Whether your private equity firm is a multibillion-dollar shop or a boutique firm managing hundreds of millions in niche assets, there’s a good chance it’s in growth mode.
Over the last 10 years, private equity assets have seen substantial growth – rising from $3.15 trillion in 2010 to $8.48 trillion in 2020, according to the private equity data resource Preqin Ltd. And this growth is not expected to slow down. Assets under management in the PE space are expected to grow to $145.6 trillion by 2025.
At the center of the surging private equity industry sit closed-end funds — a portfolio of pooled assets that allows private equity investors to target investments in unique market opportunities. Closed-end funds, which raise a fixed amount of capital during a commitment period, are often treated as alternative investments and are defined by targeted investment strategies, GP and LP profit-sharing arrangements. What differentiates them as a closed-end fund is their unique carry interest and waterfall fall calculations for realized profit and loss events.
According to Peter Mastriano, Global Fund Services senior vice president at U.S. Bank, private equity investments and their related structures have a longstanding preference by limited partner investors. The compensation to the general partner occurs only after the limited partner receives their return of capital and a preferred rate of return on invested capital. This feature of closed-end funds fit particularly well with investment strategies of today.
“Private equity is one of the oldest forms of raising capital in the U.S.,” Mastriano says. “Investment strategies that are prevalent in the capital markets today lend themselves to closed-end funds, which offers tax benefits, attractive fees, a structure sought by institutional investors. It allows access to varied asset classes that may otherwise not be available to investors.”
Given the heightened sophistication of the typical private equity investor, tax matters are paramount, Mastriano says. Closed-end funds have several benefits to consider:
Pass-through vehicle: Closed-end funds serve as pass-through vehicles to limited partners, offering distinct tax advantages. The character of income is preserved in these structures and current tax law provides benefits for the recognition of such gains. This information is provided to limited partners through data points captured within each fund’s annual K-1 form such as:
“These tax treatments can be very beneficial to an individual,” Mastriano says.
Enticing fee structure: Similarly, the fee structure on a closed-end fund can be friendlier to investors than the typical hedge fund assessment. In most closed-end funds, Mastriano explains, the manager’s compensation is driven primarily by transactions that generate liquidity for the fund, such as the acquisition and subsequent disposition of an illiquid holding. “For an investment manager, the fee structure aligns to the investor’s concerns because they aren’t collecting an incentive fee or carried interest on unrealized profits and losses,” Mastriano says.
A fund of one: Along with the approach to fees, institutional investors often appreciate having the option to structure a closed-end fund as a fund of one — an investment vehicle that manages only their capital. According to Mastriano, a fund of one provides further transparency on the fund’s fees and expenses as opposed to an offering or structure where there is little transparency into costs incurred by the fund. It also addresses instances where different investors have negotiated an assortment of investor specific fee agreements, which put other limited partners in a fund at a disadvantage. Further, the fund of one structure eliminates the risk of association or unwanted exposure to other limited partners within a fund. “Investing with other limited partners can leave an institutional investor exposed from a reputational or political vantage point if the other limited partners engage in unwelcomed or unacceptable behavior,” Mastriano explains.
With pass-through tax benefits and specific investment criteria terms, closed-end funds are an ideal option for private debt funding activities such as collateralized loan obligations, Mastriano says. Further, closed-end funds can allow limited partners to capitalize on emerging product structures such as:
As you explore the impact closed-end funds could have on your firm’s business, you might consider hiring an outside fund administration provider to handle a number of back-office duties such as:
“More and more limited partners want transparency,” Mastriano says. “As that and other client demands increase, many administrators realize they need to increase their capabilities to service ever-increasing complex fund structures and investment strategies.”
To optimize the relationship between the asset manager and the administrator, Mastriano advises that the search for a service provider should emphasize:
Ultimately, making administration changes in a private equity shop is a substantial decision. When done well, however, the service provider functions as an extension of the asset manager, supporting your management team with the functionality and visibility the firm needs to service existing investors and attract new ones.
For more information on the spectrum of fund servicing solutions offered by U.S. Bank, visit usbank.com/globalfundservices.