The Ins and Outs of Evergreen Private Asset Funds

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This newsletter was co-authored with my colleague Joe Basrawy. Based out of London, Joe was the portfolio manager for a c.$2.4B evergreen private debt structure that has been managed by Partners Capital for more than 10 years. He is also leading our work on private equity evergreen funds in Europe and APAC. His experience and insights were invaluable in writing this newsletter.

We recently met with the global head of alternative of a large European bank, and she volunteered that she was meeting “a manager launching a new evergreen private equity fund every other week”. The number of such funds has indeed increased dramatically over the past couple of years due to both demand and supply factors.

A lot of these new offerings are targeted at the wealth segment – for example, most utilise regulatory structures fit for distribution to individual investors[1] and offer very low investment minimums. Institutions and large family offices are however also paying attention because these evergreen structures offer added flexibility, and thus opportunities to optimise portfolios in a way that is impossible with closed-ended draw-down style structures. What were initially thought to be “retail products” are turning out to be useful tool for larger investors.

All of which points towards significant growth of these products in the coming few years. In this newsletter, we dig deeper into why we believe that this trend is likely to continue at pace, what investors should be looking for in these funds, and what we see as the most common use-cases and rationale for investing in these structures. We believe that investors with a solid understanding of the pros and cons of these structures stand to benefit from investing in these types of funds.

This newsletter is focused on private equity, but we believe that a lot of the learnings here could be valid for other illiquid asset classes such as private debt, real estate, or infrastructure.

Why is this happening and why it will continue

Bain & Co, McKinsey and BCG agree on one thing: both supply and demand of private assets for distribution to the private wealth segment will continue to grow dramatically. They do not agree on the actual future scale of the market, which ranges from US$1.2T to US$3T[2], but anything within this range represents material growth compared to today’s very low penetration. Indeed, with less than 5%[3] allocation of their financial asset allocation to private assets, both retail and private banking clients are under-allocated to private assets, and to private equity in particular.

Four factors will contribute to the forecasted increase:

• Demand: Retail and private banking investors have taken note of the past returns in private equity and are looking for ways to allocate more to the asset class. Similarly, private banks have been looking for ways to provide access to private assets for their clients and are actively working with GPs to innovate in this space.

• Supply: Many GPs are adapting to a reduced appetite for private assets from their traditional institutional investors (many of whom are over-allocated relative to targets). As a result, they have, sometimes desperately, been looking for new avenues for fundraising in the retail segment.

• Regulation: There is an increasing number of regulatory pathways through which asset managers can create structures that are adapted to the retail segment.

• Infrastructure: New technology solutions and new technology providers have enabled both distributors and GPs to handle the administrative burden of handling many small transactions from a large number of clients in a way that would not have been possible using manual processes.

So, while the exact pace of growth is uncertain, we agree that the market will experience material and sustained growth.

In this context, evergreen structures provide a clear advantage over closed-end draw-down style structures. Smaller investors do not have access to a back-office to manage capital calls and distributions, and many of them lack the scale or predictability of cash flow to effectively plan deployment and evaluate how much capital to commit to achieve their target allocation whilst managing liquidity. One subscription to an evergreen fund is much easier to manage than dozens of capital calls and distributions every year. As a result, our counterpart at this large European bank is now routinely meeting with managers launching such evergreen structures and it is likely that she will continue to do so for a while.

Critical questions investors should be asking

What should investors think of these structures? Let’s start with the obvious. There is no single structure that can satisfy the requirements of this new market and there are still a number of approaches. For example, listed investment structures such as investment trusts and BDCs, though we generally view them as less attractive than evergreen funds, will continue to play a role for investors in this market for some time. There are however a number of ‘market standards’ that seem to be emerging. Most private equity evergreen structures offer monthly NAV valuations and subscriptions, alongside quarterly liquidity windows with full gating[4] mechanisms to protect the fund and investors against disorderly outflows in periods of stress.

