As pension funds explore investing in alternative assets such as private equity, real estate, and infrastructure, it is important to understand the vehicles used for these investments. Specifically, compare the use of closed-end funds versus open-end funds along with the relative advantages and disadvantages of each.
Open versus closed
In some alternative asset classes, closed-end fund structures are more common; however, they may not provide optimal alignment with a plan sponsor’s objectives.
Closed-end funds provide the investment manager with a locked-in pool of assets for executing investment strategies. In a closed-end structure, investors commit capital to the fund for a pre-determined period of time. Fund gathering is also for a specified period, which prohibits new contributions once the fund raising window is closed. The investment manager is responsible for calling committed capital for purchases in the fund as well as liquidating underlying assets before the end of the fund’s life, normally eight to 10 years.
Open-end funds are familiar to most investors as they are the dominant structure in traditional equity and fixed income portfolios. Essentially, open-end funds allow for contributions and withdrawals on a perpetual basis. They have also gained acceptance in private asset classes where the underlying assets create large cash flows, which can help provide liquidity. Real estate, for example, has evolved into an asset class with many open-end investment vehicles.
Pros and cons
While both closed-end and open-end structures are available in alternative asset classes, it is important to understand the benefits and drawbacks of each option. The major advantage of closed-end funds is the objective nature of valuing the portfolio. Underlying investments are purchased following the asset gathering process and sold when the fund is dissolved. Thus, a rate of return is easily computed based on market prices. This objective return can be used to determine the return for the investor as well as for calculation of any incentive fees for the investment manager.
However, the pre-defined timing of purchases and sales of assets can be a drawback to closed-end funds. Since the fund manager buys assets over a specific time period, purchases will be subject to prevailing valuations at that time. This means that the entire portfolio will be subject to the same over- or under-valuation of a given market environment.
Furthermore, the investment manager is incented to ensure all committed cash is deployed, which may lead to chasing underlying investments over the short timeframe allocated, rather than exhibiting patience to find assets that meet all the manager’s investment criteria.
Similar issues with timing exist as the closed-end fund concludes and cash is returned to investors. First, all assets which must be sold are, once again, subject to the existing investment environment. If valuations are unfavourable, as they were for many investments in 2008, the investment manager must sell regardless. Second, counterparties who are potentially bidding to purchase these assets are most likely aware of the investment manager’s requirement to sell the assets by a certain date and may be able to take advantage of this information as the date draws closer. Finally, if the manager sells the assets too early, clients will have to look for other investments as a replacement.
Open-end funds are not subject to timing restrictions with respect to purchasing or selling assets. Therefore, the manager can make buy and sell decisions based on valuations and prudent portfolio construction, without being concerned about the specific timing of the transaction.
The main drawback of the open-end fund is the reliability of asset valuation for investors who are purchasing or selling units. When an investor purchases units of an existing fund, the investor takes proportional ownership of all current assets based on a price determined by a subjective valuation. Since there is no objective market price for the actual value of the asset, the investor must rely on third parties, who provide these appraisal or valuation services.
The need for valuation stems from the long-term nature of the assets that are held by the fund, while allowing investors to buy or sell units in the fund. As the fund holds assets of long maturity, without a required liquidation date, the fund can be seen as a better match for long-term liabilities (such as those found in pension funds and insurance companies).
Alternative assets have attracted a lot of attention lately, but there has been less focus on the vehicles used to access them.
Closed-end funds provide a known investment period with defined entry and exit dates for investors, as well as, return data based on actual purchases and sales of assets.
Open-end funds provide the ability for investors to add to or liquidate investments according to their horizon, long-term matching of assets to liabilities, and diversity of purchase and sale valuations.
Investors need to think beyond what is the most common vehicle to what is the most appropriate vehicle that best meets their objectives.