The quest for permanent capital among alternative asset managers has become a search for the holy grail. It’s a quest that has taken many different forms, but the goal is ultimately the same: to have a stable base of assets under management.
“There’s a general recognition now that there is this permanent capital alternative out there which has become much more prevalent in the last few years,” says Julie Corelli, partner at law firm Pepper Hamilton. Corelli receives more inquiries from non-clients on this topic than on any other: “We’ve set up numerous permanent-capital vehicles for our clients – more in the last five years than in the whole prior 10 years.”
But what exactly does this mean? The concept of permanent capital seems straightforward: capital that doesn’t go away, that isn’t liquidated in the traditional private-fund manner, and which the manager oversees for a sustained period. But, as is usually the case in finance, nothing is quite as simple as it first appears, and permanent capital comes in many different varieties.
For US credit managers, it has principally taken the form of business development companies. With close to 50 publicly traded BDCs and even more private vehicles, a bevy of capital has been raised for the space since the global financial crisis, though the structure has been around since 1980.
According to the LPC BDC Collateral database, there is currently $110.92 billion in total assets across public and private BDCs.
One characteristic of permanent-capital vehicles, Corelli says, is the ability to time exits from investments well. For a private equity firm, that means not being forced to sell a portfolio company because of the fund’s time restrictions, as may be the case when a drawdown fund nears the end of its life.
Corelli says a permanent-capital vehicle allows a borrower to remain in a credit manager’s portfolio for a long period. By contrast, if an alternative lender wanted to keep a loan in its portfolio but housed the investment in a drawdown fund, the firm would have to transfer the asset to its most recent fund vintage. This could lead to significant conflicts of interest.
Or, it could go the other way: a fund could reach the end of its life and still contain distressed assets. This would raise questions about what to do with the assets, rather than simply how to keep them.
Ira Kustin, a partner in the investment management practice at law firm Paul Hastings, previously told PDI: “You can end up with what you thought were plain, vanilla loans that are now a much more complicated distressed asset. You can have portfolio investments toward the end of the life of the fund that are not exactly clear regarding when you will be able to realise those opportunities.”
Smoothing out the bumps
Permanent capital lets firms avoid logistical crises and focus on originating loans, say senior executives at MidCap Financial, a fund manager based in Bethesda, Maryland.
“Fund managers have to be careful about how they originate loans [that may go] beyond the fund life and what they do with potentially long-term items like warrants that will outlast the fund,” says the firm’s co-founder and chief financial officer, David Moore. “They have to manage through the process of terminating funds, rolling investors and potentially providing liquidity. Permanent-capital vehicles don’t have to deal with those starts and stops.”
“It is a completely different mindset for investors and the people managing it,” adds MidCap’s co-founder Howard Widra, who is also chief executive of Apollo Investment Corporation BDC. “When you get money from people for vintage funds, you’re getting their view of the world at that time. Permanent capital [draws investors] that want long-term exposure to an asset class. As a fund manager, it allows you to run the business in a way that’s more relationship-based.”
Permanent capital vehicles can also let managers take their foot somewhat off the fundraising gas pedal. “If you’re a private fund manager, you’ve always had successive private funds and had to be constantly fundraising,” says Richard Horowitz, partner at law firm Dechert. He believes permanent-capital vehicles can cut down on the need for that and allow GPs to diversify their product offerings.
He adds that BDCs are “very attractive” to certain types of investors for tax reasons: “A BDC is a regulated investment company under the Internal Revenue Code. BDCs that engage in a direct lending strategy are the cleanest structures from a tax standpoint.” The vehicles do not withhold taxes when they pay dividends on US-sourced income, and these distributions are a key reason why investors hold BDC stocks.
Horowitz says BDCs serve as their own blocker from several other types of taxes. Foreign investors can avoid taxes on effectively connected income, or US income for foreign businesses. US tax-exempt investors are shielded from taxes on unrelated business taxable income – income generated outside the business’s core operations.
One US pension fund manager, who declined to be named, says they prefer evergreen, separate accounts with a termination provision for the LPs. The provision allows LPs to reduce their exposure if they undergo internal changes.
This investor likes separate accounts as they allow exposure to sectors to be customised and greater alignment with the GP. In general, the investor is not a fan of publicly listed BDCs as the liquidity does not provide investors with sufficient compensation to offset the high fees. However, the investor believes private-to-public BDCs can provide attractive opportunities if LPs can secure equity stakes once the vehicles have been publicly listed.
When looking at BDCs, most investors seem to focus on market-to-book ratio. However, the pension fund LP believes returns on equity are more important. Additionally, investors need to understand the amount of risk in the capital structure and in their credit underwriting to calculate their expected level of return.
The structure of evergreen funds presents interesting questions, the LP says –chief among which is whether profits are distributed to investors during the investment period or whether they are recycled back into the fund. “It’s a two-way street,” the investor says. “LPs and GPs have to come together to form “win-win” relationships.”