Digging deeper, there are important differences between the different offerings, which investors should scrutinise. The elephants (there are two) in the room are liquidity and valuation, but many investors can miss the forest for the trees and, faced with so much novelty, may fail to scrutinise the underlying investment strategy. Let’s take some of the key questions investors should be asking one by one.

Is this a liquid investment?

Depending on whether you are a glass half full or a glass half empty investor, the answer could be either “yes but” or “no but”. The real answer is “yes, in a normal environment”, where ‘normal’ is defined as a period where private equity exit activity and new inflows into the fund provide a source of cash to the vehicle, and where most investors are not looking to make redemptions from the fund. As any experienced investor will tell you, lower deal activity, lower inflows, and higher redemptions make for happy bedfellows in times of stress, therefore investors in evergreen funds should be ready to be “gated” at some point in time. Evergreen funds should be viewed as providing increased convenience and flexibility, but this should not be confused with guaranteed liquidity. Recent, highly publicised instances of ‘gating’ have been characterised as a weakness of certain funds; we actually see these events as a sign that the mechanism to protect investors (sometimes from themselves) is providing managers with the appropriate tools to manage flows and optimise the performance of what remains long-term investments.

Beyond the realisation that convenience does not mean liquidity, there are a few important elements that will differentiate funds and their ability to manage liquidity – including:

• What share of investments are kept in liquid assets? This typically varies between 5 and 15% and will have significant impact on both returns (cash drag) and liquidity.

• Does the fund benefit from a credit facility to smooth investments, inflows and outflows? While these NAV lines have a cost, they can have significant benefits in terms of realised IRR if well-managed.

• Does the manager dedicate resources to liquidity management? Most private equity GPs have never had to manage liquidity. They call capital when needed and the cost of missing capital calls for LPs is very high, so it is rare that they do so. Managing liquidity is a new capability that requires focus and investment in people and processes.

• Is the investor base diversified? As we have seen recently, funds that heavily relied on Asia-based private banking clients, have come under pressure when many of these investors moved “as one” to redeem their investments. To avoid this issue, a fund would need to have a geographically diversified investor base and be distributed through a number of banks and wealth managers rather than a few. Where feasible (there might be regulatory constraints in some markets), it also helps if these funds are included within discretionary portfolios and not only advisory investments. Discretionary portfolios tend to be invested longer-term and discretionary managers are more likely than their clients to take contrarian views.

• Is there a sufficient base of retail investors? This question is often counter intuitive to many investors we have spoken to. Isn’t a large retail investor base a “bad thing” for an institutional investor? Doesn’t it drive higher operational costs, which ultimately will impact return? While the answer to the latter question could be “somewhat”, the presence of a large base of small tickets from small investors is at the core of the liquidity potential of these structures. An evergreen fund relying solely on a few large institutional or institutional-like investors can see its redemptions increase dramatically following a decision from just one large investor, and such a fund may not benefit from a steady stream of inflows from smaller investors over time. As a result, that fund is at a greater risk of failing to provide liquidity during a redemption window.

• Is the portfolio appropriately diversified? As discussed above, a steady stream of realised investments from the portfolio is a crucial source of liquidity for an evergreen fund. It follows that a fund, which is overly concentrated in a given sector or sub-asset class (or, indeed, in a given private equity sponsor) may suffer from periods of reduced realisations and thus reduced liquidity.

How do I know my investments are properly valued?

For investors in closed-ended draw-down private equity funds, the valuation of unrealised investments, whilst important, may have only a minimal impact on the ultimate returns to investors. Barring a secondary sale or a situation where the GP charges fees on unrealised performance, which are not subsequently clawed back, LPs may ultimately be unaffected by how investments are valued along the way.

