Searching for Immortality: Forever Capital

What happens when the sources from which private funds draw capital become constrained?

It is rare for a group of investors to demand the dissolution of a private fund without any cause event covered under the limited partnership agreement (LPA), of a fund structured as a limited partnership. Even if those investors have the right to do so.

Let’s say the official term—the 10 years plus the two one-year extensions a fund manager is entitled to—of a private fund are up.

The end of the term is also usually the fund’s date of dissolution.

What is the legal status of a fund that exists beyond the term stated in its LPA?

It is evidently not the case that investors will receive back all their invested capital plus any profits at the time the fund is required to be dissolved if there are portfolio holdings which have not yet been sold.

It can take many more years for that to happen. And fund managers can, depending on how the LPA is written, continue to earn management fees during this time.

The sale of fund assets during a dissolution period isn’t too unlike the sale of fund assets during the actual life of the fund, except that the total time a fund holds an investment varies.

Usually, any investments sold after the dissolution date pay out as follows: to the costs and expenses of winding up and dissolution, to the creditors of the fund (possibly investors and even the fund manager), to reserve accounts for contingent liabilities or obligations of the fund; and then, well, we get to the actual distribution of contributed capital and profits back to the investors.

The Next Fundraise

If things go really well, private funds typically return investor money after 10 or so years, which also means they must raise new funds. Even with strong returns, higher fees, and eager investors, fundraising remains time-consuming and uncertain.

We may also account for the added benefit that limited partnerships offer more operational flexibility than publicly traded corporations.

But despite these advantages, can private fund managers deploy capital without the constant need to raise new funds?

One solution lies in the recent vogue of “perpetual” capital—like in mutual funds, which don’t require new money and can continue into perpetuity. Hedge funds also benefit from this model, often not having a set lifespan. (The key difference, however, is in the investor base. Mutual funds are accessible to retail investors, while hedge funds, especially 3(c)(7) funds, are restricted to “qualified purchasers” with at least $5 million in investments.)

This drive to avoid constant fundraising has led to the rise of “evergreen” funds. These funds raise capital indefinitely, with no fixed fundraising period, and some can even accept retail investors because they are registered under the Investment Company Act of 1940 (being subject to more regulations comes with the benefit of being able to raise money from the broader public).

When I initially heard of this “evergreen” term popping up, I thought to myself, isn’t that what a hedge fund is?

Like, when you invest in a hedge fund, you put all your money upfront on the date of subscription (unlike drawdown funds, which call increments of promised capital from investors over time). This money is locked up for a period of time (24-36 months, for example). The LPA may then permit redemptions (partial amounts of money taken out) or withdrawals (completely taking everything out) over a series of periods, sometimes monthly, quarterly, semi-annually, annually, etc. These redemptions are subject to “gates,” that are either based on the total value of the fund’s holdings (a fund-level gate) or a percentage of an individual investor’s account value (an investor-level gate).

But the problem with evergreen type funds—where investors can go into and out of the fund, subject to certain time and capital-based restrictions on the amount they redeem—is that they have difficulty investing in the hard-to-value, privately-held businesses that private equity (PE) and venture capital (VC) funds are known for. If an investor wants to take money out, the fund would probably have to sell an existing asset. This is the case for a mutual fund: you can request a redemption, and within a couple of days (accounting for some administrative niceties), you get your money back.

And it’s hard to do that with a mature, private company. It can’t be sold quick enough to meet investor redemptions, at least without experiencing a substantial drop in sale value.

How do you solve for the fact that you want to have capital readily available to invest in complex, illiquid enterprises without having to continuously go out and raise money?

Regulatory Reflux

The irony in the growth of the private markets is its recourse to the public markets. It’s almost as if the growth of private markets has grown towards a journey back into the world of the ’40 Act. There’s a lot of commentary out there from banks, management consultancies, research firms, etc. that talks about the benefits of creating pools of investment entities on behalf of private fund managers that can draw upon the monies of “retail,” or non-accredited, investors.

Ultimately, we aren’t really talking about investments at all. Perpetual capital and the evergreen vehicles that attempt to materialize the constant availability of that money are really all about how and when capital flows.

And if setting up a private funds business is hard, a pool of capital that invites retail money is remarkably more challenging given the additional regulations involved, among other things.

This shift in how private funds raise money requires some additional thinking, and over the next few posts we will touch on how banks and other financial institutions—far more regulated than private funds—play a role in this as well.

We might call this phenomenon the flight to regulatory capital.