Why evergreen private equity funds are set to disappoint investors

“Democratising private assets,” the narrative goes. Public markets are shrinking and the best equity opportunities are staying private longer. There is an “illiquidity premium” on offer. Private assets can become “core building blocks” of portfolios for all investors.

Large investors like industry super funds, endowments and family offices already invest significantly in private equity and other private assets. Now wholesale wealth clients (growing due to an outdated “wholesale” investor definition) and even retail can more easily join this club, via a growing number of investor friendly, open ended, “semi-liquid,” evergreen products across private equity, debt, infrastructure, and real estate. Smoother returns but periodic liquidity. What is not to like?

Sorry to dampen the mood but the clamour for private assets, especially private equity, via unlisted evergreen vehicles will likely turn out to be a disappointing experience for many investors, and a disaster for some. Rather than a welcome “democratisation of private/alternative assets” it could be seen as the “democratisation of illiquidity, opacity, high fees, and ultimately investor pain.” It is unclear exactly when major problems will occur, or which funds will be most impacted as these will only likely intensify with weakness in the economy and/or financial markets.

Many in the wealth industry are keen to anoint private assets a greater role in portfolios, but this is happening with limited assessment of either current asset valuations and fundamentals, or the structural characteristics of the vehicles being used.

This is not the case against private assets in wealth portfolios. Private equity, debt or real assets like property and infrastructure can all play key roles, particularly when valuations are attractive, fees aligned, there is sufficient transparency, and liquidity of the structure is appropriate for the asset class and that liquidity is tolerable to, and fully understood by, investors.

But most open ended, evergreen “semi-liquid” funds are not “robust” vehicles to achieve this, particularly for private equity, as this is where the liquidity disconnect is most pronounced, valuations most malleable and the risk of poor absolute returns the greatest. Still, the weaknesses of these “fair weather” fund structures will only be fully displayed in periods of market stress.

Private credit certainly has problems but, by virtue of its position in the capital stack, does not face the same absolute risks as equity. Further, its problems have already been widely covered in the media, ASIC has laid out key issues to be addressed, liquidity is generally better than other private assets and liquidity issues have been partly managed by the significant growth of closed end, listed investment trusts (LITs).

Although starting from a low base, the rapid growth of evergreen private equity vehicles could see major problems emerge. It is understandable why these funds are popular. Wealth investors have long struggled with the administrative, illiquidity and high minimum challenges of traditional long term, closed end, drawdown, private asset vehicles. At another end of the product spectrum, investors baulk at the additional volatility and discounts/premiums to NAVs that listed closed end vehicles (LICs/LITs) investing in private assets involve. Still, both structures are more robust ways to invest in private assets, including private equity, than most unlisted evergreen vehicles.

Fundamentals/valuations do not seem to play much of a role in today’s case for evergreen private equity funds. Why concern yourself with fundamentals when you can rely on the “illiquidity premiums” on offer?

For example, why is there so little discussion of how private equity valuations have increased over the years, the impact of higher interest rates since 2021/22, the current challenges in achieving exits, particularly for some vintages, and with those exits occurring with much lower average uplifts than historically? 

It is estimated there are currently over 30,000 companies sitting in private equity funds with LPs increasingly impatient for cash. A big question is whether the lack of exits is because current valuations marks are too high.

Evergreen fund flows provide relief for this liquidity blockage and help to maintain these full valuations, maximising management and performance fees. Great for the fund manager, not so great for an incoming investor.

Investors believing they will do well because historically private equity funds valued assets conservatively before exit may be disappointed going forward. Then there are the controversial issues around the valuation of private equity secondaries discussed further below.

Many are buying private assets for their perceived diversification and risk reduction benefits. But the low volatility and low correlation versus listed assets is mainly a result of the valuation approach (periodic and delayed) not the inherent asset characteristics. Volatility is a poor/limited measure of risk for wealth clients, in any case.

