Executive Summary
As advisors seek to meet the objectives of income and diversification in client portfolios, registered funds that incorporate direct access to private equity, private credit or hedge funds are often overlooked. While relatively few funds provide this type of exposure to accredited investors, there have been significant recent developments that can make them an attractive alternative.
iCapital Network is dedicated to providing insight on emerging product trends and will focus this initial primer on funds that incorporate private equity, of which there are only a handful today. Future editions will focus on private credit, direct lending, real estate and hedge funds.
The registered fund market encompasses both closed-end and open-end funds that can be sold either publicly or through private placement. To differentiate from listed closed-end funds, ETFs and open-end mutual funds, we will refer to privately placed funds that incorporate access to private capital as the ’40 Act Market, consistent with the term used by many practitioners.
Specifically, we define ’40 Act as an Investment Company registered under the 1940 Act that is a privately placed (e.g., non-listed) closed-end tender-offer fund that has elected to be taxed as a Regulated Investment Company. Additional definitions can be found in the glossary at the end of this primer.
There are compelling reasons to consider this class of investments, which is designed to provide accredited investors and qualified clients with access to the private capital markets which have historically been the domain of institutional investors, such as endowments and pension funds, and large family of offices.
Investments designed to provide accredited investors and qualified clients with access to the private capital markets which have historically been the domain of institutional investors.
• Increased Availability: The number of these funds is growing, with many new products currently in registration. Those in market have been somewhat slow to garner attention and investors’ capital, with the entire asset class now approaching just $48 billion in total assets (Figure 1). Consequently, there is virtually no independent research on the ’40 Act market; it is still small enough that traditional research firms can afford to ignore it. However, despite its relatively small size, the quality and breadth of these offerings have reached a level that we believe merits attention.
A growing number of established private equity managers are focusing on addressing the challenges of liquidity, transparency and the inevitable cash drag that can occur in making private investments through registered vehicles.
• Expanded Set of Managers: As the’40 Act market has evolved in recent years, it has attracted a growing number of firms with demonstrated success in managing private investments. Established players such as Partners Group, Carlyle (CPG) and Pantheon have launched funds under this structure and others have explored this space and we expect more new entrants.
• Improved Product Features: As these firms have become interested in tapping into the multi-trillion-dollar accredited investor market, we’re seeing positive developments in the construction of these funds (no doubt a consequence of increased competition). More of these established managers are reducing fees and thoughtfully addressing the challenges of liquidity, transparency and the inevitable cash drag that can occur in making private equity investments through registered vehicles.
• Liquidity Expectations Have Changed: Managers are keenly aware that the only way to successfully open the market is to provide real value and solve the problems that held back the often flawed first generation of ’40 Act funds, many of which disappointed investors. One of the features that has garnered attention is to more closely align ’40 Act fund liquidity with the underlying investments’ anticipated liquidity. We will discuss this in more detail later in this primer but most investors can expect lock-up periods of at least two years when a fund first launches, early repurchase fees and pro-rata redemptions if a tender is over-subscribed. There is no guarantee of liquidity.
• Limited Opportunities in the Public Market: It is no coincidence that the increase in registered funds incorporating private capital is occurring as the universe of public companies ages and shrinks. The combination of fewer IPOs, continued M&A-driven consolidation, and take-privates has led to a sharp reduction in the number of U.S. publicly-listed companies — from almost 8,000 in 1998 to around 4,000 today (Figure 2). Meanwhile, the average age of a U.S. public company has increased from 12 years in 1996 to 20 years today — with dynamic, high-growth companies primarily finding their home in the private markets, out of reach for the average equity market investor. In fact, Cambridge recently reported that top quartile PE managers have substantially outperformed the S&P 500 each year from 2008 through 2016 (most recent full year performance reporting). Even the average PE manager has outperformed the S&P 500 in 8 out 9 nine of the years tracked (Figure 3). This highlights the investment opportunity outside the public markets.
