“If you build it, they will come” – Field of Dreams
While I don’t think any portfolio manager has been beckoned by the whispers of deceased investors to build the ultimate alternative investment fund so they could come back to life and invest in it (if you haven’t seen the movie, Field of Dreams, then this analogy is making ZERO sense right now), I do believe that selecting the “correct” structure is an essential factor in being able to successfully raise money and manage a given alt strategy; this is not in any way to imply it is the only factor. But what are the various structures and some of the pros & cons of each? In this issue of Alt Blend, we’ll explore exactly that.
Open or Closed (-ended)?
There are two competing ideas we need to tease apart here: First, whether a fund is open or closed, in the sense of allowing new investments; and, second, whether a fund structure is “open-end” or “closed-end.”
New investments into a fund are also called subscriptions. A fund being “open” implies that new subscriptions are still accepted, while “closed” indicates the opposite. There are also gray areas, like “soft-closed,” where a fund may take in new money, but only from existing investors, as a way to slow but not entirely halt inflows.
Structurally speaking, an open-ended fund is ongoing. A well-known example is a mutual fund. Investors can typically buy and sell it each day (“daily liquid”), and it essentially continues indefinitely. When investors buy or sell shares, the fund acquires or sells underlying holdings to accommodate the inflows/outflows and related larger or smaller pool of shared capital. As they trade only once per day, each investor receives the same fund price on that day, based on the value of the underlying holdings. That price is known as net asset value (NAV). As an investor, when I redeem my shares, it is a function of the fund itself to provide me with the cash value based on the end of day price (i.e., current NAV).
A closed-end fund, on the other hand, is eventually closed to new investments by design. The fund sets out to purchase a specific/limited pool of assets, and then there are no additional investments accepted. Many closed-end funds (CEFs) trade on stock exchanges, but this trading doesn’t alter the underlying investment pool, and that’s a big difference vs. open-ended funds. In these exchange-traded CEFs, I buy/sell my shares to/from other investors at the market price (just like a stock), and that price can be more or less than the actual value of the underlying holdings; this phenomenon is known as trading at a premium or discount to NAV.
To get more into the nuances and other aspects of open-end and closed-end funds, click here.
Of Hedge Funds, Lockups, Gates, and Drawdown Structures
In the Alts world, even the open-end funds tend to involve less-than-daily liquidity, and these are commonly referred to as “hedge funds.” For our initial purposes, “hedge fund” simply means an open-ended alternative investment fund. Perhaps the most standard example is a fund that buys some stocks and concurrently short-sells other stocks; this is known as a long/short equity hedge fund. Hedge funds are frequently managed by a GP, and the investors are then LPs. LPs can add money regularly (e.g., monthly) and have some ability to redeem their investment from time-to-time (e.g., quarterly), but usually with some additional limitations. It’s important to point out that a hedge fund will often accept the full amount of an LP’s capital all at once.
[What, technically, is a “hedge fund”? It’s become a widely used term that can refer to a type of investment structure (as above) or investment strategy (e.g., hedging some kind of risk). It may hold publicly traded securities, private securities, or a combination of both. Often, it is semi-liquid. The name certainly implies that we should be “hedging” something, but that’s not a requirement. If you’re interested in more details about the evolution of hedge funds and other characteristics, this article provides a good overview.]
To help the GP have a more predictable timeframe during which it can invest money on behalf of LPs, a fund may incorporate a “lockup” period – or an initial period where liquidity is limited. A “hard lockup” means no liquidity, while a “soft lockup” imposes a penalty (e.g., 3% of an LP’s investment) if funds are withdrawn during the lockup period.
After the lockup period, then other liquidity provisions come into play. To avoid forced-selling of underlying holdings at potentially unattractive prices, the value of redemptions may be restricted. An example would be to limit redemptions to 5 percent of the fund’s assets in a given calendar quarter – a practice known as “gating.” If a couple of smaller investors want to redeem their holdings, it’s usually not a problem. However, when redemption requests are in excess of the gate, proceeds are distributed systematically (e.g., on a pro-rata, or first-come-first-serve basis), and the process for an investor to fully redeem can drag on for years. Bringing this full circle, hearing about a hedge fund with a “one-year soft lock, quarterly liquidity, and a 5 percent gate” should start making some sense.
In contrast to the above hedge fund example, the closed-end approach in Alts is known as a “drawdown” or “private equity” structure. In this case, the GP targets a specific fund size, such as $1 billion, and then sets out to raise that amount of LP commitments; this is the first phase of a drawdown fund, and it’s intuitively called the “capital raise” period. After the end of the capital raise, no further commitments are accepted. During the next phase of the fund – the “investment period” – the GP finds opportunities to make investments that align with the fund’s mandate and requests money from the LPs (aka “capital calls”). The process of drawing down and investing the committed capital often takes years, after which the fund is considered fully invested. The GP then moves into the “harvest period,” the third and final phase of the fund, attempting to generate profitable investment outcomes on behalf of the LPs. Funds usually make distributions along the way – consisting of a combination of returning the LPs’ capital, along with gains and income. After all holdings are liquidated/harvested, and money is returned to the LPs, the fund ceases to exist.
The GP may raise separate investment funds, either concurrently or in succession, depending on the firm’s size (human capital), opportunity set, and previous funds’ success. Private equity (buying/improving/selling private businesses), Real Estate (buying/improving/selling private real estate), and venture capital (funding startup companies) most often use the drawdown/closed-end structure.
Another structural element that we have obviously not yet touched on is that of fees, which will be the next topic of this introductory series.
Until next time, this is the end of alt.BLEND.
Thanks for reading,
Steve
