The evolution of open-ended funds

For fund manager or investor alike, the open-ended nature of these funds creates fundamental risks and benefits. With no termination date, investors have the right to pull their holding out of the fund – although when they are permitted to do so will vary – meaning managers must be ready to work around unexpected redemption requests.

But the open-ended structure also offers significant advantages, says Jamie Parish, a Partner in the finance group at legal firm Travers Smith. “You don’t have to go through the cycle of fundraising, setting everything up and going through all the legal documents again every few years,” he points out.

The fund may also appeal to a bigger pool of potential investors, because an open-ended structure is compatible with a wide range of investment time frames. But it is essential that issuers have given adequate attention to planning how the fund will be financed as market conditions change.

Riding out a storm

The right to redeem a holding in the fund on request can result in a liquidity mismatch if funds are invested in illiquid assets, leading to risks when market conditions suddenly change. The Bank of England and the Financial Conduct Authority (FCA) have therefore recommended a notice period of between 90 and 180 days before funds can be redeemed.

“The main challenge is how to balance the liquidity needs of investors (with) the illiquid assets they are purchasing,” says James Hamelin, Director for Institutional Banking Jersey, at RBS International. “We typically see this managed through insertion of a lock-up period, typically anywhere up to three years, which prohibits redemptions during that period. After this period, the manager may use controls around redemptions and cancellation of commitments, such as minimum notice periods or a limit on size.”

But in recent years, many of these funds have already survived systemic problems created by the Covid-19 pandemic and by uncertainty and disruption linked to other changes in the market.

“The pandemic has shone a spotlight on the redemption process and valuation methods,” says Hamelin. “With a fall in asset values, the amount of redemptions came under scrutiny to see whether we would see a repeat of the suspension of redemptions witnessed after the 2008 financial crisis and the 2016 EU referendum.

“As it turned out, we did not see as much pressure this time around. As we recover from the pandemic, scrutiny will continue on the pricing element, to ensure that investors are treated fairly and valuation methods are transparent.”

Despite the pandemic, new open-ended funds were also launched successfully during the first half of 2020. For example, NREP launched an open-ended real estate fund – NREP Income+ (NIP) – during this period, to invest in modern logistics facilities, middle-income residential property, offices and care homes.

“The pandemic didn’t have that much of an impact on our fundraising,” says NREP Partner Alfred Eklöf. “On the investment side, the segment and strategy mix we had defined for our fund actually benefited from the shifts in allocations of capital that were happening.”

As we recover from the pandemic, other considerations are now influencing strategy. “The big question is where inflation is heading,” says Eklöf. “But our fund provides a hedge to inflation, as rental income is linked to inflation. I think a lot of investors will find these funds appealing.”

Opening up opportunities

What does the future hold for this part of the investment landscape?

One key trend visible at present is the influence of the environment, social and governance (ESG) agenda. “With a continued focus and emphasis on ESG, we may find that managers look to hold assets longer than they typically would have done, in order to make the improvements needed,” says Hamelin. “This may sway managers into considering an open-ended structure.”

Eklöf says the impact of ESG on open-ended funds is already visible. “There has been a dramatic change in our conversations with investors,” he says. “Unless you can show that ESG is an integral part of your strategy and decision-making, then over time you will struggle to raise funds.”

“As a lender, you need to get comfortable with a fluid investor base. It is important to understand how investor queues operate; and to ensure there are suitable concentration controls in place to mitigate against reliance on a small number of investors.”

James Hamelin, Director for Institutional Banking Jersey, RBS International

Overall, the current outlook for open-ended funds is positive. “Those managers with a track record of launching value-add/opportunistic closed-ended funds are now launching core or core-plus open-ended funds,” says Hamelin. “This diversification is providing additional capital and driving up competition further for core and core-plus assets.”

He adds that in October 2021, venture capital firm Sequoia Capital announced it would consolidate all future investments through an open-ended fund structure: “It will be fascinating to see whether others follow.”

Open-ended funds: best practice

New trends and the nature of the broader financial landscape may reshape the market over the next few years, but the fundamental steps that issuers need to take when setting up a new open-ended fund and seeking to reassure lenders and attract investors will remain unchanged.

The process of financing an open-ended fund is substantially similar to that of creating a subscription facility to be used for a traditional closed-ended fund: credit analysis of investors and legal due diligence of fund documentation are both crucial. But there are some nuances in the process that are specific to open-ended funds. Lenders will want to understand how investors commit capital to the fund and the circumstances under which they can exit; and they will want to understand what the manager’s strategy will be for raising further investor capital once the fund has reached a certain size.

Parish highlights the need to manage the process of bringing new investors into the fund. “You need a commitment queue: investors who have made a legally binding commitment but sit in a queue until it’s their turn to deploy capital,” he says. “Some thought has to go into how that works.”

Parish notes that lenders will be reassured if the fund manager has flexibility under the terms of the fund documentation so that the next call on capital does not have to be from the group of investors who happen to be next in the queue. “That gives subscription facility lenders a lot of comfort,” he says. “That helps to make fund documentation more bankable.”

More generally, Parish suggests that closer and more effective co-operation between fund managers and lenders will help to improve their relationship and operation of the facility, given that the manager is in continuous fundraising mode with new investors coming into the fund; and the manager will want the lender to approve investors for inclusion in the borrowing base for the facility.

Issues linked to redemption, lock-up periods and commitment queues are also important to lenders working with the fund, says Hamelin. “The big difference with an open-ended fund is the need to consider how secure those investor commitments are,” he says. “How and when can investors redeem, what are the cancellation of uncalled capital mechanics, is there a lock-up period?

“As a lender, you also need to get comfortable with a fluid investor base. It is important to understand how investor queues operate; and to ensure there are suitable concentration controls in place to mitigate against reliance on a small number of investors.

“Post the typical lock-up period, you then also need to be comfortable with the strategy of the fund; you then need to start taking a view on the assets, as the facility may shift more towards a NAV line as the fund matures.”

In the end, says Parish, the prospects for open-ended funds in general will be determined by investors’ strategies. “They’re not going to replace closed-ended funds,” he says. “But where you’ve got strategies based on infrastructure and real estate that are likely to profit from running yields, then these things are going to be popular.”