Dan Dobry Interviewing Dr Boaz Barak
I sat down to discuss with Dr Boaz Barak, one of the worlds top investment experts who in the past was a member of senior management and Head of the Ultra High Net Worth Desk in UBS, about the opportunity of investing in Private Equity Funds in todays financial reality.
Dan: Boaz, it is always a pleasure to learn from you, for our readers, what Are “Private Equity Funds” (‘PE”) and what is an Open-ended Evergreen Funds and how Are These Funds Different from “Traditional” Funds?
Boaz: PE fund structures are typically closed-end funds that are considered an alternative investment class. Because they are private, their capital is not listed on a public exchange. These funds allow high-net-worth individuals and a variety of institutions to directly invest in and acquire equity ownership in companies that traditionally raised capital through limited partnerships with end dates. A less common alternative to this is an open-ended/evergreen fund, an ongoing structure that continues indefinitely. In these funds, capital is invested directly into an LLC on an ongoing basis with no termination date. It essentially invests preferred equity into a company: Investors buy units of a fund with a yield attached (the hurdle rate) and can buy more, or sell, whenever they wish. This kind of fund is also liberally referred to as a permanent capital vehicle or “Evergreen Fund”. The ethos between the names is primarily the same in that it relates to structures with no end date or fixed capital quotas. A core distinction is that an evergreen fund can recycle returned capital while open-ended funds distribute them to investors.
Dan: What are the Pros and cons of Evergreen Funds?
Boaz: An open-ended fund can bring some exciting advantages to its stakeholders:
- Alignment: Managers can focus on capital appreciation without time barriers. It also meshes well with entrepreneurs looking to grow their business sustainably.
- Cleaner: Fund investors can take a long-term view without constantly needing to invest.
- Flexibility: More freedom to change an investment thesis and hold other types of investment.
- Transparency: One budget and set of management fees instead of layers of costs that build up.
There are however some drawbacks as well, though, of course. If open-ended funds were perfect, then they would be more widespread:
- Illiquidity: For investors in open-ended VC funds, the promise of liquidity may be a moot point. Startups generally don’t pay dividends, and secondary fund markets are thin.
- Lumpy cash flows: Big exits at unexpected times can clean out a waterfall in one go.
- Valuation: The NAV of the fund must be transparent and consistent.
- Perception: Startups and co-investors may not know how such funds work.
As a caveat, the “real” number of evergreens is likely higher than published because this investing is widespread amongst angels, family offices, and corporate venture units. Frequently, these funds sit under the umbrella of an organization and are not disclosed through usual data channels.
Dan: How do the Returns Compare to Closed-ended Funds?
Boaz: When comparing evergreen fund performance to an overall PE benchmark (encompassing all types of funds), returns are mainly similar from a “Total value to paid in” (TVPI) perspective. As we know, PE returns have irregular returns distributions, and as such, a benchmark does not paint a complete picture. Nevertheless, despite evergreens and closed-ended funds having different mechanics, it does not seem to affect their TVPI returns.
Dan: Boaz, what are the mechanics of Raising and Operating an Open-Ended PE Fund?
Boaz: There must be a compelling reason to raise an evergreen or open-ended fund beyond just because it’s something different. It is vital to align it with motivations and ensure that it adds value to investors and to the businesses you plan to invest in.
An open-ended structure must complement an investing environment or views. For example, you:
- Have a strong belief in “the sum is greater than the parts” investing and wish to leverage a position as a timing-agnostic investor to foster this in a portfolio.
- Have a view that an investment philosophy can be distilled into an inter-generational firm that can continue without you one day.
- We are in an emerging market country where exit waits are longer.
- A good investment is when you invest and then forget about it, knowing that it’s safe and increasing in value.
However Dan, in day-to-day Operations there are small differences
With evergreen funds having no end date and the flexibility to top them up with more capital, planning investment timescales can seem endless. As with any fund, retaining dry powder for follow-ons and opportunistic plays is crucial, but exits add another dimension.
A common misconception regarding exits in open-ended funds is that they can recycle capital. That is, in theory, possible, hence the term evergreen, but it can be counterintuitive towards aligning the manager’s interests with the investors. If there are no distributions, there are no chances to realize profits. Clawback provisions are not standard in open-ended funds. So, recycling capital can make it hard to retain quality investment staff, who will be waiting for performance-related compensation.
Instead, the fund manager must look to tie up exits with future fundraising, as if investors are in cohorts bookended between exits. An exit represents a soft reset where capital can be returned and potentially reinvested by exited investors.
The NAV of the fund is of high importance, both in terms of allowing current investors to track their marks and for new investors to assess whether to buy into the fund. Providing regular, transparent, and consistent valuations of the portfolio is paramount. Everyone likes the structure and understands why it’s there and its advantages. For the model, the price per share is the ultimate equalizer, making it fair for everyone.
An open-ended fund structure also brings an advantage that LLC terms can be altered as time progresses. This is particularly useful for managing new fund buy-ins because it allows for subjective valuation elements to be inserted. NAV is a tremendous quantitative metric but on its own is not a complete tool for assessing fund value for new investors, such as in these areas:
- Network Effects. The composition of an investor base in a fund is a leading indicator of its future success and thus, sends signaling properties to the market. New investors arriving with a combination of pedigree and absolute investment dollars will benefit the existing portfolio and investor base. The new investor also benefits from having a “second mover advantage” through being able to pass into the slipstream of an established brand, operational and due-diligence practices
- Financial Justice. NAV is useful for secondary transactions, as it’s a zero-sum game: no new capital is being invested. But for new investors, whose capital will not physically be deployed in existing investments, it’s only fair to incumbents that they do not participate in their gains. This can be achieved by altering the LLC to include designated investment groups for new capital that arrives within specific timescales. Hedge funds deploy similar strategies with side pocket investments from the central fund.
Dan: How should we manage Distributions in an Evergreen Fund?
Boaz: there are several methods, in typical fund waterfalls, the following order exists for distributing returns:
- LP principal
- LP hurdle rates (a minimum IRR return for the fund)
- GP catch-up (a percentage of the LP hurdle rate)
- Final profit share (A split of remaining funds, typically 20% going to GPs)
With evergreen funds, one difference is that the preferred return (or “interest”/” yield”) component is typically paid first, before principal. If the principal were cleared before yield, investors might earn a lower return in future years (from the reduced principal base) despite not yet receiving material gains from the fund. Because an evergreen could, in theory, continue perpetually, it’s critical to reward investors appropriately for the time value of their money.
From a waterfall perspective, if preferred returns are paid out first, it may take longer for the waterfall to cascade down in its entirety. The results can vary in a proportionate split of total profits depending on the catch-up terms chosen.
Unlike evergreen private equity or real estate funds, venture capital rarely has interim cash flows between investment and exit. This can present distribution scenarios where there is nothing for an extended period, followed by a considerable exit that can instantly wash a waterfall down to its final step.
Dan: So Boaz that was fascinating, how would you summarize this interview?
Boaz: Evergreen funds may not be everything for everyone, but for some, it could be a flexible and rewarding way of putting money to work.