Private capital fund structures: alternative routes to market

The previous lesson covered the most common fund within private capital – the commingled fund structure. In this lesson, we explore some alternative routes to market available to investors in private capital: funds of funds, separately managed accounts, and direct investments.

Funds of funds

A fund of funds aggregates capital from multiple investors to form a fund that invests in other private capital funds. A fund of funds manager therefore acts as both an LP and a GP, raising capital from investors in the same way as a GP, while making capital commitments to limited partnerships as an LP. The life-cycle for a fund of funds will be similar to that of a commingled fund, the only difference being the types of investments made (in other funds vs. directly in the asset).

Funds of funds allow investors to create a highly diversified and comprehensive portfolio of investments with fewer risks compared to direct investment. They also give smaller investors access to larger private capital funds that would usually be out of reach for them due to capital constraints. We will explore some of the pros and cons of fund of funds vehicles below:

Pros

Higher levels of diversification: investments made by a fund of funds manager give an investor access to several funds consisting of varying underlying assets.
Lower levels of risk and volatility: risk is reduced through greater diversification.
Management expertise: a fund of funds manager will provide an investor with professional due diligence, manager selection, and oversight over the funds within its portfolio.
Access to top funds/managers: by pooling capital alongside other investors through a fund of funds, LPs can access funds or managers that might otherwise be out of reach to smaller LPs due to their high minimum investment thresholds.

Cons

Higher fees: funds of funds charge their own fees, as well as passing on those from the underlying funds being invested in, creating a double layer of fees owed by investors.
Lack of transparency: visibility of underlying assets of funds invested in is limited for investors.

Unlisted funds
Unlisted funds are vehicles raised by a general partner (GP), pooling capital from limited partners (LPs) to purchase assets. The institutional investor capital is overseen by the fund manager (also called a GP) and are not listed on a stock exchange.

Closed-end private funds are vehicles with a fixed life span, often 6-10 years. This method of investment is considered highly illiquid. There is usually a fundraising period when equity is gathered, followed by a final close when capital cannot be withdrawn from or added to the fund. Any profits are distributed at intervals throughout the term of the fund to the LPs, less any management fees extracted by the GP.

In contrast, open-ended funds do not lock away investor capital, allowing periodic redemptions and new commitments, with an indefinite lifespan and greater liquidity. Open-ended funds are formed between one LP and one GP to invest in assets. New funds are commonly launched every 4-6 years, once a fund manager’s previous fund is fully invested, depending on the success of the previous vehicle.

Listed funds
Listed funds are pools of investor capital raised by being floated or listed on a public stock exchange such as the London Stock Exchange, as opposed to being privately raised. Like any other public or listed security, interests in these funds are tradeable. The capital raised is invested in private assets and investors receive a periodic dividend.

Separately managed accounts

A separately managed account is a fund structure between one fund manager and one investor. The fund manager will oversee the account, making multiple investments in order to meet the strategic and other portfolio management needs of the institutional investor.

Pros

Customized to individual: a separate account addresses the needs of the individual investor, taking into account their goals and risk tolerance. Other types of fund will invest according to the objectives of the fund as a whole.
Higher levels of transparency and control: an investor will have maximum visibility and control over investments made and is likely to receive a regular report on their account.

Cons

Access: certain strategies and funds will require large initial investments, so may not be accessible to separate accounts that cannot meet these minimum thresholds.

Direct investment

Direct investing is where an investor purchases ownership in a company or asset without the use of a fund manager or fund investment vehicle. Deal sizes and structures vary, and investments can be in a single asset or a portfolio of assets. Direct investment is typically only possible for the largest, most experienced investors.

Pros

Greater control in decision-making: direct investment gives the investor complete autonomy over the selection and timing of investments and exits. Investors can select assets themselves, customizing their portfolio according to criteria such as location, asset type, and strategy, with full transparency of information. Likewise, a direct investor is not locked into a fund’s fixed lifecycle, granting them autonomy when it comes to exiting an investment. This would allow them to invest over the long term if desired.
Lower fees: an investor will not be subject to the management fees associated with fund investments and gets to keep all of the net profits that are generated from investments.

Cons

Not available to all investors: most investors lack the expertise and resources necessary to source, structure, and monitor investments, which means that direct investing is only possible for more experienced or larger investors that may have their own in-house investment teams. One possible solution to this is for an investor to co-invest alongside a fund manager. This has all the benefits of direct investing, while allowing them to utilize a manager’s skill in asset selection.
Limited diversification: due to the large size of investments, many investors will not have scale necessary to develop a diversified portfolio equivalent to that of a private equity fund portfolio. This can leave an investor exposed to asset-specific risk.
Higher operating costs: while direct investment will mean an investor can avoid some of the management fees associated with fund investments, they will be subject to substantial operating costs in sourcing and executing direct deals.

What is co-investing?
A subset of direct investing. An investor invests directly in an asset alongside a fund manager, making an allocation to the fund as well as investing directly in assets.

In this lesson, we covered three more fund structures within private capital: funds of funds, separately managed accounts, and direct investment. Having discovered the pros and cons of each structure, you now understand how investors and fund managers work together within private capital.

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