Alternative investments and the optimal fund structure
For the past few years, our Long-term Capital Market Assumptions have suggested that risk asset returns and interest rates are set to remain under pressure. Given this outlook, we have seen more and more investors turn to alternative investments in an effort to enhance returns, generate income, and diversify portfolios.
Expected returns are under pressure
Expected annualized return over next 10-15 years, USD
That said, allocating to alternatives is quite different from allocating to traditional asset classes, and should be determined by the answers to the following three questions:
1. What is the outcome you are trying to achieve? Are you striving for more income, diversification, or return enhancement?
2. What is the best fund structure for making that type of investment?
3. Which manager will you use?
The first and third questions are relatively straight forward, but the second question is a bit more complicated. In fact, the answer depends on how one responds to the first question. If your goal is to generate income or further diversify a portfolio, an allocation to core real assets would make sense. Core real assets tend to be better suited to open-ended funds, as this vehicle is better aligned with a long-term investment profile. On the other hand, if the goal is return enhancement, allocating to private equity, private credit, or other higher risk strategies seems more appropriate; in this scenario, a closed-end fund structure would make more sense. For most investors, however, it’s not about one or the other, it’s about how they can use both structures in tandem to achieve their long-term investment goals.
Structure and alignment
The bottom line is that while there are advantages to both openended and closed-end funds, the benefits depend heavily on the underlying investments.
Closed-end funds are typically best when the goal of the strategy is capital appreciation, which is why the success of the underlying investments in a closed-end fund is often dependent on significant business plan adjustments. While this creates operational challenges (cash management, drawdowns, etc.) at the fund level, the structure matches the more temporal nature of the investments, and can provide strong alignment of interests as a manager only realizes its incentives when investors receive their investment proceeds at the end of a fund’s life. While returning capital at the end of a fund’s life does create an opportunity for investors to re-allocate their assets, this makes it inherently difficult to remain fully invested over time.
At the same time the lock-up structure reduces liquidity options, and creates an element of vintage risk as closed-end funds invest and exit over defined periods where market conditions may or may not be favorable. Furthermore, managers are incentivized both economically and structurally to exit investments; with respect to core real assets specifically, investors have found that some managers are forced to exit investments that, given the choice, they would have held for the long-term.
Finally fees are a consideration; while return expectations are typically higher for closed-end funds, the fee load, and in particular the incentive fees, are often higher than for openended structures. As Bollinger and Pagliari Jr. show in their May 2019 paper, closed-end real estate funds have historically seen more significant fee drag than their open-ended counterparts. In fact, for the period from 2000-2017, the authors estimate that open-ended, core funds saw an average fee drag of 100bps, where-as value-add, closed-end funds saw an average fee drag of close to 310bps1.
Open-ended funds, on the other hand, can continuously purchase assets, have greater liquidity, shorter lock-ups, and allow the manager to engage in transactions on an ongoing basis. Open-ended funds can take a longer-term view, and as a result the structure lends itself to more mature industries and well-understood geographies. At the same time, taking a longterm view allows the strategy to remain consistent and transparent, and tends to lead a greater share of returns to be derived from income. Importantly open-ended funds allow investors to more easily adjust their allocations over time while remaining fully invested.
Another important consideration with open-ended funds is that returns are driven by valuations, rather than realizations. However for lower risk, cash flow-focused assets where less capital appreciation is expected, the valuation process is comparatively easier than higher risk assets where valuation is based on less certain future outcomes.
Once these differences are taken into account, it becomes increasingly clear that open-ended funds are usually better suited for core real assets, as they tend to have more easily forecastable cash flows and longer investment lives. That said, when it comes to opportunistic/value-add investments, or strategies where returns are a function of capital appreciation, a closed-end structure may be more appropriate. The chart below highlights this in the context of unlisted infrastructure; since 2009, a low risk approach has derived approximately half of its return from income, whereas strategies that take on more moderate levels of risk have derived only 30% of their returns from income.
Higher risk investments derive more return from price changes
MSCI infrastructure asset index, average annlzd. return, 2009-2019
While all of this makes sense in theory, does it make sense in practice? One of the biggest challenges in the alternative investment universe is measuring performance, as most strategies report an internal rate of return (IRR). However, “you can’t eat IRR,”2 and we believe there are better ways to measure investor outcomes which better align with open-ended funds.
In a closed-end fund, it is rare that you are ever fully invested, as each underlying investment is on a different time line. At the same time, closed-end fund managers can be incentivized to liquidate investments above the hurdle rate to earn carry quickly, and hold onto investments below the hurdle to earn management fees.
Open-ended funds, on the other hand, can deploy capital as it comes through the door. It is unrealistic to expect to be invested on day one in any structure, but open-ended funds provide an opportunity to get invested and stay invested longer than is the case with a closed-end vehicle. This helps remove some element of vintage risk, and allows for compounding over longer time periods. It is also part of the reason why open-ended funds value their assets more frequently.
Given the differences described above, looking at multiples of invested capital (MOIC) is a cleaner way of gauging the success or failure of private investments. IRR tells you the return on the capital that was deployed, but not how much capital was deployed, and is sensitive to the timing of cash flows. This can prove to be problematic if a closed-end fund is forced to liquidate investments towards the end of its life. On the other hand, MOIC tells you how much you made on top of what you invested; because open-ended funds usually deploy a larger proportion of capital at an earlier date and for a longer time period, this in theory should result in a higher MOIC all else being equal. Furthermore the chart on the right illustrates the importance of vintage risk and fees on a long-term allocation, especially once differences in the underlying risk profile of openended vs. closed-end structures are taken into account. Putting it in dollar terms, a $100,000 dollar investment in an open-ended infrastructure strategy would have led to an additional $80,000 of gains during a 30 year period.
Open-ended funds can deliver better long-term returns
Multiple of invested capital
There is no silver bullet when it comes to investing, and the same is true when trying to determine optimal fund structure. That said, we do believe that some asset classes are better suited for open-ended funds rather than closed-end funds.
Investors in core real assets tend to take a longer-time horizon than is usually the case with traditional buyout strategies, making them better suited for open-ended vehicles – the evolution of the core real estate investment universe provides clear evidence. This often times means they are focused on cash flow, rather than capital appreciation, but in the event that an open-ended fund does decide to liquidate an investment, it can wait for favorable market conditions. At the same time, open-ended funds allow the investors to play more of an operating role in managing the asset; in other words, it’s not just about increasing the price over a given period of time.
Open-ended funds also tend to have greater liquidity, from either income generation or redemption flexibility. This can benefit investors when it comes to adjusting allocation, as well as with liquidity needs during periods of market stress. Closed-end funds, however, can send money back when you may not necessarily want it, thereby adding an element of reinvestment risk that is not present when allocating to open-ended funds. At the end of the day, however, investing in alternative assets is a multi-step process, and the optimal fund structure will be entirely dependent on the outcome that an investor is trying to achieve.
1 Bollinger, Mitchell A. and Pagliari Jr., Joseph L. Another Look at Private Real Estate Returns by Strategy. May 1, 2019.
2 Marks, Howard. You Can’t Eat IRR. Oaktree Capital Management. July 12, 2006