In summary, semi-liquid evergreen PE vehicles allow individual investors to potentially gain access to many of the benefits of private equity investing with a better user experience.
The Capabilities Involved in Managing an Evergreen Fund
One of the consequences of accepting investor capital upfront and maintaining an ability to meet periodic redemption requests is that a portion of the evergreen portfolio is typically held in more liquid investments, including cash and cash equivalents, versus what is actively deployed to investments in private portfolio companies. This so-called liquidity sleeve can become a drag on returns if improperly managed. During normal market conditions, the liquidity sleeve holdings can range between 10% and 20% of an evergreen fund’s portfolio.
For an experienced manager with capabilities to match, several strategies can be employed simultaneously to maintain continuous exposure to private equity assets over and above the liquidity sleeve, especially in an evergreen fund’s early life. These strategies can include, but are not limited to:
- As a co-investor in businesses sourced by other managers
- As a buyer of pre-owned private equity fund assets in GP-led secondary offerings
- As a buyer of pre-owned private equity fund interests in LP-led secondary offerings
- As a buyer of new private equity fund interests in a primary offering
- As a direct investor in businesses sourced by the management team
Co-investment: Involves acquiring interests in individual companies as opposed to diversified funds. These transactions are sourced by other managers where, on larger deals especially, a manager may invite a small group of select investors to make a significant investment alongside its own fund. This has become more commonplace now that higher equity contributions are stipulated by debt investors. In this structure, the co-investor is often able to participate in the deal without paying any fees to the underlying manager.
GP-led secondary: Describes an offering that is initiated by an unaffiliated PE manager, or GP. In GP-led transactions, the unaffiliated GP identifies one or several assets to extract from one of their existing PE funds for the purposes of extending their investment duration and potentially raising new capital. The offer is backed by a new set of investors (i.e., secondary buyers) and allows existing limited partners in such GP’s PE fund to either opt in or out of the cash being offered for their interest. As with an LP-led secondary, the offer can be at a discount to the estimate of unrealized value, or net asset value (NAV), for the asset(s) involved.
Evergreen benefit: Co-investments and GP-led secondaries are less diversified and more concentrated strategies which can add significant alpha to evergreen fund performance when executed properly.9 These strategies source deal flow from third-party unaffiliated PE managers to enable continuous deployment at scale. Having a robust and high-quality network of such PE managers is key.
Secondary acquisitions of LP fund interests: This strategy involves acquiring interests in one or more PE fund(s) from one or more existing limited partners needing liquidity before it naturally arises. Acquired interests can be in closed-end funds that have completed the investment phase and are therefore fully deployed, allowing an evergreen fund manager to diligence the underlying holdings. By entering a fund midstream, certain holdings may be closer to realization, potentially resulting in a shorter hold period and faster liquidity for the new evergreen owner than the typical investor experience in drawdown private equity. Lastly, because these interests are often sold at a discount to their NAV, the potential exists for additional appreciation assuming, of course, that an NAV estimate is accurate and does not decline from that point forward. There is no formal exchange nor active market for secondary interests in funds, and managers must source and negotiate each transaction individually.
Evergreen benefit: The inclusion of an LP secondaries strategy allows evergreen managers to minimize cash drag and achieve immediate diversification while continuously deploying capital. A skilled manager can diversify acquired interests by fund vintage, manager, portfolio holdings, sector weight and geography, among other important considerations.10 In addition, secondaries can yield higher cash flows sooner given the more mature nature of acquired fund interests, helping with semi-liquidity management.
Primary offerings of fund interests: This strategy involves acquiring interests in newly formed private equity funds when first offered. Like IPOs in public markets, disproportionate value can be created and gained by initial investors, and the same principle applies to private markets. These fund interests are acquired before any investments are made. The most sought-after primary funds and best-performing GPs are often oversubscribed and limited to large institutions only. A large evergreen manager may also be able to access those exclusive offerings and identify the better managers.
Evergreen benefit: Though not as immediate as with secondaries, a primary funds strategy allows an evergreen manager to invest at scale and in a more diversified manner, especially when combined with other primary or secondary fund interests.11 A typical buyout fund will acquire ten or more private companies during the investment period following a primary offering’s closing. Cash flows may take longer to develop but growth in principal can be significantly higher. As the evergreen manager is relying on careful GP selection to create that excess return, prior experience in evaluating managers is key.
Direct investment: An evergreen manager can source, transact and manage individual private assets on its own without any third-party reliance. As with co-investing, direct investing may add alpha to an evergreen fund portfolio but only if a manager has an established track record of independently and directly acquiring, managing and exiting private companies.
Evergreen benefit: Because it is the least scalable of available strategies, a manager is unlikely to concentrate on a direct investing approach during an evergreen fund’s early life. Further out, it can be a powerful tool for avoiding potentially diluted returns and overdiversification resulting from an excessive amount of acquired fund interests.
Partnering with an experienced evergreen manager with a demonstrated track record and a deep and broad pipeline of potential investment opportunities is critical for semi-liquid fund performance. Investors should also seek products that align fee structures with manager incentives for cash management and capital deployment.12
