Open-Ended Funds in a Close-Ended Funds World

Assessing the Increasing Popularity of the Open-Ended Fund Structure and Strategy for Real Estate Private Equity Funds

What Is the Traditional Real Estate Private Equity Fund Structure?

Historically, real estate private equity funds have more commonly been close-ended. This is generally the more optimal structure to support the funds’ real estate portfolios, the assets of which generally provide returns based on value-add and capital gains, as opposed to income streams. These strategies usually require mid- to long-term capital improvement plans which are in turn better supported by close-ended funds with similar mid- to long-term lives and investor capital commitment periods.

Close-ended funds typically operate with a fixed term ranging from 10-12 years. In a close-ended fund, investors are typically locked into their interest throughout the life of the fund.

Why Would a Real Estate Fund Manager Choose an Open-Ended Fund Strategy?

With real estate private equity funds having traditionally operated as close-ended vehicles, the question to ask is: Why has there been, in recent years, a rise in open-ended real estate private equity funds? Put simply, this structure is increasingly attractive to investors for a number of reasons, and ultimately fund managers are creating these funds to satisfy the market’s demand for them. Essentially, the “the consumer is always right.”

What Is an Open-Ended Fund?

An open-ended fund is a fund type that has an indefinite life and can issue an unlimited number of shares to its investors. Investors have the flexibility to purchase and redeem shares when they choose, pursuant to the fund terms. Shares can be priced daily, monthly or quarterly and are valued based on their current net asset value. Given the inherent long-term structure, privately operated open-ended funds are typically appropriate vehicles for long-term illiquid income generating assets including core/core-plus infrastructure and real estate portfolios. Managers of open-ended funds will often build their investment strategy around the acquisition of such assets. Open-ended funds may also invest in other illiquid assets such as certain credit instruments and mature cash-flowing companies that are easy to value through appraisal. Open-ended funds may be used for traditional private equity investments but are not typically an ideal fit for assets that are hard to value or see significant fluctuations in value. Turnarounds, leveraged buyouts, and early-stage ventures fit into this category as such assets often do not generate the reliable and regular cash flow stream needed to periodically redeem LP interests.

Open-Ended Funds in the Real Estate Industry

As noted, real estate private equity funds have more commonly been close-ended. Hedge funds and funds with liquid portfolios and investments in public securities have more commonly operated as open-ended funds, as these types of investments offer an inherent ability to redeem investor interests on a more frequent basis. Fund managers in the real estate industry are more recently looking for a structure that provides more flexibility regarding how long underlying assets will be held, and investors are seeking some of the unique attributes open-ended fund structures offer over their close-ended counterparts. Recent economic changes that have impacted real estate have also brought to light some of the inherent disadvantages of investing in real estate through close-ended fund structures, and the need for more suitable alternatives. The rise in inflation, the markets unpredictability, and a general unease about the current economic landscape are all contributing factors as real estate investments can provide long-term protection. Open-ended funds are believed to be an ideal tool in maximizing potential benefits and returns to investors through pooled core real estate investments.

Advantages of Open-Ended Funds

Open and close-ended funds have many differences in how they are structured and operate. One defining difference is that an open-ended fund generally has no fixed term and gives investors the ability to both enter the fund and redeem interests periodically. Close-ended funds typically have a fixed term ranging from 10-12 years for private equity and 12-15 years for venture capital, and investors are generally prohibited from exiting the fund. The indefinite term of open-ended funds provides a benefit in their potential to raise capital in perpetuity, while close-ended funds typically operate with a fundraising period of 12-18 months and a fixed investment period of 4-6 years. This flexibility offers managers more power over the timing of acquisitions and dispositions and an increased ability to navigate through an ever-changing economic landscape. The long-term income generating assets typical in privately-operated open-ended funds provide investors with a consistent stream of income from their investment. In addition, the long-term nature of open-ended funds allows them to hold more investments with greater diversity compared to closed-end funds that have a fixed term.

Open-ended funds also often offer an attractive option to its investors to participate in distribution reinvestment plans (DRIPs). These plans allow investors the ability to reinvest distributions into the fund in exchange for additional interests. Close-ended funds often offer recycling provisions that are similar to DRIPs but that have some key differences. DRIPs are offered in perpetuity while recycling provisions in close-ended funds can typically only be reinvested during the investment period. DRIPs also are typically allowed on every distribution throughout the life of the fund whereas recycling in close-ended funds is typically capped at a percentage of commitments, often 100-130%.

Management fees in open-ended funds are typically lower than close-ended funds. Open-ended funds generally charge fees as a rate of either net asset value or contributed capital. Close-ended funds, on the other hand, often charge such fees on capital commitments early on and on invested capital later on. This could mean that investors are being charged fees before investors have even contributed to the fund, and regardless of fund performance.

New investors in mature open-ended funds are exposed to a portfolio of assets upon entering and contributing to the fund. This contrasts with a close-ended fund in which often the early portion of investment periods see negative returns as they work to build a portfolio but charge fees from inception.

Disadvantages of Open-Ended Funds

While the open-ended fund vehicle has been gaining traction in the real estate industry in recent years, it is also important to consider the disadvantages of this structure compared to a closed-end fund. From an investor perspective, it may be more difficult to predict the timeline for realized returns compared to a closed-end fund. Fund managers of open-ended funds earn incentive fees in part on unrealized investments, so there might not be an incentive for them to sell assets. Further, investors often must commit to a specific amount of time before redemption requests are allowed (lock-up periods). From a fund manager perspective, an open-ended fund can be more challenging than a closed-end fund as it is necessary to balance the liquidity needs of the investors with the illiquid nature of the underlying assets. As such, redemption requests could potentially be challenging to fulfill and need to always be considered. Another disadvantage of open-ended funds relates to the valuation of underlying assets. The process of valuing an underlying asset is generally a subjective exercise and the result may vary significantly from the actual realized value. As investors are able to redeem shares periodically in an open-ended fund, accuracy of valuations is more crucial to fund success as compared to their close-ended counter parts where periodic redemptions are generally not allowed and investment illiquidity is a principal fund characteristic. Investors may find that they prefer the objective nature regarding valuations that are reflected in closed-end funds, as the returns are based on the realized value upon liquidation of the underlying asset. Another disadvantage to consider is that the fund manager will need to dedicate more time to managing the investor base in an open-ended fund as it tends to be more complex compared to closed-end funds. More time utilized could potentially require more personnel to operate sufficiently, leading to higher operational costs with an open-ended fund. These increased costs have a drag on investor returns.

Summary

A fund manager has many factors to consider when deciding whether to structure a fund vehicle as open-ended or close-ended. There are advantages and disadvantages to both, and the goals of both the fund manager and investors need to be carefully considered. While privately operated open-ended funds create some unique challenges from a managerial and administrative perspective, there are also many benefits for investors. Real estate, due to its long-term nature and consistent income stream (in core, stabilized properties), is an asset that fits very well in a privately operated open-ended fund structure. Alternative real estate investments such as senior and student housing, warehousing, data or life sciences/innovation centers/campuses are presenting as emerging real estate investment opportunities. Open-ended real estate private equity funds are vehicles that are well-suited to exploring these and other opportunities as they emerge. These appear to be the two main drivers in the recent popularity of open-ended real estate private equity funds. The increase in open-ended fund structures launched and expected to launch in the real estate fund space will create exciting opportunities for fund managers and investors alike. EA RESIG continues to monitor developments in this area and will pass along information as it becomes available.