Perhaps the most critical concept for advisors and their clients to bear in mind when considering ’40 Act funds that invest in private companies is that, regardless of the liquidity terms, these are fundamentally longer-term holdings and should be viewed as such in a broader portfolio.
While non-listed, closed-end funds have been around for quite some time, they differ from open-end mutual funds in ways that advisors and their clients should consider. A long-held rule of thumb has been that investors should not invest in a mutual fund unless they expect to hold the investment for at least three to five years. This is particularly true of the ’40 Act structure, where investors should consider hold periods of five years or more in order to gain the full benefits of the private equity value creation process.
Perhaps the most critical concept for advisors and their clients to bear in mind when considering ’40 Act funds that invest in private companies is that, regardless of the liquidity terms, these are fundamentally longer-term holdings and should be viewed as such in a broader portfolio. Private equity firms generate an illiquidity premium through their ability to collaborate with the management teams of their portfolio companies to execute value creation plans that require three to five years (or longer) to realize. These strategies may include expansion into new markets, selective consolidation of a fragmented sector through add-on acquisitions, efficiency improvements/cost reduction, the sale of non-core assets, and/or professionalization of senior management teams. These plans take time. Put a different way, one of private equity’s main advantages, particularly over public companies which must deal with the pressures of quarterly earnings and “short-termism”, lies in thinking and acting with a long-term time horizon in mind. It is essential that individual investors understand these fundamentals and have realistic timing expectations regarding liquidity.
It is not credible to allow an entire generation of retail investors to be left with only diversified public market exposure to generate retirement returns, while institutional investors crowd into innovative business models [through the private markets] that offer potentially higher returns. – CFA Institute
Indeed, as a CFA Institute report in 2018 concluded, “Public markets are often perceived to be short-termist in their outlook, causing corporate managers to focus on meeting quarterly earnings targets rather than working on creating long-term value. Private markets are perceived to be more long term in their thinking and in their structural characteristics by comparison … it is not credible to allow an entire generation of retail investors to be left with only diversified public market exposure to generate retirement returns, while institutional investors crowd into innovative business models [through the private markets] that offer potentially higher returns.” The Institute made several policy recommendations in its report, including improving access to private market investments by retirement savers. These registered funds represent an important advancement in providing retail investors with access to the private capital markets and in leveling the playing field with institutional investors.
Current State of the Market
Since 2000, there have been several false starts in the closed and open-end registered fund space, as managers sought to deliver private market returns generally reserved for the institutional market. The first generation of these funds was characterized by high annual fees, substantial upfront load fees, market-like beta and/or liquidity mismatch issues. While there were some quality products developed in this first generation, most of the funds fell well short of investors’ expectations.
At least for now, the vast majority of advisors and their investors appear to be paying heed and staying in these funds for relatively long periods. These funds generally offer limited quarterly liquidity through a share re-purchase tender process, and a review of SEC filed documents reveals that most funds have been able to meet the redemption requests of investors who have chosen to tender their shares. Redemptions appear to have been relatively light, which is a sign that most investors and their advisors understand the longer-term nature of these funds and the need to remain invested to reap the upside. And, of course, buoyant market conditions have also likely helped.
• Matching liquidity features with the underlying investment:
o Private equity-focused funds generally register as a tender-offer fund (as opposed to an interval fund), allowing the fund’s advisor and its independent board to limit redemptions through tenders if they deem it necessary. While tender-offer funds try to maintain some minimal level of quarterly liquidity, 5% for example, these funds have fairly wide latitude in establishing the amount and timing of their share repurchases. In contrast, an interval fund must adopt a fundamental policy, changeable only by a majority vote of the outstanding voting securities of the company, and in which the timing and minimum amount of each tender is mandated (between 5% and 25%);
o Credit-focused funds often register as interval funds with a minimum requirement of 5% per quarter. In these structures, the underlying investments generally have a greater level of liquidity and the fund sponsor should be able to manage the share re-purchases even through challenging market cycles.
It is no coincidence that the increase in registered funds incorporating private capital is occurring as the universe of public companies ages and shrinks.
