Fund structures
Before looking at specific fund wrappers and regulatory structures, it’s important to understand the different ways a private markets or alternatives fund can be structured. There are capital call and fully funded models, and also closed-ended or open-ended models; when the fund has no closing date, it is referred to as “evergreen”.
Closed-ended:
Essentially, investors commit capital to a fund, from which the GP (GP refers to a general partner, who manages the private markets fund) draws over time and invests for a fixed number of years before finally returning capital and returns to investors. The process of a GP drawing this committed capital from investors is known as a “capital call”. Once the initial fundraising period is over, the fund is said to be “closed” – meaning no new investors may subscribe to the fund.
Benefits:
- Potentially higher return potential due to no cash/liquidity sleeve – this is because without a portion of the portfolio allocated to cash, more of the portfolio can be invested in higher returning private markets assets
- Potentially better alignment to longer term investment strategies which could lead to greater returns
- Clear structure with defined timelines for capital calls and distributions of returns to investors
Drawbacks:
- Lack of liquidity
- J-curve effect on returns. This means that the funds returns will initially be negative while the GP is calling capital and making investments, before returns then become positive (this effect is known as the J-curve)
- Irregular and less predictable distributions
- Potential for high fees that can affect net returns, particularly in the early years due to the “J-curve” effect where fees are charged before capital is fully invested
Open-ended:
Investors can subscribe and redeem (purchase and sell shares) intermittently based on NAV* – but often with limitations (sometimes referred to as “gating” provisions) to accommodate for the illiquidity of the underlying assets. These funds have an “infinite” life.
*NAV refers to net asset value, which is essentially a fund’s assets minus its liabilities.
Benefits:
- Periodic liquidity for investors
- NAV based pricing for simplicity
- Less pronounced J-curve return profile
Drawbacks:
- Despite better liquidity than closed ended funds, there are still likely to be limitations and gating on redemptions
- Cadence of NAV calculations can sometimes be slower or less frequent than mutual funds (e.g. quarterly)
- Potential cash drag*
- Ongoing fees that may be charged on NAV can erode returns over time, and the need for continuous valuation of assets can add complexity.
* “Cash drag” refers to the negative impact on investment returns caused by holding cash or cash equivalents instead of being fully invested in higher-yielding assets.
Fully funded
‘Fully funded’ means that investors pay in 100% of the capital upfront when they subscribe. This means the fund has 100% of its capital within it, ready to be invested from day one. Therefore, there are no capital calls, and the GP draws on the cash gradually to deploy into investments.
Consequently, the fund will inevitably hold cash for certain periods of time, leading to ‘cash drag’. Fully funded funds often maintain a liquid sleeve/portion of the portfolio to ensure they can provide liquidity to the investors. Some managers try to mitigate the cash drag by actively managing this sleeve – this is an important factor for investors to consider.
Benefits:
- Simple funding
- Immediate investable capital for faster deployment, leading to potentially quicker exposure to private markets assets
- Appeals to wealth investors seeking simplicity, faster deployment, and earlier potential return generation.
Drawbacks:
- Potential cash drag
- Illiquidity issues can still exist
Capital call
This is the more traditional approach for private markets funds and involves investors committing a given amount of capital (say $10,000,000) up front, but only investing this money as and when it is called up by the GP – hypothetically $2,000,000 in year 1, another $3,000,000 in year 2, and so on. This can be more appropriate for long-term strategies, and it can reduce cash sitting idle in the fund.
Benefits:
Drawbacks:
- Unpredictable timing for investors
- Lends itself to a J-curve return profile
Regulatory wrappers
In addition to the different fund structures that alternatives funds can use detailed above, there are also various regulatory structures/wrappers which can be used, each one lending itself to a set of unique use cases.
Below we cover some of the most common structures and their unique characteristics.