This is very different with evergreen structures, which creates several risks for investors. The most obvious occurs at the time of one’s investment or redemption from the fund – are you paying or being paid the right price for the assets? The other main risk (dealt with in the next section) is born by existing investors who may be ’diluted’ by new investors in the fund – are new investors taking a share of your investments at an accurate price? These factors make valuation a much more important topic than in closed-ended structures. As a starting point, it requires the manager of an evergreen fund to be able to value assets at times that match the subscription and liquidity windows, which may or may not match the valuations available for underlying investments or, in the case of fund investments, from underlying managers. If, as seems to be the standard for most funds, the subscription window is monthly, it means that managers need to build a capability to adjust valuations for market events even if the underlying managers are only providing quarterly valuations (and usually on a lagged basis). Similar to liquidity management, this is a new capability for many GPs, which requires investment in people and processes.

How do I know I am not getting diluted at the wrong price by new investors?

As mentioned above, one risk of misaligned valuations may be dilution. This could occur in two circumstances. First, at the individual company level, the valuation of specific assets could simply be ‘stale’ – e.g., the GP is yet to mark the asset despite market evidence, which suggests a different valuation is more appropriate (for instance, based on comparable company transactions). Second, at the overall fund level, the portfolio could include a large number of new investments that are still in the ‘value creation’ phase and which have not yet been substantially marked-up. Indeed, as shown in Exhibit 1 below, the typical NAV profile of a private equity buyout transaction is not a straight-line, rather it tends to be flat or modestly positive during the ‘value creation’ phase, with the more material uplift to valuation occurring close to realisation. The differences generated by these two dynamics may narrow down to zero over time but, if the flow of investors deviates significantly between liquidity windows, this ‘dilution’ effect could be painful for early investors. Ultimately, this risk is inevitable in an evergreen fund, and it is the price one needs to pay to have the prospect of liquidity from the fund but this has two important implications. First, investors should take this risk into account in defining their expected return from the vehicle. Second, managers can materially decrease this risk by pacing the growth of their funds and by making sure that they include a healthy mix of newer and more mature deals – which is where private equity secondaries (more on this below) can serve an important role.

Exhibit 1: Conceptual visualisation of the impact of dilution on early investors

This exhibit is conceptual and not to scale in order to make the illustration more visible

How are incentives structured for fund managers?

Private equity GPs live and die by the 2% - 20% (or variations around it). It is a simple mechanism that leaves very little to interpretation once agreed. For evergreen funds, this is slightly different. Given that ‘retail’ investors may not be accustomed to paying performance fees, some evergreen funds will choose to have fixed management fee only, at least on some share classes. This provides a very simple and transparent mechanism for fees. It however does not provide for alignment of incentives between investors and managers, which is why institutional investors are accustomed to seeing private equity funds charge performance fees. The most ‘investor friendly’ format to charge for performance in a private equity closed-ended draw-down style structure is usually the ‘European style’ fund-level waterfall, with performance fees subject to the performance of all investments in the fund. However, the perpetual nature of evergreen funds means that there will always be unrealised transactions, hence a European style waterfall cannot be implemented. Instead, evergreen funds broadly use one of two approaches when it comes to charging for performance:

1. NAV based approaches (also referred to as “hedge fund style”) rely on unrealised NAV valuations, with fees charged on unrealised returns. The main benefit of this approach is that investors pay fees based on a holistic view of the portfolio’s returns – including both wins and losses – and that these incentives are paid at predictable, pre-defined times. The main issue with this approach is that incentives are paid on an unrealised bases, which means that fees are paid earlier than they otherwise would be (reducing the compounding benefit for investors) and that this approach magnifies the importance of the valuation mechanism in place and the independence of this mechanism from the manager.

2. Deal by deal approaches rely on the realised value of transactions within the portfolio, which leaves no room for interpretation and manipulation of valuation, and allows investors to avoid paying ‘early’ performance fees as they would under the NAV based approach. One drawback however is that this structure could result in investors paying high fees amidst disappointing fund-level performance if the portfolio has a few large wins but many losses. This potential for a skewed pay-out to managers may create an incentive to “swing for the fences”, and hence it is important that the strategy of the fund does not enable this type of behaviour. For example, the guidelines for portfolio construction should ensure appropriate diversification, and the investment focus should be on deals with a more ‘bounded’ return profile, for example, prioritising private equity buyouts over venture investments.