• Registration: These funds must all register with the SEC under the 1940 Act. This registration allows access to these private opportunities for accredited investors (some funds are restricted to qualified clients), but maintains the suitability and limitations on the manner of the offering, somewhat similar to private funds.
• Board Oversight: Consistent with all registered funds, each ’40 Act fund is overseen by an independent board designed to represent shareholders’ interests. The board reviews the fund’s operations, including adherence to its stated investment objective and investment advisory fees, and is responsible for approving any share repurchases or tender offers. It is important to note that during times of market stress or dislocation, the board may decline to make a tender offer if it believes that such an action is not in the best interest of all shareholders (as noted, interval funds are required to meet their minimum stated tender amounts). For example, the board may find that to honor the tender offer, the fund would have to sell investments at distressed prices significantly below their true market value, which may not be in the best interests of the overall shareholder base (even if some shareholders wished to sell) and thus the board could decline to allow any tenders during that period. While these instances tend to be rare, they highlight the responsibilities of the board towards all shareholders, and not just those looking to tender shares for repurchase in a possible “fire sale” situation.
• Simplified Tax Reporting: Almost all of the current PE-focused registered funds now elect to be taxed as a Regulated Investment Company (RIC) by the IRS, delivering a 1099 form (instead of a K-1). This simplifies tax reporting and filing for investors in these funds.
The Cash Drag Challenge
’40 Act funds that focus on less liquid investments such as private equity also face a “ramping-up risk” that traditional mutual funds do not. When most mutual funds receive a new subscription from an investor, they can invest those proceeds almost immediately into public equities or fixed income securities. In contrast, many of the typical underlying investments made by ’40 Act funds can take months from identification to due diligence to actual investment, and then three to five years to an exit and the realization of proceeds.
Capital that is committed to private equity funds is deployed over several years and thus, in the traditional private fund structure, the fund manager calls that capital down from investors when needed as deals are completed. In the ’40 Act fund model, there is generally no call down process as 100% of an investor’s money is placed into the ’40 Act fund at the time of investment. As a result, the nature and structure of a ’40 Act fund’s deployment of capital into underlying investments can lead to significant cash drag on overall performance if not properly managed. There are strategies that ’40 Act funds can employ to try to mitigate this risk, such as purchasing equity index ETFs or pursuing an over-commitment strategy. Each of these strategies has benefits and drawbacks.
The J Curve: The J Curve refers to an investment performance arc where a significant gain follows an initial loss. In private equity, the fund manager charges fees and expenses from day one on the total committed capital. In the early years of the investment period when the manager calls down that capital to invest in private companies, those fees and expenses can result in a near-term loss since it takes time to both deploy the capital and then to create value in the portfolio companies (Figure 4).
One of the most common ways to address this “cash drag” issue in registered funds is to have a high exposure to secondary and income-generating investments until the fund reaches scale. For example, a typical private equity fund will take several years to execute its value creation plan and does not generate meaningful distributions until around year 4, leading to a relatively slow ramp-up in investment performance. By contrast, a secondary investor typically purchases a mature stake in a primary fund that is already 4 to 7 years old with portfolio companies that are close to an exit. Thus, a secondary investment will typically start generating liquidity for investors within several months from the original investment. Further, the mature nature of secondary investments means investors have the opportunity to deploy significant amounts of capital right away and reduce the “drawdown” period, which can further help alleviate the cash drag.
Similarly, investing in credit-oriented strategies allows investors to earn positive income immediately. This income allows a ’40 Act manager to build a cash cushion that can be redeployed or help meet investors’ liquidity needs.
Direct investments (or co-investments) can also help mitigate the J Curve, but not as quickly as secondary or credit-oriented investments. An advantage of direct investments is their reduced cost, as most transactions are offered on a fee basis well below the traditional 2% management fee and 20% performance fee schedule that underlying private fund managers typically charge. This low-fee structure, combined with exposure directly to privately-held businesses, leads to a shallower J Curve compared to primary investments as the investor’s capital can be put to work at a faster pace than a typical primary fund investment, which deploys capital over several years.
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