Sharing insights from our experience with numerous open-ended private market funds while representing both general partners/sponsors (GPs) and limited partners/investors (LPs) in Canada and the United States, the second instalment in our three-part article series on open-ended private market funds sets out some of the pros and cons of leveraging this increasingly popular fund type.
Pros of open-ended funds
Open-ended funds have certain benefits for LPs compared to closed-ended funds, including the following1.
Long-term investment horizons: Due to the indefinite life and typical asset portfolio of open-ended funds (namely long-maturity, income-generating assets, as discussed above), open-ended funds are often well suited to investors with long-term investment horizons, such as pension fund investors in particular (as long as there remains some reasonable time horizon on an ability to exit the fund). In addition, an open-ended fund that holds cash generating long-term assets can provide a pension fund LP with a consistent income stream that can help satisfy its obligations to make regular payments to its beneficiaries. Furthermore, the ability to hold assets for long periods of time can reduce churn of portfolio investments and the transaction costs associated therewith.
No fixed investment or disposition period: Closed-ended funds are subject to fixed time periods during which the funds can buy and sell investments. Accordingly, the returns of closed-ended funds can be heavily impacted by prevailing market conditions during these fixed periods (subject to the ability of the GP to receive extensions on these periods). Without a fixed investment or disposition period, in an open-ended fund the GP can sell assets when it believes would be most beneficial to ensure LPs receive optimal returns.
Increased liquidity: Open-ended funds can offer LPs greater liquidity compared to closed-ended funds. Specifically, LPs in an open-ended fund can request to have their interests redeemed by the fund on a periodic basis subject to prescribed limitations. In contrast, LPs in a closed-ended fund are generally prohibited from exiting the fund except under limited circumstances (including transfers/secondary transactions if approved by the GP, through the various remedies (i.e., for cause or no-fault) and circumstances where the withdrawal of the LP is necessary for legal or regulatory reasons).
Opportunistic buying and selling: Open-ended funds can, at least in theory, hold a more diversified portfolio of assets compared to closed-ended funds. Due to their indefinite life, mature open-ended funds can hold a greater number of investments than most closed-ended funds and have more flexibility to tailor the timing of their investment acquisitions and dispositions based on prevailing market conditions.
Reduction of blind pool risk: Unlike a new investor in a closed-ended fund, a new investor in a mature open-ended fund is exposed to a portfolio of assets immediately upon contributing capital to the fund, which provides for immediate diversification and reduction of blind pool risk.
Minimizing the J-curve effect: By not charging management fees on unfunded commitments and by offering investors the opportunity to be exposed to income-generating assets immediately upon contributing capital to the fund, open-ended funds can minimize or eliminate the J-curve effect that is prevalent in closed-ended funds; closed-ended funds often have negative returns in the early portion of their investment periods in part because they are charging management fees on unfunded commitments and also because they are not yet holding mature investments that are generating positive returns.
Cons of open-ended funds
Open-ended funds can also have certain disadvantages for LPs compared to closed-ended funds, including the following.
Uncertain timelines for realized returns: The indefinite life of open-ended funds may make it more difficult for LPs to forecast when they will realize returns on their investments. In a closed-ended fund, LPs can rely on the fact that the fund will liquidate its assets at the tail-end of its term and return cash to LPs. In contrast, in an open-ended fund, there is no fixed timeline upon which LPs will be cashed out of the fund. Further, given that performance fees in open-ended funds are often based in part on unrealized returns, GPs are not incentivized to sell assets in order to make large cash distributions to LPs. While LPs in open-ended funds can submit redemption requests in order to realize returns, LPs are typically subject to lock-up periods, efforts standards and other limitations with respect to executing a successful redemption.
Reduced LP remedies:
Open-ended funds usually have reduced remedies for LPs compared to closed-ended funds. For example, given that open-ended funds make investments on an ongoing basis and do not have fixed investment periods, the governing documents of open-ended funds may not include remedies related to the early termination of the ability to make new investments, which are common in closed-ended funds.
If there are specific individuals at a GP who are critical to the decision-making of an open-ended fund, LPs may look to negotiate for a period of time during which these individuals are required to devote a specified amount of time and attention to fund matters and/or to receive notice from the GP in the event such individuals fail to devote such amount of time and attention (and for the possibility of receiving an immediately-usable redemption right regardless of an existing lock-up period or otherwise). However, GPs of open-ended funds may resist such key person remedies because it may be difficult for GPs to designate individuals that will dedicate sufficient time and attention to the fund for a certain period of time or a potentially indefinite period of time. In addition, LPs may negotiate for receipt of notice in the event the GP or any of its affiliates redeems a material portion of its interest in the fund (subject to agreed-upon limitations restricting the GP or its affiliates from doing so).
While LPs may negotiate for the points above, key person, fund termination and no-fault GP removal remedies still tend to be less common in open-ended funds compared to closed-ended funds. Instead of the traditional remedies available to LPs in closed-ended funds, LPs may choose to vote with the feet and submit redemption requests—which is the ultimate remedy in open-ended funds.