It is possible to make both approaches work, though all other things being equal, we tend to favour the second approach as the relative delay in paying performance fees can have a significant compounding benefit over time. Whichever approach, it is important for investors to scrutinise and understand the mechanism and the guardrails in place to deal with the potential drawbacks described above.

Am I invested in the right strategy?

After dealing with so many novel issues on structuring, valuation and incentives, it is possible for investors to lose the forest for the trees and neglect to understand the investment strategy. Ultimately, the underlying assets in which the fund invests will be the most important driver of performance. We hold a number of core beliefs about the most appropriate strategy for an evergreen private equity fund. Some of them reflect our views on the private equity market overall and were summarised in our latest annual macro and market overview. Others are specific to evergreen structures. Overall, we believe that the following “golden rules” are useful guidelines for investors.

• Focus on Lower Middle Market and Middle Market buyouts, and on operational value add. We have gone through our approach to private equity several times in this newsletter. We believe that the middle and lower middle markets are less competitive and less subject to entry price inflation than larger buyouts. We also believe that it is easier for focused managers to drive operational improvements in these segments. Finally, we do not see multiple expansion and cheap leverage as sustainable value creation levers for private equity managers, so we target deals with managers who have a proven ability to achieve operational improvements in their companies. True, it might be easier for an evergreen fund to access deal flow in the mainstream, large cap buyout market. However, we believe that positioning at the lower end (in terms or size) and focusing on a subset of operationally focused managers will generate higher long-term returns for investors.

• Focus on direct or co-investments. While it can be acceptable for evergreen structure to have very small commitments to primary funds, liquidity is a paramount consideration in an evergreen fund, and hence direct investments (for single manager funds) or co-investments (for multi-manager funds) are far more suitable for evergreen funds given the greater certainty they provide around deployment (and the lack of an ‘unfunded commitment’ that comes with a primary fund investment). Of course, this approach will also decrease fees materially, which is especially important for multi-manager funds.

• Incorporate secondaries within the investment mix. Secondaries, especially LP driven secondaries purchased at a moderate discount to NAV, are an important building block of evergreen private equity funds. Primarily, secondaries help to mitigate the ‘dilution’ risk discussed above. They indeed provide an incentive to earlier investors in that the mark-up of the discount helps compensate for the ‘dilution risk’ from new buyout deals, which are slower to mark-up and therefore introduce ‘dilution risk’. As such, a balance of co-investments and secondaries will balance incentives between early and later investors, which is beneficial for the long run performance of the fund. Secondly, there is a cyclical aspect to secondaries in that the market can become particularly attractive at certain points in time, which has largely been true over the past few quarters. Finally, secondaries can provide an alternative source of deal flow during periods where there are fewer buyout transactions closing. Therefore, having the capability to invest in secondaries is an important tool in optimising the management of an evergreen fund.

• Ensure that the fund benefits from diversified deal flow and has access to deals on an equal basis with other investors. Given the points above about focusing on smaller segments of the private equity market and having the capability to invest in secondaries, it follows that only firms with high-quality deal flow in these areas will be able to effectively keep capital to work in an evergreen fund. Such firms typically manage many different pools of capital, across funds and managed accounts, so it is important that the evergreen fund be placed on equal footing to these other pools. Many specialist private equity investment firms give a right of first refusal over certain deals to their flagship closed-ended funds and managed accounts, with the evergreen fund being a second priority. Such a situation can lead to adverse selection, undermining the returns of the evergreen fund.

Who is this for? A few important use cases

With all the caveats defined above, we believe that many investors who fully understand the pros and cons of these structures can derive clear benefits from evergreen private equity funds. Amongst them, we believe that four use cases are particularly important.

Investors ramping up their allocation to private equity. The holy grail of private equity portfolio construction is a cash neutral portfolio that ‘pays for itself’ (with distributions from older investments paying for capital calls from new ones) and provides a stable, at target, allocation to private equity. However, getting there can take up to a decade in some circumstances, whereas an evergreen structure can be used to accelerate this ramp up. Over a decade, we estimate this could increase the IRR derived from the private equity portfolio by 1.6% and MOIC by 0.12x relative to annual commitments to a single diversified fund-of-funds solution[5].

