Evergreen Funds: The Right Fit for Challenging Times

Investor appetite for evergreen funds, also known as permanent capital funds, is growing as Limited Partners (“LPs”) require more flexible, open-ended alternative investment structures with no termination date. 

Evergreen funds are typically open-ended, they do not have a termination date and can accept new investors continuously, whilst investors also have the option to redeem their capital under certain parameters. These characteristics are in stark contrast to a traditional closed-ended Private Equity (“PE”) fund, where investor capital is tied up for a period of time (typically 10+ years).

The beauty of these “never ending funds” is that capital can be raised, repaid and/or transferred on an ongoing basis and new investors can be accepted at any point in time. Whereas a traditional PE fund is a 10+ 2-year close-ended vehicle, with a five-year investment period and an average holding period of about four to six years. Evergreen funds appeal not only to existing large institutional investors, but to newer, smaller investors coming to the asset class for the first time.

Here David Fowler, Global Co-Head of Product – Private Equity and Raffaela Mirai, Director – Private Equity Fund Administration, discuss the key drivers for growth and examine the benefits of using evergreen funds for General Partners (“GPs”) and LPs in an ever-changing private capital landscape.

Drivers for growth in times of turmoil

Due to recent changes in global private fund markets and corporate growth patterns, GPs have been rethinking their fundraising strategies in order to remain agile and seeking long-term capital as an alternative to traditional private funds.

David Fowler observes: “Increasing fundraising volumes and market competition have intensified in the past decade. This has resulted in difficulties securing investment targets and unfavourable investment conditions, making it challenging to achieve the high yields of the past, as more time has been required to generate similar levels of profits than ever before.”

In particular, there are a number of cases where corporate value has risen tremendously after an IPO, compared to the pre-IPO period, meaning that the period for achieving optimal returns has been extended.

“The private fund market has entered the periodic downward cycle where a growing number of traditional private funds have no choice but to dispose of fund assets at a discount due to difficulties in exiting their investment. These conditions have boosted demand for the evergreen fund structure that could better align exit timing,” adds Raffaela Mirai.

While the aspect of permanence does furnish an evergreen fund with the flexibility to wait out periods of market turmoil, this cannot be assumed. If a crisis causes market valuations to tumble, as happened during the pandemic, then this will have a knock-on impact on valuation-based fees. 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.

A question of time

“The great thing about an evergreen fund is that it’s another tool in the toolkit in working out how we build aligned structures,”, David Fowler, Global Co-Head of Product – Private Equity

GPs and LPs are facing more frequent fundraising cycles. Some GPs can find themselves in an almost constant fundraising mode, targeting the same investor base, while trying to operate in a highly competitive and volatile market, so time is of the essence.

Simply put, an evergreen fund is an open-ended structure with the aim to keep going indefinitely by recycling investment proceeds and raising additional capital on an “as needed” basis, either continuously or in cycles. Fund managers can both make and capture investments using evergreen funds within a timeframe they believe will increase returns.

“The time horizon problem has become more acute now that investment holding periods are being stretched by the dilatory effect of the current economic situation on the M&A market. An evergreen fund affords management more time to dispose of assets, hence it increases the opportunity to dispose at the right asset value time,” says David Fowler.

“From an LP’s perspective the time horizon of a PE fund may be a safety net, however from a view of value creation of the underlying fund asset, it can be limiting as the manager’s decisions to buy, hold and sell the underlying fund’s investments are influenced or even ordained by the ticking clock,” comments Raffaela Mirai.

An attractive fundraising option

Evergreen funds can raise capital whenever economic conditions permit, or, if an investment has a long-term potential, it can raise capital throughout the lifespan of that particular investment.

David Fowler states: “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. In addition, an evergreen fund can rely on internal cash generation to pay for new investments, a pleasant relief from the difficulties and costs of the fundraising exercise.”

A fresh take on liquidity

Because of its indefinite lifespan, an evergreen fund structure must integrate a mechanism for LPs to cash out. A number of exit options are available, for example, allowing rotating batches of LPs into and out of the vehicle over time, in essence similar to secondaries transactions i.e., new investors buying out existing investors who want to sell. This allows for periodic redemption windows, in which LPs can sell their holding in the evergreen fund back to the fund.

Raffaela Mirai observes: “For many GPs, the main question mark is not so much around the exit strategy, but more the exit price. In traditional public traded open-ended funds investors come in and out of a fund by buying and selling on the basis of the fund Net Asset Value (”NAV”).”

With evergreen funds holding asset investments privately, determining the NAV may not as easy as it first appears, and maybe be complicated by the very long horizons of permanent capital vehicles. Hence NAV provisions in the fund agreement are heavily negotiated and often very detailed.

“The liquidity issue can be solved via redemptions, but this is not without risk for the manager,” says David Fowler. “A rush of investors toward the exit could easily unbalance the fund, forcing it into untimely disposals of assets, which would defeat the whole purpose of setting up an evergreen fund structure.”

Gating restrictions and side-pocketing may be used to protect the evergreen fund from the depredation of over-redemption, but this would mean forfeiting its supposed liquidity advantage for LPs. If investors were locked in, even if only temporarily during an emergency, LPs may be far more reluctant to subscribe fresh capital in future.

A closer look at management fees

Private Equity is a strategy that makes an investment on the condition of the timely disposal of fund interests, tries to boost corporate value through support for growth, cost reduction, and governance improvement, and generates returns via exit strategies like IPO or M&A.

During the seven- to ten-year fund life, the LP generally supplies capital and pays management fees to the GP and then receives returns allocated from the disposal of fund assets upon the termination. The pre-determined liquidation of a private fund offers many benefits, for example, pressuring the GP to exit from investment at liquidation and playing a key role in value addition.

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 allow LPs to track the fund’s “capital at work,” says Raffaela Mirai. “Hence the manager is rewarded on the called-up capital leaving the portion of uncalled capital out of the equation, and the fees move directly in line with the rise of the fund’s valuation.”

David Fowler adds: “As holding periods are less of a constraint with evergreen funds, it follows that the internal rate of return (“IRR”) is not necessarily a focus for these types of funds. Instead of IRR, the manager’s carried interest is based on NAV and yield.”

Conclusion

Evergreen funds are not a new phenomenon but are currently gaining some momentum. The type of flexibility they offer can be very helpful under challenging economic circumstances, and also highlights how times are changing, as the reality is that the holding period of a traditional fund just isn’t suitable for every investment.

The concept that one size fits all, or the traditional so-called ‘Vanilla Funds’ is no longer the case. Right now, flexibility, plasticity and elasticity will support GP and LP successes in the PE market.