McDermott Will & Schulte, a global law firm

The market is steadily acclimating to evergreen fund terms, and evergreen funds have been proven to appeal to sponsors and investors alike.

Private credit fund assets under management have grown more than tenfold over the past 15 years, with growth accelerating more recently as banks have moved away from middle market lending. The size of the asset class and the characteristics of the typical loan or private credit portfolio are driving interest in evergreen fund structures.

• Evergreen funds can raise capital perpetually. In contrast, closed-end funds – while widely used for lending and private credit investing – require an on-and-off cycle of fundraising and negotiations to raise successor funds.
• Investment proceeds, and sometimes income, are recycled perpetually for further investing until an investor elects to withdraw.
• The terms can be tailored to the sponsor’s asset focus. A sponsor does not have to settle for a structure that requires distributions by the end of a set term (as required by a closed-end fund), face the pressure of generating cash to pay withdrawal requests within 30 to 45 days (as required by a hedge fund), or attempt to market controversial liquidity controls such as side pockets or withdrawal gates (as seen in hedge funds).
• Investment guidelines are usually more flexible than in a closed-end fund. And investment strategies can evolve over time as market opportunities change.
• Investors are usually more receptive to a sponsor’s terms. When investors evaluate evergreen funds with terms tailored to match the asset characteristics and the sponsor’s investment objectives, they’re less likely to insist on “market” terms than they might with a closed-end or open-end fund.

• Control over investment duration. Evergreen funds have lockup periods, but when you compare these periods to the typical term of a closed-end fund, they are shorter. And when the lockup is shorter, investors tend to be less concerned about other fund terms and negotiate less.
• More predictable exit timing. Credit assets tend not to be long-term holdings. For example, loans tend to be refinanced in two to three years, there is a robust market for trading loans, and securitization is a popular exit strategy. That all means the length of the payout period after requesting a withdrawal is more predictable for investors (and usually limited to two to three years).
• Easier to upsize. Because an evergreen fund is diligenced for the initial investment, internal approvals to upsize may be quicker (as compared to securing an allocation for a successor fund, which requires its own due diligence, a new document review, and its own subscription agreement and side letter).

• Explain it up front and clearly. Evergreen funds are still new to the private funds market, and many investors do not understand how they work.
• Highlight the hybrid terms and your reason for choosing them at the outset. This will save time and confusion as you move through investor negotiations. The most important terms are:
  • Fundraising is perpetual (subsequent closings do not use a cost plus method)
  • Lockup period duration (shorter than a closed-end fund investment period)
  • Management fee basis (varies from hedge and private equity funds)
  • Incentive compensation basis (different from hedge funds and carried interest)
  • Withdrawal process (flexible but takes longer than hedge funds)
• Point out the sensible connection between the target asset class characteristics and the evergreen fund’s terms. There is no narrow range of “market” terms for evergreen funds. This is better for sponsors and investors than a traditional closed-end or open-end fund structure. Explaining the tailoring of terms up front can help due diligence and negotiations move smoothly.
• Ask the investor’s business team to give a heads-up to their counsel that the hybrid terms are acceptable. Without the up-front orientation, investor-side counsel often default to closed-end fund “market” terms, which can prolong document review and negotiation.
• Set liquidity expectations by explaining expected portfolio turnover. A key feature of evergreen funds is that investors can withdraw using a liquidating account: When assets are sold, the withdrawing investor gets its share of the proceeds. Investors might fear that not striking a withdrawal date net asset value means they will never get paid out. Providing portfolio turnover expectations can address this concern. Some evergreen funds have a “stub buyback option” or “cleanup call” to prevent a long-term holding of a fractional remaining interest, which can alleviate investor concerns about the payout period.
• Educate investors about the sponsor’s investment allocation policy and how the evergreen fund will get its share of investment opportunities. Most evergreen fund sponsors have multiple other investment products, such as closed-end funds, funds of one, managed accounts, CLOs, business development companies, and/or interval funds. Investors who typically invest in closed-end funds expect the fund to have exclusivity and/or priority to receive suitable investment opportunities. Depending on the sponsor’s other products, an evergreen fund may receive certain priority, but usually not absolute or perpetual priority.

Hybrid and customized evergreen fund terms are part of their appeal for sponsors and investors alike. As evergreen funds become more common in the private funds market, they should become more familiar to investors.