A different problem lurks for the more staid perpetual vehicles with a heavy dose of secondary investments. The booming private aftermarket includes stakes in other managers’ funds and slices of so-called continuation vehicles, where buyout barons effectively sell assets to themselves. These deals typically carry a discount of, say, 10% to net asset value. The issue is that accounting rules allow perpetual funds to write the investment back up to face value immediately. Morningstar analysts wrote last year that semi-liquid manager Cliffwater had credited over a fifth of all the returns on its Cascade Private Capital Fund to these “day-one” gains, and noted that it was by no means the worst offender. The practice, which Apollo Global Management APO.N CEO Marc Rowan has said makes “no sense,” can flatter the early performance of evergreens, raising the risk of investor disappointment down the line.
Costs are another issue. Many evergreen managers take a performance fee of between 10% and 15%, sometimes in cash. This is troubling because the performance of perpetual vehicles is generally based on unrealized valuations. BXPE and some other funds have a range of clawback-style mechanisms to mitigate the mismatch, but they don’t get around the risk of a manager rewarding itself with handsome cash payouts based on paper gains, only for returns to deteriorate in future years. A better model comes from KKR, which has used locked-up shares in the evergreen vehicle as the currency for performance fees.
The overall impression, then, is of an industry that is still figuring itself out. Perhaps the biggest question is what happens when investors head for the exits. The equity evergreens often have financial penalties or other restrictions discouraging holders from cashing out after just a year or two. Still, the underlying buyout assets are less liquid than short-term loans. And there’s an unhelpful pro-cyclical dynamic: the money comes in fastest when markets are hot, which is often the worst time to invest. Outflows are most likely in a crisis, when bargains abound. Just as with old-fashioned inventions, experimentation might involve a few blowups.
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