As an attorney who specializes in fund formation, there is frequent discussion around the use of an open-end or “evergreen” or closed-end fund structure. They each have their benefits and are commonly utilized across the fund world. Open-end funds are typically found in fixed-income offerings, debt funds, exchange-traded funds, and some hedge funds. Closed-end funds are commonly seen in private equity, real estate, and real estate investment trusts (REITs).
In this article, we will cover the differences between each fund structure, and how they can be implemented into your business strategy.
Key Features of a Closed-End Fund Structure
Set “Horizon Date” meaning investors typically invest for the life of the fund which is set in the fund’s offering documents. This means the investor has limited liquidity, particularly in privately offered funds.
Fixed Amount of Units / Capital to be Sold. Closed-end funds typically set a fixed dollar amount to be raised. After that figure is hit, new investors cannot come in. Publicly offered funds are then traded on exchanges. Privately offered funds just shut down the offering and the sponsor will likely start fund 2 shortly thereafter.
Closed-end funds are more valuable in portfolios that derive their income from capital gains. It prevents an uneven balance of investors coming in much later and deriving less value because their unit value was significantly higher compared to earlier investors. Publicly offered funds alleviate this by trading the units on exchanges thereby having the market strike the price of the units. Private offered funds specifically utilize closed-end funds with a predesignated raise period that is staggered before the deployment of capital to reduce or mitigate these issues.
For these reasons, we typically use closed-end fund structures for real estate funds and real estate syndications.
Key Features of an Open-End Fund Structure
No set Horizon Date. Open-end funds can operate for as long as the sponsor or the investors deem the fund should remain open. This means the investor has increased liquidity and is only subject to the restrictions of the redemption plan.
The unit price is based on Net Asset Value, which is set every accounting period (daily, monthly, quarterly). This makes it well-suited for funds where the assets typically do not appreciate in value. For example, debt funds are well-suited as product offerings for open-end funds, especially bridge lending funds, as the value of these loans does not increase over time, nor do they trade at a premium. For this reason, open-end funds are very popular in the private lending market.
Other Factors to Consider When Selecting Between the Two Structures
Redemption Disputes vs. Capital Calls
Open-end funds often struggle with disputes with investors concerning liquidity, this particularly true a down market or if the portfolio is underperforming. Even if the fund has a very thoughtfully planned redemption policy, investors often start seeing red and start uprisings to exit the fund and get their money out. This is particularly true in privately offered funds. Closed-end funds do not share this same pain point as it’s clearly disclosed that the investors are locked in for the fund’s life cycle.
Alternatively closed-end funds can face other issues when assets underperform. When this occurs, they typically must rely on capital calls to investors. This can create significant stress for sponsors as it creates increased disputes and pressure on the sponsor in the form of litigation, frivolous claims derived from investor frustration, and reputational damage.
Flexibility to Address Market Concerns
One major point of consideration for open-end funds is to ensure the fund is the terms are locked in at inception. Changing them will usually call for a vote of the investors and could potentially result in investor exits. Closed-end funds allow the sponsor to create vintages that address the current market’s conditions. This is a challenge that has been particularly true in real estate and private lending because of the volatile interest rate environment.
Which Fund Structure is Right for My Business?
Structuring a fund can be challenging. This is why it’s important for sponsors to work with experienced fund counsel who specializes in the arena they wish to work in. Determining open vs closed-end is one minor piece. There are several areas of consideration including regulatory selection, securities compliance, structuring the fees and waterfall, and finally understanding the compliance obligations in the fund’s area of business.
If you’re interested in forming a fund and you would like a consultation – please feel free to contact us at Geraci LLP.
