14 August 2024
Kondi Nkosi Country Head in Schroders South Africa
Kondi Nkosi
Private markets are inherently less liquid than public markets, and locking up funds for a significant period is unfamiliar to many private investors.
Additionally, regulators around the world are concerned about the potential risks associated with private assets during market stress. A key focus of regulators is on the liquidity mismatches that can arise if open-ended funds invest in illiquid investments and allow too much flexibility on redemptions.
But private asset managers are exploring ways to address this liquidity challenge, including evolving from fixed-term funds to more flexible indefinite-term funds, and introducing open-ended semi-liquid funds as well as offering new regulated structures.
Semi-liquid, or ‘evergreen’ funds
Semi-liquid funds, as the name suggests, offer a balance between liquidity and the potential for attractive returns by investing in a mix of liquid and illiquid assets.
While these funds do not require capital to be locked up, like closed-ended vehicles with fixed terms, redemption windows might still be infrequent and subject to limitations and are therefore most appropriate for investors with a longer-term time horizon. The options in the semi-liquid fund space are increasing with more providers coming to market with new vehicles offering a diverse range of strategies.
Within semi-liquid structures, investors can buy and sell at a prevailing Net Asset Value (NAV) as they are transacting with the manager of the fund (rather than other investors in a secondary market). This allows investors to deploy their capital immediately into a diversified private markets portfolio at the NAV of the fund at a given time, rather than waiting for their cash commitments to be drawn down over time.
Investing at a fund’s NAV reduces volatility or public market beta compared to daily traded listed closed-ended funds. This type of closed-ended fund relies on a secondary market for liquidity where the price investors receive is based on the prevailing market supply and demand dynamics.
However, this also means that liquidity in a semi-liquid fund is not as high as it is for listed closed-ended options. Semi-liquid funds typically deal less frequently (often monthly or quarterly), with prescribed notice periods and can “gate” when certain thresholds are breached, potentially limiting the amount which can be redeemed at a given dealing date.
In semi-liquid funds, a well-constructed portfolio, diversified by geography, sector, and asset type (and with a potential small allocation to liquid investments), can engineer a level of “natural liquidity” that is regular and consistent. Semi-liquid funds also employ liquidity management tools that can control liquidity within the fund, such as setting redemption limits and realising liquid investments (see below).
A clear assessment of a fund’s mechanics to provide liquidity is crucial to any wealth manager allocating client’s capital to this fund structure.
How does liquidity work?
1. Portfolio construction and risk mitigation
The portfolio must offer a prudent spread of risk to avoid concentration risk. For example, it might be exposed to a range of vintages to establish a baseline of natural liquidity through distributions. Geographic, asset class and/or sectoral diversification also reduces the risk of being exposed to shocks or events impacting the liquidity of the entire portfolio.
Some semi-liquid funds may invest a portion of their portfolio into more liquid assets, which can be sold more readily to meet redemptions at a given dealing date.
Another consideration for portfolio construction is the pace of deployment for new subscriptions and being able to accommodate changes in subscription activity. Typically, closed-end funds allow investors to make commitments which are called over a certain period.
However, semi-liquid funds are evergreen open-ended funds so subscriptions must be invested faster, and the volume of subscriptions might vary from one period to the next. This means that an investment manager must be confident that their investment platform is broad and deep enough to accommodate irregular inflows and invest quickly, whilst maintaining diversification.
In this structure, a cash balance or pool of liquid securities in the fund is actively managed by the investment manager. It is a function of the level of subscription and redemption activity, the pace of deployment and distributions from the underlying portfolio. Funds will maintain a cash balance to meet redemptions and avoid selling down any of the more long-term private markets assets for a discount.
Open-ended funds should also have the flexibility to use secondary sales to help manage liquidity in the portfolio. Actively selling portfolio investments can help to raise cash in the fund in periods where subscriptions are low and redemption requests are increasing. For many assets classes, the secondaries market has become very deep and therefore more liquid than it was 10-15 years ago, although it can still be prone to high cyclical discounts. Hence the importance of a diverse portfolio to provide more flexibility when looking to sell assets.
2. Specific liquidity management tools
Given the inherent liquidity in the asset classes, there is a range of tools investment managers will incorporate in the design of the fund to ensure the investment strategy is adhered to over the long term. This includes mechanisms that restrict the fund liquidity in accordance with the long-term nature of the asset class, and avoid a forced sale of assets that might damage performance. These tools can also vary based on the fund and its investment strategy.