Proponents of private assets do believe that one should only invest with the “best” alternative managers given the high dispersion of returns, and advisers seem confident they can determine those. In the evergreen space the “best” managers are seen as the larger, better-known names, who have extensive resources to source and manage assets and, importantly, to market these new funds to the wealth management space.

That marketing has become more aggressive. Many of these alternative asset businesses are listed and pressure to build assets and earnings in the short-medium term is significant. If your competitors are setting up evergreen funds then it is hard to resist this move, irrespective of any concerns. As Charlie Munger used to say, “in judging the outcomes look to the incentives.”

“The average investor should have as much as half their portfolio in private assets,” is a growing refrain typically based on simplistic analysis using historical private asset returns and the low volatility of infrequently priced assets. Yet any analysis that fails to adjust for the different pricing mechanism of private versus public assets should be ignored.

Shouldn’t the wealth management industry be more sceptical about why the private asset industry is so keen to recruit a new class of investor, now?

Evergreen funds lack robustness because the illiquidity mismatch in most cases means that their viability is heavily reliant on continuous inflows, valuation of assets is opaque and their viability as long term investment vehicles is untested, particularly through periods of significant market stress.

Of course, managers will talk about their liquidity sleeve, their debt facility, their ability to sell assets, their marketing power, to keep inflows coming as their lines of defence against any potential illiquidity problems. In benign markets these are fine but in hostile ones these defences will quickly melt.

“Semi-liquid” is a dangerous term as there will be little if any liquidity at the times most investors come seeking it. Semi-liquid implies to many investors that they can still easily get their funds back, albeit only at specific points in time, when in a stressed environment in which funds gate it could take years to get your money back. Years in which returns could deteriorate significantly.

Gating is not always a major negative event for a single fund, but it can be, and almost certainly is if there is contagion in a period of stress with many funds gating at the same time. In addition to investors no longer having access to their funds, it increases pressure to sell assets, resulting in downward bias in private asset prices. Of course, managers will continue to earn fees on gated funds.

It is true that some evergreen private equity funds are better structured than others. Initial fund lock ups and clear communication of the true nature of liquidity access and the appropriate investor time horizon can improve the robustness of a vehicle. If advisers and most unitholders think of their evergreen investment as essentially illiquid but with potential for liquidity at various points in time then structurally it is likely to be stronger and the risk of problems reduced, although not eliminated.

At the other end of the spectrum some evergreen funds are so focused on ensuring liquidity they maintain a particularly large “liquidity sleeve” or include other publicly listed assets which can dampen returns or mean the product then fails to provide true exposure to the asset class targeted.

The problem is that many advisers and investors using these evergreen vehicles only see the positives and do not fully consider their vulnerabilities and downside risks, particularly around liquidity and valuation impacts in stressed market environments.

This is all complicated by the fact that the vulnerabilities of any individual evergreen structure in a crisis cannot be easily discerned by a narrow assessment of the specific characteristics of that fund or even the assets it holds. Much also depends on the behaviour of other advisers that recommend, and investors that hold, that fund, as well as the behaviour of those in other evergreen products. This creates a complex ecosystem where predicting future outcomes across changing market environments is challenging. Unlike a fund investing in liquid public markets, investors in evergreen private funds ideally need to know who they are investing alongside. Most do not, especially as they are often investing in global pools of assets with a range of access points from different countries.

Ghosts of past illiquidity crises

Australian retail investors have been through major crises caused by liquidity mismatches before. Major ones include,

1. Unlisted property trust crisis early 1990s
2. Capital guaranteed funds early 1990s
3. Certain hedge funds and Fund of hedge funds - GFC 2007-2008
4. Mortgage/high yield funds - during and post GFC 2007-2010

Of course, the specific elements of these problems/crises differ from each other and today. History does not repeat but it can rhyme. It would be useful for industry participants to revisit these periods, especially the unlisted property trust crisis as I expect the outcomes of that crisis will rhyme with the future of today’s private asset, evergreen funds.

So, what did those outcomes of the unlisted property trust crisis look like? It was a brutal period for those with large exposures and with unlisted property funds ending up in one of three broad categories.

