Considerations
Investment Return
Traditional closed-end funds are designed for specific investment reasons. For example, by calling capital only when needed, fund managers try to maximize clients’ internal rate of return (IRR) and multiple of invested capital (MOIC) by investing in the best opportunities when they come to market. The arrangement gives investors optionality on their use of that cash in the period when their closed-end fund manager is not calling capital.
The upfront investment for semi-liquid funds may have different return implications. Responsibility for capital deployment passes to the fund manager, who must endeavor to act promptly to avoid “cash drag” on returns, i.e. the lower return of cash sitting in the portfolio diluting the overall return. But by trading off control of cash flow timings, the manager of the semi-liquid fund typically has to maintain a “liquidity sleeve,” consisting of cash and/or public market investments, to hold capital if it cannot immediately be matched with a private investment opportunity.
The untapped capital in the liquidity sleeve may affect the overall return, depending, of course, on how it performs in comparison to the private market targeted. Investors evaluating semi-liquid funds will have to consider this feature and decide if the illiquidity premium is acceptable and whether having some liquidity is justified.
Risk Profile
With upfront capital calls in semi-liquid funds, the investment manager must deploy the capital fully. As mentioned, managers unable to invest quickly into private markets may invest elsewhere, such as mainstream asset classes. Inevitably, such exposure could increase the correlation to traditional markets. Understanding how such exposure affects the risk profile warrants some consideration by investors.
Valuation
Confidence and accurately calculating valuations for both incoming and exiting investors is paramount in semi-liquid structures. For instance, issues could arise if investors exit at heightened valuations and this occurs at the expense of remaining investors. Likewise, investors coming in at undervalued entry points could disadvantage other fund participants. Valuation issues can, of course, be mitigated through appropriate valuation procedures. Investors should test the procedures through the due diligence process and select only those strategies that display a consistent ability to price investments in a fair manner for all investors.
Like semi-liquid structures, reliable valuation methods for closed-end funds are also key. However, the more synchronous nature of calling and distributing capital to all fund investors on a simultaneous basis reduces the complexity on pricing that is faced by semi-liquid funds.
Redemption Benefits
Investors will always find the ability to make redemptions at their own discretion to be an attractive feature. Semi-liquid structures facilitate choice in redemptions compared to less liquid conventional private market solutions. Specifically, semi-liquid funds feature an option that allows periodic redemptions, typically on a quarterly basis subject to fund level gates (a mechanism in place to restrict redemptions when over a set percentage). The redemption mechanism lets fund managers pay out cash in an orderly fashion, giving investors the option to adjust their exposure over time and to tap liquidity from a hitherto less liquid solution.
Other liquidity provision mechanisms include subscriptions replacing redemptions and, in some cases, credit lines; both, while helpful, should not be fully depended on.
Investors should assess the redemption options to determine what is most appropriate for their needs. They must also consider any potential trade-offs in their sought-after illiquidity premium and whether they believe they will receive a commensurate level of return and risk. Answers will vary for each semi-liquid strategy and individual investor appetite.
Other Investor Behavior
By introducing additional liquidity demands, manager behavior may change and influence the fund’s risk-and-return profile. In a semi-liquid structure, the manager may be under pressure to deploy cash quickly to avoid cash drag and in response lower underwriting standards. They may also need to satisfy redemptions by selling to meet investor orders. In contrast, more traditional structures grant managers the flexibility to deploy and liquidate as they see fit over time.
Consequently, the investment process is not as straightforward for the semi-liquid fund manager. They have to employ a disciplined approach to asset sales in order to avoid becoming a forced seller. Gating mechanisms, which allow managers to limit redemptions, do help with this. However, they may risk some client dissatisfaction if mishandled. Managers can also mitigate liquidity risks by having a diversified investor base.
