Evergreen funds: the future for private market investing

THIS article is not about trees. But trees do provide an excellent visualisation of a trend that we believe will change the way we invest in private markets forever.

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

10-year lifespan

Imagine a tree that you planned to grow for only 10 years. It “calls” on your resources for the first five years, starts bearing fruit in the next five years, and then is cut down and sold for parts after 10 years.

Traditional “closed-end” funds comprise a system of committed capital, capital calls and distributions. The vast majority of private equity, private credit, private infrastructure, secondaries, venture capital and private real estate funds use the closed-end fund structure, which is also the most common vehicle for large institutions to invest in private markets.

The evergreen tree

Now imagine another tree that you could grow for as long as you like, for which you could provide resources upfront without needing to cater for capital calls. You would have the ability to add more resources to speed up its growth, or sell off some parts for money.

Over the last 15 years, meaningful developments have been made in private markets investing, much like the mutual funds market in the 1920s to 1940s. Evergreen funds (also known as “open-ended” or “semi-liquid” funds) are those without a fixed end date. They provide more flexibility than closed-end funds because they allow investors to periodically redeem units. They also generally have lower investment minimums, making it easier for all of us to allocate to private markets.

A personal reflection

I started my working life at the UBS investment bank, with a team focused on advising some of the top PE managers, who sought to raise funds from the top institutional investors – mainly 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 how my family and friends do it, 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 PE was a must. The information asymmetry compared to public market investing, access to capital and connections of the managers, and ability to financially engineer and create value to generate returns – all these seemed like obvious wins.

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

IRR mirage vs the more tangible MOIC

The 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.

The multiple on invested capital (MOIC) tells us the value of an investment relative to its initial cost.

Upon investing in closed-end funds, I realised a few key issues with my approach:

•  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.
• Capital calls were predictable, but the subsequent distributions – or when I would receive proceeds from the funds – were very unpredictable. This made it hard for me to commit to more PE funds in a vintage, strategy, and manager-diversified way that the large sophisticated institutional investors were doing.
• 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: Even though the funds were reporting net IRRs in the high teens, due to their capital call and distribution nature, I was getting only 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.

The amount needed to create a world-class private market portfolio

In closed-end funds, to achieve enough manager and strategy diversification, one would need to invest in at least seven top-tier funds per year, which would require US$5 million to US$30 million per fund. 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 five years.

A world-class private market portfolio would require me to have around US$500 million in fund commitment over five years. This means my overall investible wealth would need to be many times that amount, which of course is not achievable for most of us.

But the evergreen fund makes diversification 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 PE programmes of the US pension funds.

Buyer beware: gates, fees and expenses

Evergreen funds do come with their complexity. “Gates” are worth highlighting. A gate is a restriction on selling 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, gating makes a run on the fund, and therefore the need to fire-sell its assets, unlikely. Yes, this helps the manager retain assets and therefore generate fees for themselves. But it also protects the investor by protecting the value of the fund’s underlying assets from market shocks.

Most importantly, it means that you should allocate only to evergreen funds for goals or liabilities that are longer in duration and can handle periods of illiquidity when redemption gates may apply.

You must understand your net return after all fees and expenses, and ensure that 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? Such incentives may influence what you are pushed to buy.

Evergreens here to stay

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

Evergreen funds enable me to rebalance my asset allocation, get immediate and full exposure, invest or redeem when I choose, and achieve a diversified exposure I would not be able to replicate on my own. I also love that I can stay invested for as long as I want and compound my wealth in the funds without my tree being cut down after 10 years.

By 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 10th year is almost 2.5 times what you earned in the first year.

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

The writer is the chief executive of Endowus, an independent and holistic wealth platform advising over S$5 billion in client assets across public and private markets