1. Funds that got into trouble, faced large redemptions, gated, and announced closure/gradual wind-down into a worsening direct property market. Investor returns were poor and there was a significant investor opportunity cost as it usually took years to get money back.
   
   
2. Funds that gated, and managers/unit holders took decisions to list on an exchange or merge with listed entities, seeing near term losses as the listed entity immediately traded at a substantial discount to the previous NAV. (And that NAV was under pressure).
   
   Note the recent listing of BPRE a US property interval fund that listed at a 40% discount to the latest NAV, or Blue Owl’s recent proposal to merge one of their unlisted private debt BDCs with a listed fund that trades at a 20% discount (since abandoned so the fund remains gated).
   
   In the unlisted property trust crisis, longer term investors who saw a conversion to a listed entity may have eventually seen their investment recover, if well managed, as they were now in a vehicle not under pressure to sell assets (and continuing to earn fees for the manager). Still, it was a painful journey.
   
   
3. The evergreen survivors - a few funds that survive as evergreen vehicles, perhaps with periods of gating but with feature modifications such as inclusion of more liquid assets or a more sustainable private/public hybrid model. Ironically though, the ones in this category tended to be smaller vehicles that had less success in raising money through the boom period.

As with private asset funds today, the use of leverage was variable - some unlisted property trusts had leverage, although many did not. In fact, some had significant cash or other liquid assets that soon dissipated as investors chased liquidity wherever it was available.

When the Evergreen Fund gates go up

Most evergreen fund investors (and advisers) fail to read IMs and PDS and therefore do not understand how long redemptions can be delayed and the manager’s extensive ability to gate redemptions. But fund managers might also be surprised when the complex liquidity plan for their evergreen vehicles does not prevent delayed redemptions or gating. Some managers will think any gating is temporary with business soon to return to normal, some will be focused on earning management fees for as long as possible, so gating is not their major concern.

If gating situations were isolated to a few funds, it may not be a major problem for the industry. However, once gating becomes widespread it is likely to become much more serious and an existential threat to the evergreen private equity structure. Firstly, because selling pressure in assets intensifies and returns deteriorate. Secondly, a gating contagion encourages investors to seek out liquidity wherever it is still available. Thus, funds that looked well positioned from a liquidity perspective also come under pressure.

Many focus on the 5% of NAV quarterly amounts that are typically available for redemption, but it is the build-up of the queue for future quarters that accentuates the underlying asset selling pressure and pressure on managers to deliver solutions to investors. Many will fail to understand the crucial interconnections and the behavioural drivers during such times that can defy rational analysis and simplistic, siloed views of individual products. “Engineering liquidity” will be a challenging task for all and predicting which path various managers and funds will take, or forced to take, in a stressed period will not be easy.

A recent article from Andreea Meliniti of Private Equity Insights highlighted the issues for managers. “Private wealth is coming into private markets, but only the firms willing to draw hard lines - on who can invest, how capital is managed, and what liquidity really means – are likely to navigate the transition without reputational damage.”

Secondaries games

One of the most controversial elements of the evergreen private equity funds space is the accepted approach to valuation involving writing up discounted purchases of secondary investments to the last stated NAV. “NAV Squeezing” as it is sometimes called.

Secondaries have been a big focus of a number of the newer evergreen private equity funds. Secondaries attractions include the ability to provide immediate diversification, greater clarity on the status of companies held and potentially more liquidity, partly because they are usually purchased at an age where money is being returned to investors.

In the earliest days of secondary transactions such sales were seen as an avenue for desperate/distressed sellers needing near term liquidity in a traditional long term closed end drawdown fund and so prepared to sell as a discount. In that world, where there were limited transactions and few evergreen funds, writing up discounted purchases to NAV could be more easily accepted. In a closed end secondaries focused fund, investors would only get equal access to liquidity when assets were realised, and fees were normally based on committed capital and those realisations.

