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Alternative Insight – February 2021

The forever fund: evergreen capital in private equity

 

The traditional private equity fund is a 10-year close-ended vehicle, with a five-year investment period and an average holding period of three to six years. Some argue that the time-limited model encodes short-termism into the private equity perspective. The manager’s decisions to buy, hold and sell investments are influenced or even ordained by the ticking clock.

The time horizon problem has become more acute now that investment holding periods are being stretched by the dilatory effect of the pandemic on the M&A market. Term extensions and fund restructurings afford management more time to dispose of assets; certainly, extensions were common practice even before the advent of coronavirus. Several big PE houses also offer long-life funds, with terms of 15, 20 or even 25 years, designed to accommodate longer holding periods.

But why not do away with term limits altogether? That is the defining characteristic of the evergreen fund, an open-ended structure that aims to carry on indefinitely by recycling investment proceeds and raising additional capital on an as needed basis, either continuously or in cycles. How does it compare to the traditional 10-year fund?

Fundraising

In general, the best time to raise a new fund is when the economy is booming. But a traditional fund cannot simply raise additional capital whenever it feels like it, because it is limited to a 12- or 18-month subscription window. When that ends, the fund is closed to new investors. The GP’s next fund will have to wait until the end of the current fund’s investment period or, if sooner, the deployment of most of its committed capital.

By contrast, an evergreen fund can opt to raise money whenever economic conditions permit, or throughout the lifespan of a particular investment if it has long term potential. The process should be quicker and simpler because management uses the same vehicle for successive fundraising rounds; it does not need to establish and negotiate terms for a new fund every four to six years. It may also be able to skip some of the other structures, such as co-invest programs and continuation funds, which have developed over time to augment the traditional 10-year fund. Finally, an evergreen fund can rely on internal cash generation to pay for new investments, which offers some relief from the rigours and costs of the fundraising carousel.

Liquidity

Liquidity will always be a challenge for private equity funds, given the types of investments that they make. But, on account of its indefinite lifespan, an evergreen fund must integrate into its model a mechanism for investors to cash out. If an evergreen fund is listed on the stock exchange, then its units will be publicly tradeable like any regular PLC. Or it may involve rotating batches of investors into and out of the vehicle over time, with new investors buying out existing investors who want to sell. Or the fund can offer periodic redemption windows, in which investors can sell their units back to the fund.

Investor units are bought and sold on the basis of NAV (net asset value). But the NAV of privately held investments is often not easy to determine and may be complicated by the very long horizons of permanent capital vehicles. Thus, NAV provisions in the fund agreement are heavily negotiated and often very detailed. Third party valuers can be pricey, so fixed dates are typically used for NAV-based investor transactions.

Providing liquidity via redemption has its risks for the manager. A rush of investors toward the exit could easily destabilise the fund, forcing it into untimely disposals of assets (perhaps at below-market prices, if the fund is perceived as a distressed seller) to finance redemptions. In extremis, a run on the fund could topple it into paralysis and insolvency.

Gating restrictions and side-pocketing can be deployed to protect the evergreen fund from the depredation of over-redemption, but only at the cost of forfeiting its supposed liquidity advantage for investors. Having locked investors in, even if only temporarily during an emergency, management may find that they are far more reluctant to subscribe fresh capital in future.

Fees

Management fees tend to be broadly comparable to those in 10-year funds, although some evergreen managers calculate their fees on portfolio valuations instead of committed capital, or they may charge a blended fee calculated partly on NAV and partly on commitments.

Valuation-based fees are good for investors insofar as they track the fund’s “capital at work”, and thus do not reward the manager for the portion of uncalled capital. On the other hand, if valuations rise, fees rise with them; investors will not benefit from the kind of stepped-down fees which are standard in the second half of a traditional 10-year fund term.

Incentivisation and strategy

Since holding periods are much less constrained, IRR (internal rate of return) is not a focus for an evergreen fund. Instead of IRR, the manager’s carried interest is based on NAV and yield.

This form of carry should motivate an evergreen manager to invest in strongly cash generative businesses that benefit from patient capital and strategic planning, for instance pursuing acquisitions or developing industry partnerships to cement or expand its portfolio companies’ market position.

The evergreen fund does not need its strategy to be exit-oriented. High-yielding companies may well become mainstays of the fund’s portfolio. The manager may elect to sell underperforming companies, thereby freeing up cash to recycle into new investments or investor redemptions. But it is not on any artificial deadline to do so. Rather than book a loss on that particular asset, management could wait for a more advantageous time arises to divest. This type of flexibility is very helpful in times of economic crisis, but it also reflects the reality that the holding period of a traditional fund isn’t suitable for every investment.

Whereas a traditional fund must deploy most of its capital during its pre-agreed investment period, even if this coincides with high asset prices, an evergreen manager is better placed to ‘time’ the M&A market, buying when valuations are lower.

Similarly, there has been a growing trend of managers forming continuation funds to retain assets that they believe to have long term value beyond the traditional fund term. Evergreen funds may offer a quicker and more cost-efficient way of achieving similar ends.

Resilience in a crisis

While the aspect of permanence may furnish an evergreen funds with the flexibility to wait out periods of market turmoil, this cannot be assumed. If a crisis causes market valuations to tumble, as has happened in the pandemic, this will have a knock-on impact on valuation-based fees/carry. Crises also cause investors to worry about their own liquidity position, and an investor in need of cash is obviously far more tempted to make redemptions.