Private markets pioneers: the drivers behind the next generation of investment vehicles

The success of private markets during the last three decades has been inextricably linked with the 10-year close-ended fund structure.

As the private markets industry evolves and looks to move into new geographies and open up new pools of investor capital, however, managers are looking to a new generation of investment vehicles to underpin the asset class’s next wave of growth.

A significant step

The shift into fund structures other than the 10-year close-ended fund is a significant one. The 10-year fund has been the bedrock of the alternative assets space and has proven to be an ideal fit for both institutional investors with long-term investment horizons and for managers seeking to unlock value in private companies, away from the short-term quarter-to-quarter scrutiny of the stock market.

Furthermore, the classic “2-and-20” fee structure of the ten-year fund (a two percent management fee and 20 percent carried interest bonus paid out if a fund delivers returns above a pre-agreed threshold) has ensured ironclad alignment of interest between manager and investors, standing in stark contrast to public equities where investors will have varying investment horizons and even conflicting objectives.

Even the relative illiquidity of ten-year funds has been source of advantage, affording managers with the opportunity to pick the ideal window to exit assets. The fact that it not easy to trade in and out of assets in a ten-year fund, meanwhile, has also meant that when private markets managers invest, they invest for keeps and stick with portfolio companies through good times and bad. Dumping an asset when there is a bump in the road is not really an option.

A new era dawns

The ten-year fund will remain a cornerstone of the private markets industry years to come, but for all its advantages, managers with ambitions to open up new investor bases and pools of capital will have to look beyond the comfort and familiarity of the ten-year fund and add new investment structures to their platforms.

Perhaps the single biggest push to widen the fund structures private markets firms use to raise capital is the opportunity presented by the democratization of private markets.

Institutional investment has been the main source of capital for private markets managers historically but after a challenging period for fundraising, which has seen institutions tap the brakes on allocations to new funds, managers have had to look to non-institutional investors to sustain fundraising levels.

Non-institutional investors – including family offices, high-net worths, retail investors – have invested in private markets funds for decades, but only in very small numbers. Bain & Company estimates that private markets managers haven’t even penetrated five percent of the addressable non-institutional investor base, even though these investors account for around half of overall assets under management (AUM).

The prize for unlocking the non-institutional market is a substantial one, with Bain & Co forecasts estimating that during the ten years to 2034 individual allocations to alternatives could more than triple – potential reaching up to US$12 trillion.

The illiquidity and high investment minimums of 10-year close ended funds, however, mean that managers have no option but to embrace new investment vehicles if they want to tap into the non-institutional opportunity.

Non-institutional options

There are various pathways that managers can follow to raise non-institutional capital, ranging from semi-liquid and interval funds to feeder funds.

Alter Domus will cover these structures in more details in later sections fo the series, but fundamentally, what managers are seeking are structures that help individual investors and small family offices to overcome the two biggest hurdles to gaining exposure to private markets assets via close-ended 10-year funds – illiquidity and high investment minimums.

Semi-liquid structures are an example of an alternative structure that addresses liquidity concerns individuals may have. These structures will typically offer individuals with the opportunity to make capped redemptions at set periods, based on the NAV of the semi-liquid fund. Unlike institutions, which can sit out long hold periods, life events such as illness or divorce make the prospect of locking up a large of net worth in a ten-year fund a daunting prospect for an individual.

Semi-liquid funds are not designed to offer daily liquidity in the way that equities do, but if for whatever reason an individual does have to take out cash, the structure does provide windows to do so.

When it comes to investment minimums, meanwhile, the feeder fund structure is an example of investment vehicle that can help to bring in investors who wouldn’t be able to underwrite the minimum cheque sizes for 10-year funds.

Feeder funds essentially cluster together smaller allocations from several investors and then invest this pool of capital into private market funds via an umbrella fund. The private wealth units of investment banks have offered feeder funds to their clients for decades, and more recently tech-enabled feeder fund platforms and offered another route into private markets, at much lower investment minimums.

Institutions seeking alternatives

But while new investment vehicle uptake may be predominantly driven by the non-institutional opportunity, managers are finding that there is also significant interest and appetite from their institutional clients for fund structures other than the vanilla ten-year fund.

In an interview with PEI, for example, Partners Group’s co-head of private wealth Christian Wicklein noted that around 40 percent of allocations to evergreen funds managed by Partners Group came from institutional investors.

As private markets have matured and expanded to encompass not only private equity, but also private credit, infrastructure and real estate investment strategies, institutions have spent more time curating private markets allocations across multiple strategies.

Semi-liquid investment vehicles have appealed to institutions as the option to take liquidity when redemption windows open provides scope to adapt to shifting market backdrops and refine allocations.

Semi-liquid structures also enable institutions to gain immediate exposure to a portfolio of assets, as opposed to investing in a blind-pool, ten-year fund, where there is a gap between a funds first close and putting capital to work in the first deals.

Embracing new structures

Overall, whether seeking more capital from non-institutional investors, or providing more sophisticated institutional LPs with the greater flexibility and optionality they are demanding, managers will have to complement cornerstone 10-year funds with other investment vehicles that provide more scope to take liquidity or invest smaller cheques.

When taking the decision to offer investors with the choice of different fund structures it is essential that managers have the necessary back-office plumbing in place to be able to administer and account for the specific requirements that come with taking on non-institutional investment or offering liquidity at during fixed redemption windows.

Items to consider include running know-your-client (KYC), onboarding and investor reporting processes that have to be able to handle hundreds of non-institutional clients rather than smaller, experienced groups of institutional investors.

When offering liquidity in redemption windows, meanwhile, managers also have to be able to forecast how much cash will be required to cover capital calls when redemption windows open and publish NAV numbers more frequently than when serving institutional LPs invested in ten-year funds exclusively.

For many managers, the decision to raise capital using different investment vehicles comes with the requirement to review and upgrade operating models.

This can require significant amounts of upfront capital expenditure to strengthen internal back-office teams, or bring in third-party support from experienced fund administration partners, who understand the commercial and regulatory demands that come with running a mix of investment vehicles, and have the economies of scale and technology infrastructure to handle the associated higher back-office workloads.

As managers adapt their front office fundraising routes to market their back-office capabilities will also have to evolve.