Investing in closed-end funds - challenges & advantages

Investing in private markets requires significant expertise, time, and resources. Investors usually delegate this task to professional managers and pool their capital into closed-end funds. These time-limited structures provide managers with the flexibility to execute their mandate: capital is called and deployed as opportunities arise, and assets can be held as long as necessary. Investors must be patient, as redemptions are not possible.

Closed-end funds have been used successfully for decades in private markets, but they are tailored to sophisticated investors who can overcome significant hurdles.

First, investors need expertise and resources to build a private market fund investment program. They must diversify their investments over time, ideally over five to seven years, to mitigate timing risks. Investors should also diversify geographically, by fund manager, strategy, asset size, maturity, and industry.

Second, investors need sufficient capital to get access to private market closed-end funds which require significant minimum amounts. Smaller investors, even if they have direct access, may not be able to diversify properly if they have limited capital to invest. For large capital deployments, investors can write large tickets to a few mega-funds, reducing diversification; write smaller tickets to many funds, which is hard to manage; or delegate, losing negotiation power. Large capital deployments in closed-end funds are challenging.

Third, investing in closed-end funds can be an operational challenge. These funds require short-notice payments that are hard to plan and distribute unexpectedly. Investors must model their exposure and manage cash actively.

Introducing the evergreen fund alternative

While sophisticated large investors have learned to handle the challenges of closed-end funds, those with fewer resources and smaller amounts to invest often find it difficult. Managers have introduced the open-end (or ‘evergreen’) private market fund to address these challenges.

First, evergreen funds offer choice. In a fund of funds format, they provide indirect, diversified exposure. In a direct format, they offer targeted private market exposure similar to closed-end funds.

Second, they are operationally simpler. Investors do not need to invest regularly in new funds; they stay in the existing one. There is no capital call: investors deploy the whole amount upfront. There is usually no distribution. Evergreen funds continue to invest by recycling proceeds from sales and using any new capital.

Third, evergreen funds are accessible with limited amounts, usually USD 100,000 or less for retail investors. They can also accommodate larger amounts, though managers may set limits to manage risks associated with sudden capital inflows.

Do not call me ‘semi-liquid’

If evergreen funds have these advantages, why did they account for less than 1% of the capital raised in 2022?

First, the number of products has been limited due to a lack of demand. Sophisticated, patient investors use closed-end funds for a reason. As managers started to address smaller investors’ needs, they have launched evergreen strategies.

Second, evergreen funds have operational challenges. Investors wishing to leave must give notice to the manager, who will organise their exit. Redemptions are organised quarterly with a cap of 3% to 5% of net asset value (NAV). Without luck or exceptionally favourable conditions, if all investors want to exit at the same time, they will at best get 20% of their investment back per year. More importantly, redemptions depend on available cash in the fund. If insufficient, investors will have to wait for the next redemption window. Investors must be patient. Evergreen funds are not ‘semi-liquid.’

Third, evergreen funds are subject to contagion risk, unlike closed-end funds. Significant redemptions negatively impact the fund’s activity. The manager may use proceeds from sales to meet redemptions instead of investing in new assets, reducing diversification and generating timing risk. Remaining investors bear the consequences of others leaving.

Fourth, evergreen funds suffer from a performance drag related to unused cash. Managers may not have corresponding investment opportunities when cash becomes available, significantly affecting returns.

Fifth, evergreen funds may lack cash to seize new opportunities if exits and new capital are scarce. Managers may miss high-performance deals when market conditions are challenging.

An optimistic outlook

Evergreen and traditional closed-end funds are complementary and serve different purposes. Investors who want the ability to redeem or have limited amounts to deploy can use evergreen funds. Those lacking scale but wanting a long-term program can choose diversified closed-end funds of funds and use evergreen products to fine-tune their exposure. Sophisticated, large investors can deploy larger amounts in evergreen funds without multiplying investments.

With the ‘democratisation’ of private markets, evergreen products are expected to grow. Their long-term success will depend on how managers handle redemption requests and performance in stressed markets.