The rapid rise of evergreen and openend private market vehicles has been celebrated as a breakthrough for defined contribution (DC) investors. Reduced J-curve effects, immediate diversification, simpler cashflow management and a smoother member experience are all compelling benefits. However, in the race to solve implementation challenges, investors risk overlooking a more fundamental question: what behaviour does this fund structure incentivise?
Today, in order to ramp-up quickly and access a diversified portfolio, most LTAFs look to allocate to a limited range of GPs, typically into open-end evergreen structures. But the jury is out on whether these are the right risks to focus on for the long term, given the incentives this creates.
For decades, institutional private markets were built around closed-end partnerships and these still represent 80% of private funds open to investment today. While we have seen significant growth of evergreen structures, they remain relatively new to GPs, with DC investors placing an operational burden on their often-untested platforms.
Historically, capital was raised, deployed, grown and ultimately realised via closed-end structures. The model is simple but powerful because the incentives are clear. GPs succeed by buying assets well, improving them operationally and exiting them at attractive valuations. Performance fees and future fundraising depend on demonstrating realised value creation – rather than simply maintaining assets under management with untested valuations. Every investment has a beginning, a middle and, critically, an end.
The discipline of having to return capital creates urgency around capital allocation, operational improvement and exit timing.
Getting value back matters
Private market assets are often described as long-term investments, but successful private equity strategies are not ‘buy and hold’. They are ‘buy, improve and sell’. The discipline of having to return capital creates urgency around capital allocation, operational improvement and exit timing. It forces managers to continually reassess whether an asset remains the best use of capital, by deploying into the most attractive opportunities and exiting after the strategy has added value.
In many respects, the finite life of a closed-end fund is not a burden requiring greater programme management. It is one of its greatest strengths. Indeed, with 95% of private asset funds charging a performance fee, mostly driven from their internal rate of return (IRR), closed-end structures create the right incentives to return the best outcome back to investors, by managing the portfolio dynamically.
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Closed-end structures, of course, bring well-known challenges for DC schemes. The J-curve creates negative early cashflows, deployment is dependent on vintage timing and investors must manage both capital calls and distributions. Outcomes can vary materially depending on market conditions during the investment period, making vintage diversification essential and necessitating a more complex and diversified implementation programme with the right resources and skills wrapped around it.
This is why open-end structures have gained traction; they are simpler to scale quickly on ramp-up and require less programme management, albeit with more oversight. By combining mature assets with new investments, evergreen funds can significantly reduce J-curve drag while providing immediate diversification across vintages and underlying holdings. This offers a more diversified and easier ramp-up – but these benefits come with an important trade-off.
Evergreen manager incentives
Evergreen funds have no fund termination date, no requirement to crystallise gains within a prescribed timeframe and often no equivalent fundraising event that tests whether value creation has genuinely been delivered. Capital is continuously recycled and assets can remain within the portfolio for extended periods. While this creates operational flexibility, it also raises a legitimate question: what incentivises the evergreen manager to sell an asset? It would create more work, in selling the asset and finding a new opportunity.
This question is particularly relevant today. Private market returns have historically been driven not only by manager selection, but by dynamic capital deployment through different market cycles. Some of the strongest vintages emerge following periods of stress, when capital scarcity creates attractive entry points. Equally, successful exits often depend on managers being willing and able to sell assets when valuations become stretched.
The irony is that the features viewed as the weaknesses of closed-end funds may actually be the source of some of their strengths.
Additionally, evergreen structures weaken the link between performance and true value being returned via realised exits. They also introduce risks to ensuring manager economics support dynamism, a key source of returns that the investment case is built on.
For DC investors, therefore, the debate should move beyond liquidity and speed of deployment. The real challenge is assessing whether an open-end vehicle can replicate the alignment mechanisms that have historically underpinned private market returns, which can depend on incentives, asset class dynamics and the nuanced sectoral opportunities offered by specialist GPs.
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The irony is that the features viewed as the weaknesses of closed-end funds may actually be the source of some of their strengths. The J-curve is inconvenient, but it reflects a manager actively deploying capital into new opportunities. Fund expiry is operationally cumbersome, but it creates accountability around realisation. Vintage risk introduces uncertainty, but it also allows managers to exploit changing market conditions rather than perpetually owning a static portfolio.
For professional DC investors, the correct conclusion is not that one structure is superior. Rather, each structure solves a different problem: is the objective dynamic longer-term outcomes or shorter-term risk management? This obviously drives a slightly different answer across the DC glidepath, and it is certainly an issue that places emphasis on skills, governance and resources. But, as things stand today, I would certainly argue we may be placing too much emphasis on liquidity and evergreen structures.
James Monk is the Fidelity International Investment Director for FutureWise