanded access for certain investor types can be an attractive characteristic for evergreen funds, one of the reasons institutional investors gravitate towards private markets is the alignment with longer-term investment time horizons. Herein lies the asset-liability mismatch conundrum when structuring an open-ended vehicle for investors that offers increased liquidity, while the underlying invested assets are, by nature, illiquid.

What is asset-liability mismatch?

Asset-liability mismatch refers to a situation where the duration and liquidity of a fund’s assets—portfolio companies, real estate, etc.—do not match the duration and liquidity of its liabilities—that is, investor commitments. In the traditional drawdown structure of a closed-end PE fund, the asset-liability mismatch is mitigated by the finite fund life, which ensures that the fund will eventually liquidate its assets and return capital to its investors. However, in an evergreen or semi-liquid fund, the asset-liability mismatch is exacerbated by the indefinite fund life and potential investor preference for more immediate liquidity.

On one hand, the evergreen fund structure allows a fund manager to pursue longer-term and more strategic investments without being pressured by the exit clock. At the same time, it also requires the fund manager to maintain a stream of distributions to fund investors.

Scrutinizing solutions for asset-liability mismatch

While there are various mechanisms to address this mismatch, they may become a drag on performance or a deviation from the fund’s investment objective.

Evergreen structures with fund-level redemption limits may also be subject to proration events, which occur when aggregated redemption requests exceed the fund-level limit. Investors would only receive a portion of their redemption request in this situation. Gating restrictions (that is, limiting redemptions) and side-pocketing (or the segregation of illiquid assets) can be deployed to protect evergreen funds from over-redemption, but at the cost of forfeiting their supposed liquidity advantages for investors.

Temporarily locking investors in during periods of severe distress may lead to fundraising challenges in the future. Furthermore, providing liquidity via redemption poses risks as a rush of investors toward the exit could destabilize a fund, forcing it to finance redemptions with untimely asset disposals (perhaps at below-market prices).

The opposite scenario also poses challenges. Trends observed during previous cycles have shown that capital from retail investors tends to flow in as valuations rise. As a result, evergreen funds may be compelled to deploy capital inflows across an inopportune market backdrop or during a period of peak valuations.

How fees influence incentives

Capital commitments are called over the life of the investment period in the traditional fund structure as the manager gradually constructs the portfolio. Once the investment period expires, typically between three and five years, the fund enters “harvest mode” and the management fee tends to scale down as the focus shifts to monetizing the underlying assets over the next five to seven years.

Evergreen funds usually have fixed fees in perpetuity, based on portfolio valuations rather than committed capital, or they may charge a blended fee calculated on NAV and commitments. The valuation-based fees used by evergreen funds can be attractive to the extent that they flow with the fund’s deployed capital, so they do not reward the manager for not putting capital to work. Alternatively, if valuations rise, fees increase simultaneously, and investors do not benefit from the kind of stepped-down fees that are standard in the latter half of the traditional PE life cycle.

Lastly, consider the alignment of incentives. While traditional funds also charge a performance fee, it is typically tied to a preferred return, further aligning the manager and investor by providing an incentive to produce outperformance. And while evergreen vehicles may or may not charge a performance fee, there is usually a sales load and early repurchase fee, along with annual fund expenses in addition to the underlying fund fees.

The perils of performance comparisons

The limited track records of evergreen funds, as well as the differing portfolio construction approaches of each structure, contribute several sources of imprecision to performance comparison attempts.

Gradual deployment and return of capital in the traditional PE structure contrasts with the much shorter time frame in which evergreen funds are expected to invest and accommodate redemptions, so performance comparisons would need to account for the timing of cash flows.

Differences in portfolio composition also raise issues. Evergreen funds typically have large allocations to secondaries, which can exhibit higher volatility and correlation more akin to public equities. Coupled with the differences in valuation and performance measurement methodologies, as well as the many assumptions required to arrive at return figures, we believe investors should avoid placing too much confidence in performance comparisons.

A note on preferential treatment

One risk rarely mentioned with evergreen vehicles—particularly as it relates to larger asset managers that offer multiple products for various client types—is that they may be vulnerable to “cherry picking.” This takes place when firms allocate higher conviction investment opportunities towards their larger, institutionally-backed flagship products, underscoring the importance of understanding firmwide allocation policies.

Balancing innovation with a selective approach

Evergreen, open-ended and other semi-liquid fund structures continue to innovate with the goal of expanding the appeal of private markets to a larger and more diverse investor base. These structures may offer more flexibility than traditional fund structures, the potential for long-term value creation, and portfolio diversification. However, there are important limitations and structural drawbacks that need to be understood.

As always, stewards of capital need to strike a careful balance. They must consider their ability and willingness to invest across private markets, the advantages and drawbacks of different fund structures, and their skill in selecting strategies that best suit investor goals and preferences.

This article summarizes our comprehensive research on the development of semi-liquid evergreen PE funds. You can read our full-length analysis here.