There is a growing number of open-ended evergreen private equity funds. The overwhelming majority of private equity funds are closed-end vehicles with finite lives. Private equity evergreen funds are a new development that offer investors a different set of tradeoffs than traditional private equity funds. I view this development as part of the larger democratization of alternative investments and we can find new evergreen vehicles in private equity, credit, venture, real estate and so on. A reminder that these are simply examples as this site does NOT provide investment recommendations.
Challenges of Drawdown Funds
Perhaps the biggest difference between evergreen private equity funds and traditional private equity funds is the structure. Traditionally, private equity funds have been “drawdown funds.” Funds with this “private equity structure” have a “drawdown” where they call capital over time (rather than calling 100% of committed capital immediately). So an investor who commits $1 million may only invest $100,000 in year one, $300,000 in year two, and so on. A similar dynamic occurs when these types of funds wind down, distributing say 6% of the fund in year seven, 18% in year eight, 34% in year nine, and so on. So investors slowly invest capital and slowly receive it back.
The above dynamics present several challenges to the investor:
- The pace of capital calls is unknown and investors must be ready to fund capital calls with only a week’s or two’s notice (generally). Therefore, investors with uncalled commitments need to maintain sufficient liquidity. Whether that liquidity comes in the form of lower-returning liquid assets or a credit line, there is often either an opportunity or explicit cost for this liquidity.
- Oftentimes, investor commitments are not fully called. A fund may only call 60% of commitments or 95% of commitments or some other number.
- Given the closed-end structure of private equity funds and the capital call and distribution activity, PE investors usually develop a “recommitment strategy” where expected distributions from older funds are earmarked for expected capital calls from newer funds.
- Given the above three challenges, investors cannot easily project how much they will have invested at any point in time. Consequently, many investors practice an “overcommitment strategy” in which they commit more capital than they have. This mitigates the risk of cash drag from uncalled commitments and inefficient cash flow management. However, overcommitting requires careful planning to ensure the investor does not default on a capital call.
The above challenges are routinely addressed by institutional investors, but can be problematic for individual investors.
Traditional PE: Fund performance is typically quoted as an internal rate of return (IRR). There is a famous saying that “you can’t eat IRR,” which is a way of saying that IRR is an academic metric that may not accurately measure the economic return to investors. Investors should always evaluate both IRR and “multiple of invested capital” (MOIC also called “total value to paid-in capital” or TVPI). I cannot count the number of times I’ve seen pitchdecks with eye-popping IRRs before learning that the multiples are disappointing. Understanding, negotiating, calculating, and verifying private equity waterfalls can be a job unto itself.
Evergreen PE: Rather than IRRs, performance is reported in time-weighted returns (like publicly-traded funds). Low returns are more difficult to obscure through financial engineering.
Traditional PE: Fund performance calculations are based on the capital that is called, which may or may not be a material amount. The opportunity cost of uncalled capital is not included in a fund’s returns. As an example, consider an investor who wants to keep sufficient liquidity for expected capital calls. The investor decides to hold $100,000 of uncalled capital in bonds earning 4% rather than an illiquid investment yielding 10%. At the portfolio level, there is an opportunity cost of 6%, which is not reflected in a fund’s performance reporting. This is why many investors practice the aforementioned overcommitment strategy.
Evergreen PE: Capital is invested immediately and return-generation begins immediately. Investors know how much they are investing and when.
Traditional PE: Many private equity funds have a 10-year life, plus optional extensions. So many private equity investors don’t get their last dollar out until 10-15 years have passed.
Evergreen PE: Evergreen funds are often open-ended, which means that the funds accept capital on an ongoing basis. Additionally, many have liquidity features that provide investors the option to tender or redeem their investment on a periodic basis.
Investment Minimums & Investor Qualifications
Traditional PE: Many private equity funds require investors to be a qualified client or a qualified purchaser. Minimum ticket sizes generally start at $250,000, but can be $20M+. Thus, it is difficult for many individual investors to diversify within private equity unless they have a few million dollars (on the low end).
Evergreen PE: Since many evergreen vehicles are designed to alleviate the challenges of traditional PE for individual investors, the minimums and qualifications are generally lower.
Traditional PE: Many private equity sponsors launch a new fund (also called a vintage) every 1-3 years. So an investor may commit to Fund I and have their capital called over a number of years. Once the majority of capital is called, the sponsor launched Fund II. Again, capital is called over a number of years for Fund II. The investor then commits to Fund III just as Fund I begins to distribute capital back to the investor. This is perfect because the investor can use the Fund I distributions to cover the Fund III capital calls. This example is overly simplistic, but it illustrates that allocations to a manager often remain relatively constant even if there is a lot of committing, contributing, and distributing going on.
Evergreen PE: Rather than distribute all proceeds to investors, an evergreen private equity fund can reinvest a portion of the proceeds that it receives. So investors can make a single investment and upsize or redeem as needed, rather than embarking on a recommitment strategy of continually recycling capital into subsequent vintages.
‘40 Act Funds
There are an increasing number of evergreen private equity vehicles that are registered with the SEC under the 1940 Investment Company Act. The funds are often referred to as ’40 Act funds or registered funds. The ’40 Act structure often provides additional investor protections and efficiencies.
Tax Reporting: ’40 Act vehicles tax reporting is typically via a 1099, which is much simpler than a K-1. While this may marginally increase fund expenses (and possibly limit tax benefits), it often reduces individuals’ tax prep complexity and costs.
Minimums: Many ’40 Act vehicles have investor requirements that are even lower than accredited investor requirements.
Diversification: While some ’40 Act fund sponsors view registered funds as a distribution channel and/or stuff their evergreen vehicles with their own assets, an increasing number of funds contain assets of other managers.
Traditional Private Equity vs Evergreen Private Equity
I believe there is room for both types of vehicles. Traditional private equity has many benefits for institutional investors (and even some individual investors). However, permanent capital vehicles in the form of evergreen fund structures alleviate many of the challenges that private equity investors face. Based on the rapid growth of evergreen vehicles, it seems that individual investors (without teams of investment professionals) find these funds attractive.