The key tools are:
Redemption notice periods
Investors in the fund are required to provide advance notice of when they wish to redeem from the fund. These vary from fund to fund but a three-month notice period has commonly been adopted in line with a quarterly redemption frequency. Applying such a notice period removes the tendency for investors to behave impulsively according to macroeconomic events or volatility in the listed markets.
Whilst other regulatory regimes may offer more flexibility when structuring other semi-liquid funds, many managers elect for a similarly extended notice period when compared to typical open-ended mutual funds.
Redemption limit
A key feature of semi-liquid vehicles is the ability of managers to set limits on the total percentage of the overall portfolio redeemed at each dealing day. As an example, a manager might determine that 5% net redemptions per quarter is appropriate, giving an annual limit of 20% per year.
This limit should be set in line with underlying liquidity of the fund’s portfolio, so it could vary from fund to fund. Limiting redemptions to a set amount ensures that redemptions can be paid out of liquid assets or cash. This is in the best interest of investors as it protects the longer-term illiquid assets from being sold at a discount, which would impact the returns for all investors.
Redemption suspension limits
Under normal circumstances, investors can buy or sell shares in a semi-liquid structure according to the specified dealing frequency and cut-off time. However, there may be exceptional situations or market stress events where the fund manager has the discretion to temporarily stop accepting redemptions and/or subscriptions for a specified period if they believe it is in the best interest of existing shareholders.
Lock-up periods
When a fund is new, there might be a ramp-up period during which no redemptions are permitted to allow a portfolio to be developed and create sufficient diversification. The lock-up period varies according to asset class and investment strategy.
Special dealing procedure after suspension period
During any period when the calculation of the fund’s NAV per share is suspended, no shares can be issued or redeemed. If the suspension of the NAV calculation lasts for a specific pre-determined period, the managers may introduce additional measures to handle extraordinary circumstances they believe require special procedures to protect the interests of existing shareholders. This could involve all investors being offered the option to redeem, followed by an extended period for the manager to liquidate fund assets and return funds to investors.
These rules provide flexibility to managers in managing liquidity and protecting shareholders’ interests during exceptional market or economic conditions. It’s important to note that such measures are typically implemented as a last resort and are intended to be temporary in nature.
These liquidity mechanisms aim to strike a balance between providing investors with access to their investments and ensuring the fund’s overall stability and liquidity. However, it’s important for investors to understand that these mechanisms may introduce additional risks and limitations. Fund structures and their liquidity mechanisms can also vary depending on the jurisdiction and regulatory framework.
What happens when an investor chooses to redeem their holding?
In some semi-liquid funds redemption requests are first netted off against subscriptions received in the same period. If the net of those flows is positive – there are more subscriptions than redemptions, then additional commitments and secondary purchases can be made in the portfolio.
If there is a net outflow, it will be met by the fund liquidity as outlined above.
If redemptions for the quarter exceed the established threshold, then the amount will be reduced pro rata to ensure every investor in the fund has been treated fairly. The amount not dealt will then roll into the next dealing day, where it will be treated equal to other redemptions received for that dealing day, unless cancelled by the investor.
Liquidity management in other structures available for private investors
Closed-ended funds. While closed-ended private asset vehicles have been around for a long time, there has been product innovation to better address investor needs, especially private individual investors.
Some closed-ended funds can now have single capital calls, shorter investment periods, lower investment minimums and regulatory structures that open up to a broader set of investors. Whilst the primary objective of the funds is to remain invested for the fund term, in some cases the manager will operate liquidity windows when investors are able to trade with one another or with a buyer of last resort.
Closed-ended listed. Liquidity for closed-ended listed funds, or investment trusts (ITs) in the UK, in normal market conditions is in line with other traded equities, with intra-day trading available. This liquidity profile and ease of access is what has traditionally driven their potential suitability for more retail or “mass affluent” investors.
In traditional ITs the share price can move independently of the stated NAV. Investors may face a situation, if selling, where the share price is at a (potentially significant) discount to NAV. Many investors favour the IT structure for exactly this reason, attracted to the potential to take advantage of a dislocation between the trading price and intrinsic value, but it must be factored in when making the decision to invest in these assets.
Obtaining liquidity has caused some issues in the past, with isolated instances of adverse market environments compromising the ability of sellers to find a willing buyer on the other side. In our view, this should be managed by appropriate portfolio construction and due regard to an individual client’s circumstances, such a time horizon, risk appetite and need for liquid access to their capital.