Key takeaways:

• In the last several years, individual investors have increasingly embraced semi-liquid evergreen funds to access alternative investments. A shift can also be seen in the institutional market and with family offices.
• With no drawdown period, evergreen funds provide immediate access to a diversified portfolio and may have the ability to provide some liquidity in a traditionally illiquid asset class.¹

Overview
With more than 99% of the 33 million businesses² in the U.S. being privately held, institutional investors have long used private equity (PE) as a means to tap into this vast ecosystem of private companies. The reason is clear: returns from private equity have consistently ranked among the highest of any asset class on a 5-, 10-, 15- and 20-year basis.

However, that attractive performance historically has been difficult to access by investors other than large institutions. For example, in a traditional PE vehicle, investors must commit to funding high dollar amounts, often exceeding $5 million, which are paid in over time as and when fund managers find companies to acquire. These are known as draw-down funds and are best suited for large investors given the significant amounts and unpredictable timing of the capital required. The payback of capital is also unpredictable. A PE fund can go many years before selling its holdings and returning principal and gains to its investors.  Until then, investor capital is locked up with few means of realizing value.

Industry Innovation Creates Broader Access to Private Equity
Over the last few years, asset managers have developed new fund structures to address these issues. In the process, they have made private markets available to a broader range of investors, including the individual investor. These funds tend to offer some of the same benefits as drawdown funds—diversification³ and attractive returns—but with easier access through immediate exposure to a diversified portfolio of companies, lower investment minimums, periodic liquidity, simplified tax reporting and no ongoing capital calls. Individuals with as little as $25,000 to invest now have an opportunity to take advantage of institutional products overseen by experienced managers and investment teams in an investor-friendly structure.

Individual investors are increasingly embracing these innovative new structures, which have become one of the fastest-growing segments of the asset management industry. In the U.S. alone, net assets under management totaled $381 billion across 351 semi-liquid evergreen funds as of Q3 2024, with more than half of these funds having been launched just in the last four years (Display 3).⁴

Throughout this rapid growth, managers and investors have gravitated more toward income strategies such as real estate and private credit, while allocations to semi-liquid evergreen funds offering access to private equity remain in their early stages. As confidence in the semi-liquid structure and investor education on the benefits of private company investing increase, allocations to private equity are likely to grow. This can be seen when considering the 43% that institutional investors have allocated to PE in traditional funds versus the 15% allocated so far to semi-liquid evergreen funds (Displays 4 and 5).

Individuals should educate themselves on these products before investing. Semi-liquid is different than liquid, and liquidity is not guaranteed during times of market stress. Moreover, the cash held in these funds to support a liquidity mechanism can dampen overall returns when compared to drawdown funds, which are unencumbered by periodic tender offerings.

How Traditional Drawdown Funds Work
For a PE fund using the traditional drawdown structure, committed capital is staged in over time to fund individual company investments as and when they occur (the investment stage). As shown in the hypothetical example below (Display 7), full deployment does not occur until year four. The cumulative value of those investments then shifts upward, setting up the “harvest stage.” This is when a fund attempts to sell down its holdings, returning originally invested capital plus gains through cash distributions. Display 8, also hypothetical, shows total distributions of 1.74x for each dollar invested, although in fact, a much lower 0.47x was invested over the 13-year life of the fund (average invested value).

How Semi-Liquid Evergreen Funds Work
Like a traditional PE fund, an evergreen fund pools capital from multiple investors to invest in a diversified portfolio of private companies.⁵ However, unlike closed-end vehicles, evergreen funds remain open perpetually, raising new capital for future investments without time-sensitive closes or a drawdown structure.

Investors in evergreen funds gain immediate access to a fully deployed portfolio of private equity holdings so that client assets are always fully invested. When a PE manager exits a position through a realization, capital is automatically recycled into new deals, creating a perpetual investment cycle without the need for additional outside capital to be raised. Evergreen funds may generate returns as soon as an investor commits to the fund and are structured in such a way to allow for periodic redemptions, typically every three months and up to 5% of the fund’s net assets – thus, the term “semi-liquid.”

The Power of Compounding
Fully funded from the start, an evergreen fund provides immediate exposure to a diversified PE portfolio, resulting in a compounding effect that can grow committed capital more significantly than a drawdown fund at equal rates of return.⁶

Displays 8 and 9 illustrate the different outcomes from an evergreen fund with a 12% compound annual return (CAGR) and a drawdown fund with a 12% internal rate of return (IRR). The former grows to 3.7x on a higher upfront and continuously invested value, whereas the latter returns 1.74x, albeit on a much smaller initial contribution (0.25x) and average invested value (0.47x). Because an IRR incorporates time value of money and distributions received by investors start sooner while contributions end later in a drawdown fund, the two have identical 12% rates of return. For an evergreen fund paying out the same 1.74x in total distributions, the CAGR would need to be only 5% (Display 10), suggesting that a well-performing evergreen fund can do more with less. That is before considering the timing of cash flows and lower invested balances, however.