Investors who do not have an indefinite time horizon. There are many investors, even very large ones, who do not have the luxury of a 50-year time horizon, whether for personal or for estate planning reasons. For investors who may need to dial down the illiquidity of their portfolio at some point, investing via an evergreen structure can enable a higher allocation to private equity on average. This can provide material enhancements to returns compared with annual commitments to draw-down type structures. As an illustration, we have modelled the returns of an investor deploying an initial US$20M into a diversified portfolio with a target allocation of 25% to private equity. As seen in Exhibit 2, allocating to an evergreen structure would yield a materially higher IRR and MOIC.

Exhibit 2: Return benefits accrued by investing in an evergreen structure on a 20-year time horizon

The Illustrative Returns of an Investor Deploying an Initial US$20M into a Diversified Portfolio with a Target Allocation of 25% to Private Equity[6]

Small investors. For investors who would consider committing less than US$1-2M per year to private equity, or investors with private equity portfolio smaller than US$10M, the administrative burden of committing to draw-down type structures every year may be overwhelming. It may also preclude them from accessing the best managers (or even the asset class altogether) due to the prevalence of high minimum investments for closed-ended funds.

Pretty much anyone who pays taxes[7]. The large endowments who invest in private equity via draw-down structures are often not subject to taxes. However, mere mortals and most investment vehicles do pay taxes, so why should they invest in draw-down structures, which have not been optimised for tax-paying investors? While there is no general rule and while investors should seek tax advice on a case-by-case basis, evergreen structures generally enable the deferral of taxation until units in the vehicle are sold, which enables returns to compound for longer than in draw-down structures. Taking the example of a hypothetical UK investor, we have evaluated that the benefits from compounding capital gains in an evergreen fund could be 0.8% per annum over a 12-year assessment period[8].

***

Evergreen structures investing in private assets are a relatively new tool in the toolkit of long-term investors and market standards will continue to evolve. They present a number of benefits for investors who seek convenience and liquidity, who seek to accelerate their private equity programme or who seek to invest within a shorter than 25 years investment horizon. Investors however need to scrutinise the details of how managers intend to execute the fund strategy.

[1] For example, Luxembourg ELTIF or UCI Part II.

[2] Bain & Co Report “Future of Retail and HNW Capital for Alternative Investments”, McKinsey Report “Private Markets Rally to New Heights”, BCG Report “Unlocking the Art of Private Equity in Wealth Management”.

[3] Preqin; GlobalData; Bain estimates.

[4] A redemption gate is a provision that can be implemented, generally at the discretion of the manager, and that limits the amount investors are allowed to redeem from a fund in a given period. Its objective is to prevent a run on the fund and is typical when a fund holds underlying investments that are less liquid than the liquidity provisions of the fund itself.

[5] For illustrative purposes, we compared the return profile of a typical fund-of-funds private equity portfolio consisting of 20% VC, 75% buyout and 5% secondaries with that of an optimised portfolio which allocates 50% of the year 1 commitment budget to evergreen PE and then ramps up to target allocation. Hypothetical return expectations are based on simulations with forward looking assumptions, which have inherent limitations. Such forecasts are not a reliable indicator of future performance.

[6] Hypothetical return expectations are based on simulations with forward looking assumptions, which have inherent limitations. Such forecasts are not a reliable indicator of future performance.

[7] Partners Capital are not tax advisors. Tax treatment will depend on the individual circumstances of each client and is subject to change. Clients should consult their own tax advisors to understand the tax treatment of a product or investment.

[8] Assessment and actual benefits may vary depending on jurisdiction and investor situation.

Important Information

Investment returns will fluctuate with market conditions and every investment has the potential for loss as well as profit. The value of investments may fall as well as rise and investors may not get back the amount invested. Past performance is not a reliable indicator of future performance.

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