By Steven Novakovic, Managing Director of Educational Programs, CAIA Association
Allocating capital is all about optimization. In theory, we can optimize in an unconstrained world, but in practice we all invest in a constrained world. Constraints can be exogenous, such as regulatory constraints, or prudently self-imposed, such as liquidity constraints. For every real world constraint that is imposed, investors move further away from the theoretical maximal optimization. So it is within these constraints that investors seek optimization.
While it may seem obvious to say, it is worth stating that removing (unnecessary) constraints leads to improved outcomes. One great illustration of unnecessary constraints comes from the contrast of TPA and SAA. Traditionally, SAA is built on a foundation of buckets – stocks, bonds, real estate, private equity, etc. While TPA eschews buckets and evaluates investments through a different far less constraining lens. At times, allocators in the SAA world can get stuck on the question of “Where does this fit?” In some cases, that problem is resolved through a “special situations” bucket, or some other catch-all. But for SAA adherents that don’t have that luxury, they may pass on that multi-strategy fund because it doesn’t fit. Or the Private Equity director may skip out on a fund with too much real estate exposure at the same time as the Real Estate director says no to the same fund because there is too much private equity to it.
Unnecessary constraints such as these can get in the way of saying yes to a good investment and getting on step closer to that optimized portfolio. As such, another way to think about it is having more options and optionality available leads to fewer constraints and improved optimization. Note that having more options does not necessarily mean using those options. What is important is having the options.
One of the great developments over the last decade is the increase in options available to investors. Looking across the landscape, more investors are using tools like co-investments, or secondaries than ever before. Portfolios have emerging strategies like digital assets, and strategies once viewed as emerging, such as infrastructure, are now core. The expansion, and use, of these options resulted in more tools available in the LP toolkit to build an optimal portfolio.
The latest tool to come around is not new by any means and is actually commonplace in many institutional portfolios. That is, of course, evergreens. What is new, and unusual, is the new way in which evergreens are being used, specifically for private market investments. To many, this use serves as a solution to bridge the gap between institutional and retail. To support the democratization of alts. So it may be fair to ask, why a tool “designed” for retail investors would be relevant for institutions.
The answer? It is another option that can help remove unnecessary constraints. Consider the traditional private equity style drawdown fund. This structure is one built around constraints. To begin, the GP is constrained with a defined investment period. While there may be tangible benefits to this constraint, there are inherent and well-known conflicts. One such is the concern that if the investment period is nearing its end and there is still a meaningful amount of unfunded commitments, the GP may feel pressure to make an investment to put the money to work. Whereas, in an unconstrained world, that GP may have held off on making that investment.
Another constraint of the drawdown fund is the fixed life. In practice, it can feel like some drawdown funds live forever, but in theory the legal documents constrain the GP to begin liquidating investments within a pre-defined window of time.
Again, there are real tangible benefits to building a structure with a fixed operating period, and there are inherent and well-known conflicts. A fixed life may place pressure to unnecessarily sell an asset. It is kind of funny if you think about it. The model of investing in drawdown funds is one where LPs tell GPs to sell high quality businesses and send the capital back so the LPs can invest into a blind pool with the hope of owning another high quality business. When done well, LPs go from owning one company compounding at 20% per year to another company compounding at 20% per year.
Of course, this is a bit of an oversimplification, and not all companies compound at 20% per year. And there will be a time when it makes sense to exit an investment in pursuit of something better. But sometimes there is no reason to sell a business. Imagine telling Warren Buffett after 7 years of owning GEICO that he had to sell it. SpaceX took 24 years to go public and did so at a tremendous valuation. How much money would investors have left on the table if they were forced to sell their ownership in year 14?
These are constraints that don’t exist, or at least aren’t as strong, in evergreen funds. By definition evergreen funds invest in perpetuity. They can hold an asset as long as Warren Buffett! And they don’t have an artificial clock ticking telling them when they are no longer allowed to make new investments.
This isn’t to say that evergreen funds are better than other funds, it’s just to say they are different. And they offer a different set of options. And this set of options can reduce unnecessary constraints. And as an LP this should be a good thing. While private market evergreen funds may have taken hold thanks to retail investors, it is time for institutional investors to add this tool to their toolbox and take it out when they need to solve for an unnecessary constraint.
Read CAIA’s latest report on Evergreen Funds: The Window Narrows: Evergreen Funds and the Choice Before the Industry.