An additional benefit of evergreen versus drawdown is that it removes the need for complex liquidity management. Investors in drawdown funds must rely on unpredictable assumptions to plan for cash outflows and inflows associated with acquiring and then disposing of assets over a multiyear timeframe. In evergreen funds, investor capital is fully drawn up front with subsequent sales from asset dispositions fully reinvested.

Tax Considerations⁷
From a tax standpoint, a traditional drawdown fund can impose a greater maintenance burden on an individual due to their limited partnership structure. Limited partnerships generate a Form K-1 for tax reporting purposes, which can delay or complicate the filing process for individuals. Like mutual funds, most evergreen funds are organized as investment companies and generate a Form 1099 which is more standard and easily handled for tax preparation purposes.

Operational Considerations
Lastly, for investors seeking to maintain a consistent allocation to private markets, evergreen funds streamline the operational process of toggling between private markets, public markets, and cash. An institutional investor in a drawdown fund typically experiences an average uninvested capital balance that is significant relative to their formal commitment to such fund (Display 11). This is because much of the committed capital initially goes unused and later, once the PE fund starts selling assets, distributions to the investor are not typically recycled. As shown in Display 12, an investor in an evergreen fund, on the other hand, funds the entirety of their capital commitment upon subscribing to the fund and, for the duration of their commitment, maintains continuous exposure to PE assets outside of a required liquidity sleeve that is maintained by the evergreen fund manager, as discussed further below. Moreover, a well-constructed private markets portfolio can be diversified by vintage, manager and asset class (private equity, private debt, etc.). As a capital management tool, an evergreen fund provides an easier way for individual investors and their advisors to achieve this diversification without allocating to multiple funds.⁸

In summary, semi-liquid evergreen PE vehicles allow individual investors to potentially gain access to many of the benefits of private equity investing with a better user experience.

The Capabilities Involved in Managing an Evergreen Fund
One of the consequences of accepting investor capital upfront and maintaining an ability to meet periodic redemption requests is that a portion of the evergreen portfolio is typically held in more liquid investments, including cash and cash equivalents, versus what is actively deployed to investments in private portfolio companies. This so-called liquidity sleeve can become a drag on returns if improperly managed. During normal market conditions, the liquidity sleeve holdings can range between 10% and 20% of an evergreen fund’s portfolio.

For an experienced manager with capabilities to match, several strategies can be employed simultaneously to maintain continuous exposure to private equity assets over and above the liquidity sleeve, especially in an evergreen fund’s early life.  These strategies can include, but are not limited to:

• As a co-investor in businesses sourced by other managers
• As a buyer of pre-owned private equity fund assets in GP-led secondary offerings
• As a buyer of pre-owned private equity fund interests in LP-led secondary offerings
• As a buyer of new private equity fund interests in a primary offering
• As a direct investor in businesses sourced by the management team
   

Co-investment: Involves acquiring interests in individual companies as opposed to diversified funds. These transactions are sourced by other managers where, on larger deals especially, a manager may invite a small group of select investors to make a significant investment alongside its own fund. This has become more commonplace now that higher equity contributions are stipulated by debt investors. In this structure, the co-investor is often able to participate in the deal without paying any fees to the underlying manager.

GP-led secondary: Describes an offering that is initiated by an unaffiliated PE manager, or GP. In GP-led transactions, the unaffiliated GP identifies one or several assets to extract from one of their existing PE funds for the purposes of extending their investment duration and potentially raising new capital. The offer is backed by a new set of investors (i.e., secondary buyers) and allows existing limited partners in such GP’s PE fund to either opt in or out of the cash being offered for their interest. As with an LP-led secondary, the offer can be at a discount to the estimate of unrealized value, or net asset value (NAV), for the asset(s) involved.

Evergreen benefit: Co-investments and GP-led secondaries are less diversified and more concentrated strategies which can add significant alpha to evergreen fund performance when executed properly.⁹ These strategies source deal flow from third-party unaffiliated PE managers to enable continuous deployment at scale. Having a robust and high-quality network of such PE managers is key.

