If you’ve ever managed a traditional (fixed-life) fund, you’ll know that from the moment you raise funds, to the moment you put the money to work in your first investment, to the ultimate exit and liquidation of the fund – the clock is always ticking. One thing is for sure, investing is not easy, and while some may have the Midas touch, the majority don’t, which is why evergreen private equity structures with unlimited life spans could be an investment alternative.
Because of the dynamics and faulty incentives within the typical private equity fund structure, investors may not be getting the best deal. For instance, selling the best companies too early in order to generate the promised Internal Rate of Return (IRR), or charging high management fees on the ‘left over’ portfolio companies, even after the investment horizon has been reached. Investors could also avoid paying transaction fees for just having the portfolio companies passed around between other private equity funds (a case of I scratch your back, you scratch mine) in which they’re also investors.
Fortunately, as an investor (or Limited Partner) you have options. You can switch from the typical “patient capital” structure, to a “permanent capital” structure, similar to an asset holding company or investment holding company – one that can stand the test of time.
Every few years, a valuation is done on the assets and decisions made to either sell the not-so-good performers, and retain the cash-flow-generative or best-performers. The returns generated (through either redemptions or dividends) should ideally be recycled back into the structure for the next investment, rather than distributed to the investor. The challenge of course is valuing the private companies in the absence of any sale (more so with venture capital portfolio than private equity). But of course, you have auditors and valuation experts for that debate.
The solution of removing the ‘time’ pressure, creates a paradigm shift towards investing. If you think about it, when you have a fantastic asset, why would you even want to sell it!? This may sound like a Berkshire Hathaway model, and it probably is.
How would you incentivize the fund manager (or what we call General Partner)? By providing a carry based on the valuation, equity growth curve and yield. This avoids having to use IRRs as a yardstick. Such a change in mindset, allows for the fund managers to source high quality, cashflow generative or yielding businesses that can compound, at reasonable valuations and develop more strategic relationships with the portfolio companies as against just looking at it as a financial asset that is available for sale. The fund managers would become more focused on building value, and less worried about exits. They may even forget about the artificial limits of harvesting the portfolio before it’s ripe or going for fire-sales as they run out of time and also avoid resorting to financial engineering (e.g. using debt) to improve IRRs and instead focus on absolute returns.
If you ask anyone in fundraising or fund placements, they’ll tell you the best time to raise funds is during a boom. It’s easier and faster and nearly every investor is in the herd mentality, coupled with a dose of FOMO. However, the moment the closing takes place, the timer is set to go and the fund manager may even be forced to invest during a peak for unsustainable valuations, leading to terrible liquidations or ultimately restructuring. A look at the vintage year, will give you an indication of how typical funds have performed so far. With evergreen structures, since the investment returns are recycled back in, there isn’t a need for the placement team to go with hat-in-hand to investors for additional capital every few years.
So what about the liquidity? Well, that will always be a challenge for private equity. While cash flow generation may provide a small amount of liquidity, the ideal situation after growing the equity curve is to create asset value (net asset value) that is greater than the sum of the individual assets (parts), and then list this on a public exchange or alternative secondary market. Doing so, can provide investors with short term liquidity (that would be subject to time and cash limits for redemption). The other alternative is to rotate investors out of the structure (but risk dilution) by finding new investors who are willing to come on board through new subscriptions and buy out the previous ones. If liquidity is one of your criteria, this may not be for you. Having said that, with evergreen structures, you really won’t have to worry about re-deploying your capital.
This is not legal advise in any way, so seek your own legal counsel before venturing into this type of structure. Depending on how you setup the structure (using an LLC or WLL), you may not even come under typical regulatory requirements, as there is no longer a third-party investment advisor guiding you on the sale-and-purchase of a security. This structure could provide flexibility to balance the regulatory requirements and limited liability concerns.
Why not just extend or lengthen the fund period? While this is possible, it is most-likely an after-thought and leads to other governance and risk issues. This is more like patching a tire puncture, rather than designing and using a flat less from the start. You might as well just have a three year fund, with indefinite one year extensions!
If you ask me, I feel that direct investments are the way to go, they offer a more customized approach to asset allocation for investors. The evergreen private structure could provide a better investment alternative to traditional private equity fund structures, and even fund of fund structures with cleaner, more aligned, flexible and transparent advantages. But fund managers would likely have to negotiate a lower management fee rate to reflect the longer time lines. Not sure how many would agree to that!
1. Permanent capital: Perpetual cash machines or try this
2. Firms such as Golden Gate Capital, General Atlantic, Public Pension Capital Management, Sutter Hill are worth checking out for ideas about these special purpose acquisition companies.