However, in today’s world where the secondaries market has become much more active, and there are now an increasing number of open ended, evergreen funds investing partly or fully in secondaries and taking in money as frequently as daily and offering some liquidity monthly or quarterly, writing discounted secondary purchases up to NAV immediately is seriously problematic. Some might say it introduces a Ponzi scheme element into a component of the returns being generated by such funds.

Fund performance becomes partly dependent on the net inflow (and starting size) of the fund as well as the discount level of secondaries purchased with those inflows. It is therefore no surprise that secondaries focused evergreen private equity funds are currently outperforming. In addition, fees, both management and performance, are often based on this exaggerated, unrealised, performance and fund asset level. Of course, secondaries managers will say that this performance dynamic is only a small part of what they do and the main game is identifying quality assets, underlying improvement in company profitability, multiple re-rating etc.

Yet, in a net outflow situation however, the dynamic could turn decidedly negative. Indeed, an outflow situation could be worsened because the influx of money seeking secondaries may have meant purchasers paid up excessively in recent times. So not only is a fund overvalued because of the write-ups from the discounts to NAV, but the actual current sellable value of the fund stakes may even be below the original purchase prices. This is also ignoring the possibility raised earlier that valuation marks on underlying private equity companies may also be overstated. Of course, there is as much going on in a fund at any one time (realisations, capital calls, NAV changes etc.) so this is clearly simplifying the situation.

It is also true that an increasing number of secondaries held are GP led or continuation vehicles where there may not be a discount to NAV. (Although the growth of these continuation vehicles opens more cans of worms that will not be explored here).

Of course, advisers and investors may rationalise participation in secondaries focused funds on a belief they will be able to exit their “semi-liquid” funds before any major problems emerge and can benefit from these flow dynamics in the meantime. Others may not even be fully aware of these dynamics as few managers talk openly about this “dirty secret’ of the secondaries, evergreen private equity industry.

At the very least advisers using these secondaries focused products should only do so knowing the full nature of the game they and their investors are playing and have fully communicated the downside risks of these dynamics to investors. Still, there must be some legal risk for an advisory firm who, down the track, needs to justify the initial investment into a now gated, or winding down, poorly performing, secondaries evergreen fund when the future risks of such dynamics are quite clear today.

Conclusion

Private assets can have a role in diversified portfolios, but they should be sized appropriately based on the current fundamentals/valuations, as well as the structural robustness of available vehicles. Advisers and investors need to clearly understand how they will be rewarded in the long term for the illiquidity, opacity, and higher fees that private assets bring, especially through evergreen funds.

Not all evergreen private assets funds will disappoint, just most, and it is not just poor returns that is a concern. It is the lack of flexibility of a portfolio heavily constrained by illiquid investments, it is the administrative hassles of dealing with gated investments, it is the stress caused by poor transparency and not knowing when money will be accessible, it is missing out on other investment opportunities because of this inflexibility and distraction.

Regulators, focused on the Guardian/Shield failures are busy looking backwards to take various industry players to task with the aim of preventing a similar episode in the future. All good, but fortunately fraud and misbehaviour at that scale is rare. Indeed, over longer-term cycles much more investor money is typically lost in overvalued, unsuitable, or flawed product structures. Importantly, most participants in, and proponents of, such products, fully believe they are doing the right thing by clients at the time.

Perhaps these concerns are misplaced, and evergreen private equity funds will be fine. But more than 40 years of experience of researching and building portfolios across the asset spectrum and seeing non-robust asset and fund structures disappoint or fail through various crises, suggests this is where the probabilities lie.

A key objective for all investors and industry participants should be to invest only in robust investment products. And “robust” needs to be defined by their ability to survive, and deliver, across a range of market scenarios and industry stresses. Most evergreen funds offered today, particularly into private equity, fail that robustness test.

I will finish with a quote from financial historian Mark Higgins who has written extensively on private markets and particularly evergreen funds.

“The rapid growth of evergreen and semi-liquid private-market vehicles is not innovation, but rather a late-cycle mechanism for warehousing illiquid assets, delaying price discovery, and sustaining the appearance of stability.”