Private equity and closed-end funds are growing in popularity and presenting new benefits and opportunities for investors.
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.
Last year North American private equity assets grew 26 percent – rising from $2.892 trillion in 2017 to $3.58 trillion in 2018, according to the private equity data resource Preqin Ltd. The number of private equity funds in the marketplace has also gained momentum. In 2018, private equity funds in the U.S. market totaled 2,296. As of second quarter this year, that number has jumped to 3,951 – a 72-percent increase from 2018 and more than double the 1,829 recorded in 2017.
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.”
Tax, fee and structure advantages for the private equity investor
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:
- Return of capital
- Capital activity recognition
- Long-term interest/dividends/gains earned on capital
- Short-term interest/dividends/gains earned on capital
“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.
Versatility in unique asset types
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:
- Qualified opportunity zones (QOZs): The QOZ program was established within the Tax Cuts and Jobs Act of 2017 and defers taxes on capital gains invested in an economically distressed community.
- Business development companies (BDCs): BDCs have existed since 1980 but have recently gained in popularity as a debt alternative for early-stage companies, local governments, and some municipalities that otherwise struggle to raise funds via bond issuance. “A good example is a town or geographic region that can’t issue bonds but needs funds to build roads, create jobs and raise real estate values,” Mastriano says. “With a BDC, they finance roads, infrastructure, and businesses that create economic development.”
Third-party administration can bolster your operations
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:
- Satisfying client requirements for a third-party administrator to ensure transparency into the closed-end fund’s books and records
- Enhancing the technological capabilities of the firm’s reporting and investor communication
- Providing access to other products and services such as custody, credit lines for investment financing as well as capital call management
“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:
- Technology that results in more automation and less reliance upon manual processes
- Capacity and a spectrum of services that can handle your expanding front to back-office (middle office) needs as the investment complexity grows
- In-house knowledge of tax matters, given the importance of taxes to closed-end fund investors
- A strong customer service function to help keep client satisfaction high
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.