One open- and closed-ended hybrid is the Orchard Landmark Fund, which invests in the direct lending space in Asia. OCP Asia manages the 2013 vehicle in addition to several drawdown vehicles. The vast majority of investors in the fund are based outside Asia and can redeem their money once every three years. Although it generally takes a long time to deploy an open-ended vehicle at the outset, the money is then distributed in 25 percent increments every quarter. “I think [an open-ended or drawdown fund] is more of an investor’s preference rather than [reflecting] any difference in the underlying investments,” says Dan Simmons, a Hong Kong-based partner at OCP Asia. “Some investors prefer having a shorter liquidity structure, which gives them more flexibility in terms of managing their own capital and has the benefit of investing 100 percent of the capital upfront.
“Under a drawdown structure it generally takes some time to fully invest the fund, while it takes a long time to deploy an open-ended fund only at its outset.” He emphasises that OCP Asia does not consider the Orchard Landmark Fund, launched in 2013, to be permanent capital.
Steve Nesbitt, chief executive of LP consultant Cliffwater, believes permanent capital is particularly well suited for retail investors, wealthy individuals and smaller institutions. The firm recently held a close on $135 million for its Cliffwater Corporate Lending Fund, which will partner with credit managers from across corporate middle-market lending; this will involve first- and second-lien loans, and lower to upper mid-market, private equity-backed and non-private equity-backed lending. “Convenience is a big part of it,” he says. “This is particularly true with the investor group we are seeking. [In drawdown funds], the unpredictable timing and level of capital calls and distributions can upset the LPs’ desire to stay true to asset allocation targets, not to mention the administrative stress. With a permanent vehicle, you make the desired capital allocation and it stays there.”
Advance of the hybrid
Nesbitt says drawdown funds remain preferable for some institutional investors, such as large public pension plans that have the size and ability to monitor these vehicles. LPs with large investment and administrative teams can oversee the 100-plus funds that generally comprise a diversified portfolio of private assets.
For smaller investors without those resources, Nesbitt believes permanent vehicles make sense.
“[Those large institutional investors] who have the resources will likely continue to prefer the traditional GP-LP structure because it gives them flexibility on terms,” he says. “It is really a trade-off between the convenience of permanent vehicles versus the governance of private funds.”
Pepper Hamilton’s Corelli says permanent-capital vehicles are a good fit for family offices. “They have the ability to stay in as long as the allocation to that area works [in their portfolio],” she says. “To preserve the ability to get out when they want to, they’ll pay close attention to the liquidity provisions. Every permanent-capital or evergreen vehicle has provisions which enable liquidity for the investor.”
Corelli says family offices have become “much more sophisticated” in recent years: “Even smaller family offices now have a CIO who has seen permanent-capital vehicles and is comfortable with them. Families even use permanent-capital vehicles as platforms to help manage some of the dynamics between family members.”
One credit manager found that permanent-capital vehicles have presented LPs with a tough question: where to put permanent capital in their portfolios. Permanent capital does not have the drawdown structure that private equity and private credit funds operate, but nor does it have the relative security of blue-chip corporate bonds.
Where it has found a home for many investors is as a private equity beta play. Alternative credit permanent-capital vehicles do not have the equity upside potential of buyout funds. However, they do have high floors, which mitigates the all-or-nothing risks that come with buyout investments.
Interval funds are another source of finance that some regard as permanent capital. Most are non-traded, though there are a few public funds. According to Interval Fund Tracker, the net assets held in such vehicles rose from $12.5 billion at the end of 2016 to $27.3 billion as of 31 March.
Credit-focused vehicles account for 26 percent of the latter figure, while 27 percent is invested in real estate and 26 percent comprise derivatives and insurance-linked securities. The remainder is mostly invested in other strategies, including equity, infrastructure and agriculture. However, the share of interval-fund AUM dedicated to credit is set to grow, as more than half the interval funds in the registration process with the SEC are credit-focused vehicles.
Interval funds have been capturing the interest of investors for some time. CION Investment Group teamed up with Ares Management to launch an interval credit fund in 2016. Michael Reisner, co-chairman and co-chief executive at CION, told PDI in 2017 that interval funds provide retail investors with access to new assets that have traditionally only been available to institutions: “With the redemption features, interval funds are perfect for investment managers, which have traditionally focused on illiquid investments, to bring their products out to retail investors in a ’40 Act wrapper.” Reisner was referring to the US Investment Company Act of 1940, under which all interval funds, and BDCs, have to register.
Other large financial houses have joined the fray. In November 2017, The Carlyle Group and OppenheimerFunds announced a joint venture, the OFI Carlyle Private Credit Fund, to target private credit and retail investors. Managers large and small have joined the quest for permanent capital that has permeated the alternative asset space. The grail may soon be within their grasp.
By Andrew Hedlund, with additional reporting from Andy Thomson, Adalla Kim and Rebecca Szkutak
Interval funds shop for retail investors
Options are growing for those wanting liquidity and investment opportunities beyond those offered by BDCs.
