Are “evergreen” funds really the future of private market investing?

The original version of this article first appeared in The Business Times. 

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This article is not about trees, but trees provide an excellent visualisation of a movement that we believe will change the way all of us invest in private markets forever.

A fair warning that this article will attempt to introduce a lot of private market lingo and jargon, as we believe it is important to educate on the asset class as it becomes more relevant and accessible to a broader audience.

The 10-year lifespan tree

Imagine a tree that you planned on growing for only 10 years, and would “call” on your resources for the first five years, start bearing fruit in the subsequent five years, before being cut down and sold for parts after 10 years. 

Traditional “closed-end” funds work in this system of committed capital, capital calls and distributions, and are the way the vast majority of private equity, private credit, private infrastructure, secondaries, venture capital and private real estate funds are structured. They still make up almost the entire private market fund industry and are the most common vehicle for large institutional investors to invest in these asset classes. 

The evergreen tree

Now imagine another tree that you could grow for as long as you like, and could provide the resources you wanted to give it upfront without needing to manage for resources it could “call” on demand, but with the ability to add more resources if you want to speed up its growth, or cut off some branches to sell for money if needed, nature permitting.

Over the last 15 years, meaningful developments have been made across the private markets investing industry, much like in the mutual fund industry in the 1920s to 1940s. Evergreen funds (also known as “open-ended” or “semi-liquid” funds) are investment vehicles with no fixed end date, and provide more flexibility than “closed-end” funds because they have some liquidity with terms allowing investors to periodically redeem units, and generally have lower investment minimums, making it easier for all of us to allocate to private markets.

A personal reflection and realisation

I started my working life at the UBS investment bank on a team that focused on advising some of the top private equity managers in the world in raising money for their funds from the top institutional investors in the world, primarily global pension funds, sovereign wealth funds, school endowments and the occasional very sophisticated family office. 

I was enamoured by the stark difference in the way these institutions approached investing versus my family and friends, which I now realise is the difference between speculating and investing. 

They talked about things like the “denominator effect”, “j-curve”, “vintages”, “liabilities-driven asset allocation”, “distributions to paid-in capital or DPI”, and the big no-brainer of “diversification”. I finally understood the evidence-based endowment approach to investing made famous by the Yale endowment’s incredible track record. 

I admittedly was sucked into thinking that investing in private equity was a must. The information asymmetry versus in public market investing, access to capital and connections of the managers, and ability to financially engineer and create value to generate returns, all seemed like obvious wins. 

I started convincing everyone around me, including myself, to deploy more in the asset class through closed-end funds. It was years later that I realised an important shortcoming in my approach as an individual investor. 

The IRR mirage, versus the more tangible MOIC

Internal rate of return (“IRR”) tells us the performance of an investment, taking into account the size and timing of its cash flows (capital calls and distributions), and its current value. 

Multiple on invested capital (“MOIC”) tells us the value of an investment relative to its initial cost. 

Upon deploying to “closed-end” funds, I realised a few key issues with my approach: 

1.  I had to reserve the capital I had committed in very liquid cash-like investments like money market funds, which could be called on short notice, causing a MOIC drag despite high IRRs

2. The predictability of capital calls and subsequent distributions of when I would receive proceeds from the funds was very unpredictable, making it hard for me to commit to more private equity funds in a vintage, strategy, and manager-diversified way that the large sophisticated institutional investors were doing

3. Despite being in the industry, I was often too small an investor to get access to top funds consistently and be in the information flow to make fully informed decisions

I did some math, and even though the funds were reporting net IRRs in the high teens, due to their capital call and distribution nature I was only getting around 2x MOIC and DPI after 10 years. On a fully-deployed investment, this equates to a significantly lower IRR of around 8 per cent. 

How much does one really need to create a world-class private market portfolio?

Through closed-end funds, to achieve enough manager and strategy diversification, one would need to invest in at least 7 top-tier funds per year, which would require US$5-30 million per fund in commitments. To achieve enough vintage diversification and for the private market portfolio to be self-sufficient with capital calls being fed by distributions of other funds maturing, I would need to do this for at least 5 years. 

This would mean a world-class private market portfolio would require me to have around 500 million in fund commitment over 5 years, which would mean my overall investible wealth portfolio would be multiple times this, which of course is way beyond achievable for 99.9% of us.

The innovation of the evergreen fund makes this possible in a few clicks. Being fully deployed also means that a much higher MOIC is possible. With simple math, a net IRR of 11.6 per cent achieves a 3x MOIC over 10 years, which is very close to the returns of the longer-running evergreen funds since before the global financial crisis, and very close to the publicly reported returns of mature private equity programs of the US pension funds. 

Buyers beware: “gates”, fees and expenses

Evergreens do come with their complexity, and the industry has been creative in coming up with self-serving solutions that may help us as investors as well.

“Gates” in particular are worth highlighting. A gate is a restriction to sell down more than a certain percentage, typically 5 to 10 per cent, of the fund in a given quarter. As the fund is primarily invested in private companies that are not publicly traded, the gate makes a run on the fund, and therefore the need to fire-sell its assets is unlikely. Yes, this does help the manager retain assets and therefore generate fees for themselves, but it also protects the investor by protecting the value of the underlying assets of the fund from market shocks. Most importantly it means that you should only allocate to evergreen funds for goals or liabilities that are longer in duration and can handle potential periods of illiquidity when redemption gates may be hit. 

You must understand your net return after all fees and expenses, and make sure you are being compensated for the risk and illiquidity you are taking on. 

It is also important that you understand the incentives that a distributor or advisor may have in showing you one product versus another, and if the advice you are receiving is truly conflict-free. Are there trailer commissions being paid by fund managers for distribution? Are there subscription and transaction fees that may cause churn? What are the ongoing fees and expenses? All of these incentives may influence what you are pushed to buy, and the fact that these products are less liquid means you should have a closer look before you press “go”.

Evergreens are here to stay

Closed-end funds have merits and do provide more control to sophisticated institutional investors with multi-billion dollar private market programs. Many of the evergreen funds invest in closed-end funds and have a lot more resources to do this well versus us as individuals or family offices.

The ability for me to rebalance my asset allocation, get immediate and fully deployed exposure to the asset class, invest more or redeem some when I want, and achieve diversified exposure I would not be able to replicate on my own tells me that evergreen funds are here to stay. I also love the fact that I can stay invested for as long as I want and compound my wealth in these funds without my tree being cut down after ten years. 

The Swiss private markets specialist Partners Group has some of the longest-running evergreens on the market, with many managers such as EQT, Blackstone, Ares, Carlyle, Oaktree, KKR, Hamilton Lane, HarbourVest, and others launching their offerings in more recent years. 

In the laws of nature, the volume of each tree growth ring is exponentially larger than the last. Assuming a return of 10 per cent, the amount you earn in the tenth year is almost 2.5x what you earned in the first year. 

If used well, evergreen funds give us another great tool to compound wealth. 

Choose Endowus Hong Kong, allocating private markets in a smarter and easier way. 

On Endowus, you have access to private market offerings managed by top-tier managers. Contact our private wealth arm via privatewealth.hk@endowus.com to learn more.

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