Secondary acquisitions of LP fund interests: This strategy involves acquiring interests in one or more PE fund(s) from one or more existing limited partners needing liquidity before it naturally arises. Acquired interests can be in closed-end funds that have completed the investment phase and are therefore fully deployed, allowing an evergreen fund manager to diligence the underlying holdings. By entering a fund midstream, certain holdings may be closer to realization, potentially resulting in a shorter hold period and faster liquidity for the new evergreen owner than the typical investor experience in drawdown private equity. Lastly, because these interests are often sold at a discount to their NAV, the potential exists for additional appreciation assuming, of course, that an NAV estimate is accurate and does not decline from that point forward. There is no formal exchange nor active market for secondary interests in funds, and managers must source and negotiate each transaction individually.

Evergreen benefit: The inclusion of an LP secondaries strategy allows evergreen managers to minimize cash drag and achieve immediate diversification while continuously deploying capital. A skilled manager can diversify acquired interests by fund vintage, manager, portfolio holdings, sector weight and geography, among other important considerations.¹⁰ In addition, secondaries can yield higher cash flows sooner given the more mature nature of acquired fund interests, helping with semi-liquidity management.

Primary offerings of fund interests: This strategy involves acquiring interests in newly formed private equity funds when first offered. Like IPOs in public markets, disproportionate value can be created and gained by initial investors, and the same principle applies to private markets. These fund interests are acquired before any investments are made. The most sought-after primary funds and best-performing GPs are often oversubscribed and limited to large institutions only. A large evergreen manager may also be able to access those exclusive offerings and identify the better managers.

Evergreen benefit: Though not as immediate as with secondaries, a primary funds strategy allows an evergreen manager to invest at scale and in a more diversified manner, especially when combined with other primary or secondary fund interests.¹¹ A typical buyout fund will acquire ten or more private companies during the investment period following a primary offering’s closing. Cash flows may take longer to develop but growth in principal can be significantly higher. As the evergreen manager is relying on careful GP selection to create that excess return, prior experience in evaluating managers is key.

Direct investment: An evergreen manager can source, transact and manage individual private assets on its own without any third-party reliance. As with co-investing, direct investing may add alpha to an evergreen fund portfolio but only if a manager has an established track record of independently and directly acquiring, managing and exiting private companies.

Evergreen benefit: Because it is the least scalable of available strategies, a manager is unlikely to concentrate on a direct investing approach during an evergreen fund’s early life. Further out, it can be a powerful tool for avoiding potentially diluted returns and overdiversification resulting from an excessive amount of acquired fund interests.

Partnering with an experienced evergreen manager with a demonstrated track record and a deep and broad pipeline of potential investment opportunities is critical for semi-liquid fund performance. Investors should also seek products that align fee structures with manager incentives for cash management and capital deployment.¹²

Building a Robust PE Allocation
Portfolio construction is a personal choice; investors do not have to pick between drawdown and evergreen PE structures. Combining the two may produce better returns while decreasing reinvestment and diversification risk.¹³ An evergreen vehicle can also serve as a capital management tool. Proceeds from a drawdown fund can be quickly reinvested into an evergreen fund, thereby maintaining a desired target PE allocation. Moreover, investors may choose to maintain a baseline level of diversified exposure to PE through investment in an evergreen fund while making periodic investments into niche sector-, region- and company stage-specific drawdown funds.

Conclusion
Sophisticated large institutions often evolve away from investment portfolios that consist exclusively of public assets to programs incorporating private markets to reduce volatility and add excess return. This same opportunity is now available to individual investors through the introduction of the semi-liquid evergreen fund structure, with private equity only recently becoming a more widespread option relative to private credit and real estate. Private markets have become a staple of large professionally managed portfolios and now individual investors may create those same allocations with less operational hassle, smaller investment minimums, and optimal diversification by using semi-liquid evergreen funds.¹⁴

¹ Diversification does not eliminate risk.
² Source: U.S. Business Administration.
³ Diversification does not eliminate the risk of loss.
⁴ PitchBook, as of September 30, 2024.
⁵ Diversification does not eliminate the risk of loss.
⁶ Diversification does not eliminate the risk of loss.
⁷ Morgan Stanley does not provide tax advice. The taxation of partners and partnerships is extremely complex. Each prospective investor is urged to consult its own tax advisor as to the tax consequences of an investment in a Partnership. Prospective investors should note that the tax treatment of each investor depends on such investor’s individual circumstances and that the tax treatment of any investor, as well as the tax treatment of the funds, may be subject to change in the future.
⁸ Diversification does not eliminate the risk of loss.
⁹ Diversification does not eliminate the risk of loss.
¹⁰ Diversification does not eliminate the risk of loss.
¹¹ Diversification does not eliminate the risk of loss.
¹² Past performance is not indicative of future results.
¹³ Diversification does not eliminate the risk of loss.
¹⁴ Diversification does not eliminate the risk of loss.