Why long-term hold funds are here to stay

November 2022 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

November 2022 Issue

There is an increasing focus by investment managers and investors on holding long-term development real estate, private equity (PE) and venture capital (VC) investments. This global evolution has important ramifications for investment fund offerings and investors.

Long-term asset holdings are not a new concept for asset classes such as real estate and infrastructure. Both long-term closed-ended and evergreen open-ended funds in these assets have been fairly successful with both institutional and retail investors. However, there have been numerous disasters where fund managers were not able to meet investor expectations around liquidity and valuations did not match the values at which investors invested in or exited such funds. Some of these issues have been so significant that some major institutional investors will no longer invest in pooled structures for these types of assets.

So why, then, are we seeing a surge of similar types of funds in development real estate, VC and PE?

Firstly, there is a global shortage of good quality assets compared to an increasing pool of pension and superannuation capital and their constant inflows (let alone substantial family offices and other institutional investors).

Secondly, as institutional investors get bigger, they want and need to invest at scale. Many would prefer large, deep relationships with fund managers rather than voluminous smaller relationships and investments.

The challenge with this dynamic is that most investment strategies and funds are limited by scale. There are only so many deals and so many team members to hunt deals and investors demand the timely deployment of capital. Some venture capital strategies have struggled to satisfy the deployment needs of some large investors. Long-term holdings address this because the capital deployed from the initial seed through future growth and mature funding rounds is in aggregate significant.

Thirdly, while the returns of these asset classes have often been above listed markets on a sustained basis when offered in a typical eight to 12 year closed-ended fund, there is often much more financial sense in continuing to hold quality assets.

Many investors have lamented having to fund an early-stage company and pay carry, fees and tax to then buy back into the same asset when a growth PE manager buys – then more carry, fees and tax, before then it lists and more tax and fees are paid to a listed equity manager. It can be very inefficient for some investors and some assets. Leaving capital at work means there is no tax leakage from a disposal.

Now, this is not to say this is the case for all assets, because it is not. Some assets are shorter term trades. Some are not built for the long-term hold.

The other issue here is that institutional investors are often structured by teams – the early stage team, the PE team, the real estate team, the listed equities team and so on. So, when an asset moves between these stages or attributes, it often requires a different team with a different mandate. This does not work. However, some large investors are no longer structured this way, or if they are, their mandates now permit traversing stages. So, the fourth reason is that large investor mandates have become more flexible.

Lastly, staying invested in an asset that you know well often creates better risk-adjusted returns. This is because if a manager has known an asset for a long time it often de-risks the asset compared to the risk of the unknown at the point of investment. For example, there is no due diligence risk when you move from early stage to growth – you know the asset and you understand the potential risks. Also, the returns are augmented by the lack of the inefficiencies – there is not the same level of fee, cost and tax leakage.

There is the ‘falling in love’ factor with some investments, where a manager should have sold them but did not, however quality managers are typically too disciplined to make this mistake.

So, let us put all this into a real-life example.

A fund manager is able to invest across the spectrum from early to listed stage. Its returns have been exceptional. It saw the inefficiencies in the typical ‘sell an asset every three to four years’ approach.

If an asset can graduate to a long-term hold, then the fund manager and its investors happily continue to hold. Not all assets are good for this as they carry too much risk, such as climate, environmental, disruption and regulatory risk.

The challenge is that long-term assets often do not continue to grow at a 25 percent internal rate of return (IRR) each year. Their return profile changes. And the skillset required to run an asset long term can be different from a typical short-term fix or grow type strategy skillset. However, a quality mature asset that graduates to the long-term hold class can often be refinanced and capital returned to investors, resulting in a very low actual cost base. Yes, the return at that point has often dropped compared to the original cost base, but with a return of capital and the business steadily earning a nice yield, which can result in the actual return on the revised cost base being very compelling.

Then there are those assets where the business is not a neat three-to-four-year hold. To do the right thing by the business takes longer. If these assets find themselves in closed-ended funds, they can run beyond the term of the fund and some investors may want liquidity. Enter the continuation fund. This is effectively a newly established fund buying an asset from another fund managed by the same manager. This enables those investors who want it to have liquidity while those wanting to roll their investment into the new fund can do so. This takes the pressure off managers to exit and provides sufficient time to exit a business when it is the right time. This can only be good for the industry and investors.

The model that has evolved for both long-term asset funds and continuation funds is to ensure that there is a governance framework around valuation and process. This invariably involves a vote of usually around 60-70 percent of investors, or a vote of the investor advisory committee to clear any conflicts of interest. There is also a robust process around pricing which can involve taking market bids. Typically, prices are struck on a disciplined arm’s length basis.

The next important element is ensuring that the economics are calibrated appropriately. This will usually involve either a crystallisation of carry on switching to a long-term hold or continuation fund, or a rolling in of such carry to the new structure. The general investor expectation is that some or all of such carry is rolled into a continuation fund, whereas long-term funds usually involve part payment of carry along the way, so the manager’s team stay fed.

As an asset moves through its stages, such as development real estate moving into a stable real estate asset, the risk and returns both decline, and as such performance-based payments also tend to be based on lower return thresholds.

Lastly, there needs to be an ‘escape route’ for investors if things do not go to plan. To this end, there are often gateways to the continuation, such as performance thresholds that need to be met or periodical votes of confidence to continue holding. Further, for those investors who do want out, and there will always be some, there needs to be events of liquidity along the way. This can be via secondary sales, fund-level debt facilities, asset level refinancing or recycling of capital.

Businesses are often not built for the timelines of traditional fund structures and that, with the reasons set out above such as the efficiencies of keeping a good asset, is why long-term and continuation funds will be more prominent in the future.

Nathan Cahill is a partner at Gilbert + Tobin. He can be contacted on +61 2 9263 4055 or by email: ncahill@gtlaw.com.au.

Nathan Cahill

Gilbert + Tobin