Navigating the shift from closed-ended to open-ended structures in private capital

At Ocorian, we are observing a growing trend towards more flexible fund structures. Traditional closed-ended funds are increasingly giving way to open-ended and evergreen options. This is not merely a minor adjustment but a fundamental shift in the investment landscape, driven by the evolving needs of both investors and fund managers.

In this article, Charlotte Cruikshank, Global Head of Fund Onboarding & Solutions, and Michael Reid, Solutions Director with Ocorian’s Fund Services team, discuss the reasons for the shift from closed-ended to open-ended funds and some potential challenges fund managers should consider before implementation.

What are the drivers behind the momentum towards evergreen structures in private capital?

A need for more flexibility

The primary driver of this shift is the evolving financial landscape. Recent market conditions have heightened the need for investor flexibility. With liquidity concerns growing, the prospect of being locked into 10-year or longer investment horizons is no longer appealing or practical for many investors.

Alignment with longer-term investment strategies

The shift towards evergreen funds challenges the trend towards longer investment holding periods. Unlike traditional closed-ended funds, they avoid the pressure of forced exits, eliminating the need for costly restructuring or the use of continuation vehicles. This structure is particularly well-suited for asset classes that require extended holding periods to fully realise their potential, such as clean energy, real estate and other infrastructure strategies.

Democratisation of private capital

Evergreen funds lower the barriers to entry into private markets, making them more accessible to a broader spectrum of investors. By reducing minimum investment thresholds and enabling immediate capital deployment instead of relying on capital call mechanisms, these structures democratise access to private market investments. This appeal extends beyond institutional investors to include retail investors as well.

Risk management and diversification

The continuous cycle of capital raising and deployment within evergreen funds can foster enhanced diversification over time. Unlike the constrained 4-year investment horizons of traditional closed-ended structures, evergreen funds offer the flexibility to adapt to emerging opportunities. This dynamic approach facilitates the construction of a more balanced and resilient portfolio throughout the fund's lifecycle.

Considerations before implementing evergreen funds

While offering numerous advantages, the transition to evergreen structures presents several challenges. Fund managers must navigate intricate valuation methodologies, manage redemption requests effectively without disrupting fund stability, and ensure equitable treatment for all investors. These challenges will be explored in greater detail below.

What are the challenges to overcome when implementing evergreen funds for private capital?

Commitments and units

These new 'hybrid' fund structures still necessitate upfront investor commitments and employ traditional closed-ended mechanisms like drawdowns and distributions.

Following a drawdown of committed capital, investors are issued units (or shares) in the fund. While drawdown procedures and unit issuance mechanisms vary, many funds implement a queuing system. Investor commitments are typically grouped into tranches based on their entry date, with drawdowns occurring sequentially.

Initially, units are issued at a nominal value. Subsequently, after a predetermined period, the issue price is adjusted to reflect the fund's performance. This adjustment is typically calculated based on a derived value of the fund's Net Asset Value (NAV) (may be trading NAV, adjusted NAV, IFRS NAV, or other relevant metric). The NAV per unit price may be further adjusted to account for factors such as estimated transaction costs associated with investor contributions, equity revaluations, and the amortisation of set-up costs, as outlined in the fund's governing documents.

Funds will typically issue different classes of units, based on an investor’s commitment size, or timing of when they join the fund.

Each class of units will have different rights and conditions attached to it such as applicable management and performance fee percentages, dividend entitlements, and carried interest allocations. Issuing multiple unit classes provides a flexible framework for managing the unique arrangements and circumstances of each investor.

Distributions and redemptions

Income and capital proceeds are typically distributed to investors at predetermined intervals in proportion to their holdings. However, a growing trend involves reinvesting share classes where all proceeds are automatically reinvested within the fund.

These funds typically include a 'lock-up' period, requiring investors to maintain their unit holdings for a minimum duration, usually between three and five years. In certain cases, the lock-up period may extend until specific conditions are met, such as the fund's NAV reaching a predetermined threshold. Upon the expiration of the lock-up period, investors may submit redemption requests.

Similar to the subscription process, investors are typically grouped into tranches for redemption purposes. This approach safeguards the fund and streamlines the operational redemption process. The redemption price for units is calculated based on the prevailing NAV per unit, with potential adjustments for expected redemption-related costs, such as those associated with the sale or refinancing of underlying investments.

Redemptions are generally funded from available cash reserves. However, if the fund experiences temporary liquidity constraints, it may employ various strategies to fulfil redemption requests. These may include:

• Accepting additional investor commitments
• Utilising available borrowing facilities
• Disposing of a portion of the fund's investment portfolio
• Facilitating a unit matching service, enabling the transfer of units between existing investors
• Implementing a queuing system for redemption requests within the same tranche, with pro-rata payments made to investors until their requests are fully satisfied

These strategies are designed to ensure that the fund can meet its redemption obligations while maintaining a balanced and sustainable investment approach.

Performance fees

A significant shift arising from this new operating model relates to the remuneration of fund managers.

Traditionally, fund managers typically received a flat percentage management fee based on capital commitments during the investment period and capital deployed thereafter. This was often supplemented by carried interest, a performance-based fee awarded for returns exceeding a predetermined hurdle rate (the preferred return).

Under the new model, these fees are generally consolidated into a single performance fee calculated as a percentage of the fund's Net Asset Value (NAV). This approach allows for greater flexibility, enabling the charging of different fees to various investor classes through the issuance of different unit classes.

This transition towards NAV-based fees can be more attractive to investors as it directly aligns manager compensation with fund performance, eliminating the payment of fixed fees based solely on commitments or invested capital. However, managers must carefully consider the implications for their funding and cash flow, as their returns may be lower in the initial years when realised and even unrealised investment gains are expected to be modest.

Carried interest

While carried interest models are becoming less prevalent, they still feature in some newer fund structures. One approach we observe involves issuing additional "performance" unit classes alongside standard units to facilitate carried interest and preferred return payments.

For instance, when investors subscribe for and receive standard units (e.g. Class A units), the fund may also issue:

• Class B units exclusively to the fund manager.
• Class C units to both investors and the fund manager.

This combination of unit classes enables the implementation of a traditional waterfall distribution mechanism, often with the following steps:

1. Return of capital: Investors (holding Class A units) receive their initial investment.
2. Preferred return: Investors (holding Class A units) receive an IRR-based preferred return on their investment.
3. Manager catch-up: The fund manager (holding Class B units) receives distributions until a defined hurdle rate is achieved.
4. Profit sharing: Subsequent distributions are allocated to investors and the fund manager (holding Class C units) based on pre-defined hurdles or profit-sharing ratios.

Summary 

Administering these types of evergreen fund structures can present significant complexities. Therefore, clearly defined rules and guidance regarding unit classes and their intended purposes are crucial.

At Ocorian Fund Services, we have invested heavily in our technology stack, including our eFront platform, to effectively support these structures. This enables us to introduce a high degree of automation and a robust control framework.

For further information on any aspect discussed in this article or to explore how Ocorian can assist you with servicing your fund structure, please contact our fund services team.