Interval funds are a growing strategy for credit managers looking to increase their retail investor base.
These evergreen vehicles offer liquidity at set intervals, which can range from monthly to semi-annually. They invest in a mix of liquid and illiquid credit strategies, which means they can offer liquidity while garnering higher returns from the illiquid holdings.
These vehicles can draw a more traditional investor base, but are also able to tap into a larger pool. This includes retail investors, which have been a growing focus among debt shops.
“Investors are looking to diversify their portfolios away from traditional investments,” says Daniel Picard, FS Investments’ head of product development. “Interval funds are a way to capture some of the illiquidity premium while still having some certainty on the liquidity schedule.”
FS currently offers multiple interval funds in addition to its private and public BDCs. Picard adds that the firm’s interval funds are structured more like closed-ended funds than its BDC products.
The vehicles have more longevity than standard closed-ended products and fall under the same regulations as permanent-capital vehicles such as BDCs. However, there is a debate over whether they should be considered sources of permanent capital.
“While both BDCs and interval funds provide investors access to the illiquidity premium, a BDC is typically designed as a means of accessing private companies,” says Picard. “An interval fund allows for more flexibility in the investment strategy.”
Meghan Neenan, a managing director of financial institutions at Fitch Ratings, says the flexible mandates within interval funds can give retail investors exposure to sectors they would not otherwise be able to access.
“BDCs are limited in what they can invest in,” she says. “Seventy percent [of investments] have to be in qualified assets, which are generally loans to mid-market companies. Interval funds have a broader mandate, which may include CLOs, European direct lending and real estate.”
Neenan envisages the strategy growing while fund managers continue in their efforts to attract retail investors.
“Retail investors in general are interested in getting more exposure to alternative asset classes that they historically couldn’t buy on their own,” she says. “It gives them the opportunity to have a higher potential return exposure.”
How short-term capital can destroy a relationship
The focus of private debt has been on the sponsored market, but if lower returns drive GPs to non-sponsored opportunities demand for longer-term vehicles should grow.
With sponsored deals currently accounting for around 80 percent of the market in Europe, the need for long-term relationships between borrowers and lenders is arguably limited. However, as the sponsored market becomes increasingly competitive and returns are driven down, more fund managers are turning their attention to the non-sponsored market.
Dealing directly with a business, rather than through the effective intermediary of a sponsor, is akin to traditional bank lending. Long-term relationships matter in this type of lending, and questions are therefore being raised about the appropriateness of the typical closed-ended fund, with its eight- to 10-year lifespan, given that borrowers may be expecting support over a longer period.
“Relationships matter a lot more [in the non-sponsored market],” says Pietro Nicholls, a principal in investment management at RM Funds. “It’s a very different dynamic in terms of how you interact with the business, and permanent capital is well suited to it.”
The Edinburgh-based fund manager invests across alternative asset classes. In 2016 it launched an investment trust, listed on the London Stock Exchange, which it is using to build up a portfolio of debt investments. Listed vehicles such as this are rare in private debt, but the firm believes they have obvious advantages for investors keen on retaining some element of liquidity.
“A listed vehicle puts no pressure on the investor,” says James Robson, the firm’s chief investment officer. “If they decide that they don’t like the manager or strategy anymore, then they can get out at the given share price that day.”
Thus far, most listed vehicles in the private debt space have focused on niches such as infrastructure or peer-to-peer lending. Institutions such as pension funds have tended to direct most of the capital they have earmarked for debt investments towards private rather than publicly listed funds. However, as the asset class matures, listed options may become more widespread.
Europe edges towards evergreen
LPs in Europe have shown support for permanent capital by backing US BDCs. Options in the old continent are more limited but growing.
For European investors targeting long-term private debt exposure, looking to the US BDC market has been the obvious solution. In some ways, BDCs are a better bet than traditional funds as they are more tax-efficient. However, this advantage is at least partially offset by the high fees charged for what are essentially products aimed at retail investors.
In Europe, the options for investors seeking longer-term exposure than that provided by traditional closed-ended private equity-type structures are somewhat limited. However, as private debt grows and matures as an asset class in the continent, some evergreen vehicles are popping up. Rather than primary funds, these are typically in the form of separately managed accounts and segregated mandates that invest alongside closed-ended funds.
Abhik Das, head of private debt at Munich-based fund-of-funds manager Golding Capital Partners, sees benefits in such arrangements. “Pension funds often want to deploy capital at a steady pace and to keep their exposures stable rather than having large distributions and drawdowns,” he says. “From the asset managers’ viewpoint, it gives them more permanent investing firepower and means they don’t fall victim to the fundraising cycle, and the possibility of windows opening up where they’re short of capital.”
There is also the possibility, he adds, that assets and portfolios may shift between managers with greater regularity as the currently fledgling secondaries market develops further.