If you needed reminding of the pitfalls of housing illiquid assets in an open-ended fund, then the recent woes of star manager Neil Woodford offer a stark warning.
In the current climate, many institutional investors are finding it tough to achieve the stable, long-term returns they want from their traditional equity/fixed income allocations. So increasingly they’re turning to illiquid securities—in particular private equity, private debt and the various types of real assets—for the attractive return and diversification potential they offer. But these instruments need to be held in the right vehicle.
Hence the growing interest and flows we’re seeing into closed-end and hybrid funds.
Investor appetite continues to increase …
A few figures serve to highlight the trend:
- Unlisted closed-end funds have expanded steadily since 2014, reaching nearly $53 billion in assets under management at the end of 2018, with further growth expected through 2019, according to research by UMB Fund Services and FUSE Research Network.
- Private equity investment in Europe set a new record in 2018, growing 7% to €80.6 billion, a report by trade association Invest Europe noted. Pension funds contributed almost a third of the total capital raised.
- Preqin research found family office interest in alternative investments is on the rise, with the majority now targeting private equity (61%) or real estate (57%). Median allocations among family offices are highest in private equity (19.0%) and hedge funds (17.5%).
- The latest Preqin figures also show private debt assets under management (which are typically held in closed-end funds) hit a record $769 billion as of June 2018. Assets are expected to grow further in 2019, with almost half of investors planning to expand their allocation over the longer term. The Alternative Credit Council (ACC) predicts the sector will reach $1 trillion by 2020.
… Producing greater fund complexity and diversity
While closed-end funds were once largely associated with private equity and real estate, we’re now seeing greater diversity of assets and vehicles.
Investors are flocking to the private debt market, drawn by the promise of diversification, attractive yields and reliable income streams. Interest in syndicated loans and mezzanines is flourishing too. These instruments often come with complex structures, with many using special purpose vehicles and intracompany loans for tax purposes.
The investor appetite hasn’t gone unnoticed among hedge fund managers either. Surging capital flows into other alternative sectors are inciting some traditional hedge fund managers to introduce hybrid fund structures that incorporate more illiquid assets, including private debt and private equity-style offerings, in an effort to deliver enhanced returns to investors.
Meanwhile, law firm Ogier notes that in return for their capital, some of those investors moving into the private equity arena expect to receive similar offering terms to those they get when investing in hedge funds. Along with beneficial fee terms, investor requests may include favourable lock-up periods, and enhanced transparency and information rights, often requiring greater look-through into the final investments.
Operational challenges of supporting closed-end funds
The growth and diversity of closed-end and hybrid funds—with their complex fee, payment and return calculations, and investors’ heightened servicing expectations—present substantial operational issues though. Proper support will require specialist administrative expertise and sophisticated system functionality.
We see three main challenges that fund managers (or their administration providers) need to solve:
- Look-through to the investments: Older private equity funds that invested more in private companies didn’t need much investment accounting functionality. But today, modern private equity funds and the newer breed of hybrid funds require more complex investment accounting that can feed into the investor accounting to provide investors with detailed look-through to the underlying assets.
- Managing multiple closes: The life of a private equity fund involves multiple investment rounds. Whenever new investors come in, the fund must rebalance its profit and loss since inception, and the capital calls and distributions to investors. Without the right system capabilities, calculating those re-balances can be extremely manual and tedious.
- Reporting: Investor demands for greater transparency are upping the reporting ante.
The Institutional Limited Partner Association (ILPA) has been leading the push for private equity managers to provide more comprehensive reporting in specific formats to investors. To generate those reports, managers need to track all the different P&L components, management fees, partnership expenses, capital calls and drawdowns, carried interest and waterfall calculations.
Keeping investors happy
Given the wall of capital flowing into private equity, private debt and other alternative assets, the number and range of closed-end and hybrid funds only looks set to grow. Tantalizing opportunities beckon for fund managers in the space. But this is no easy money.
Investors—especially institutional ones—expect high-quality servicing throughout the lifetime of the relationship … and fund managers must jump through stringent due diligence hoops to prove they can deliver it.
Do you have that operational expertise and the right infrastructure capabilities to compete at this level?