Permanent capital: A bridge too far?

Serendipity Capital was established in Singapore in 2020 to build a concentrated portfolio around key disruptive themes in financial services. Six investments have been completed to date – there will be no more than 15 in total – generating a 75.4% IRR and a 2.2x multiple. The portfolio, now valued at nearly USD 500m, functions as a permanent capital vehicle.

“This model suits people with a focused investment strategy. Building out financial services is a long-term endeavour. The industry is by nature cyclical – it’s a leveraged bet on a macroeconomic story,” said Rob Jesudason, Serendipity’s CEO and one of three founders who come from financial services backgrounds. Most shareholders in the company have a similar heritage.

“The problem with funds is you must deploy immediately and in the last two years, you are incentivised to exit your best assets. For early-stage investments, even 7-8 years can be a relatively short time and we don’t want to be a forced divester.”

The notion of holding top-performing assets for extended periods, even in perpetuity, rather than being governed by fund timelines is broadly appealing in private equity, yet difficult to execute. Most institutional LPs are so conditioned to traditional structures and terms that managers suggesting a departure from the norm must sell the concept as well as their own investment narrative.

Permanent capital also triggers concerns about long-term alignment, liquidity, and ease of exit, which means it remains at the margins of the industry. The strategy is pursued by some smaller sector specialists and VCs, and it is increasingly embraced by global firms for strategic reasons, but there is precious little in between. Few people envisage much near-term change, in Asia or globally.

“When open-ended PE funds emerged, they were seen as the Holy Grail, but the reality is that they are complex and difficult to structure. We haven’t seen many versions of them,” said Justin Dolling, a partner at Kirkland & Ellis. “In 2015-2017, when global sponsors put together long-dated funds and everyone said, ‘This is going to be the big change.’ Those funds still exist, but it’s not like we are seeing all sponsors raising long-dated funds.”

Perpetual and long-dated capital pools continue to grow within the large listed multi-strategy private equity firms. The Blackstone Group’s perpetual assets – mostly in real estate, credit, and insurance – rose 132% year-on-year in 2021 to reach USD 313.4bn out of USD 880.9bn in total assets under management (AUM). Nearly 60% of Apollo Global Management’s USD 497.6bn in AUM is perpetual.

In private markets alone, The Carlyle Group has raised two long-dated funds, while KKR has USD 37.6bn in its core investments strategy, which targets stable businesses with a longer holding period and a lower risk profile than traditional private equity deals. It has made two investments in Australia: snack foods producer The Arnott’s Group and cancer care clinic operator GenesisCare.

These strategies are described as the product of relationships with institutional players – such as sovereign wealth funds – that have long-dated investment horizons and want to write big cheques.

David York, a managing director at VC fund-of-funds Top Tier Capital Partners, makes the same observation of Sequoia Capital’s new approach to the US and Europe (Asia is excluded), billed as a move towards permanent capital. “Some investors want to write USD 500bn to USD 1trn cheques – it’s risen so they keep their pro rata – and they want to put money to work forever,” he said.

Sequoia steps up

Last year, Sequoia revealed that LPs would no longer invest directly into traditional closed-end funds. Rather, they will commit capital to an open-ended liquid portfolio of positions in select companies that the firm has backed through IPO. It will become the sole LP in future closed-end venture sub-funds, with the proceeds of these investments flowing back into the open-ended portfolio.

Roelof Botha, a partner at Sequoia, observed that the new structure “removes all artificial time horizons on how long we can partner with companies.” There will be no forced exits for expiry of fund life reasons, so public shares can be held long after IPO. He cited the example of Square, which had a market capitalisation of USD 2.9bn when it listed in 2015 and hit USD 86bn five years later.

The strategy touches on a common LP pain point. Chuan Thor, founder of China-focused AlphaX Partners, recalled taking Qihoo 360 Technology public in the US in 2011 at USD 30 per share but later having to exit at a 33% discount because the fund life was ending. The return was still 20x. However, he held onto his personal shares until 2016, by which point Qihoo’s share price was above USD 100.

As to the option of distributing shares directly to LPs instead of selling via the fund, Thor noted that it isn’t for everyone. “Some LPs are hesitant about receiving shares because they run into tax issues when selling by themselves rather than have the fund sell them,” he said. “And then some investors, like corporates, don’t have teams to do public share trading, so they don’t know whether to sell.”

An advisor familiar with the Sequoia structure describes it as “part hedge fund, part fund-of-funds, and part making sure that the existing closed-end structure stays intact as much as possible.” Some inspiration was drawn from publicly traded vehicles launched by fund-of-funds managers that plug into other products as LPs, specifically how the different product layers interact and address cash flow issues.

The conversion to the new structure – said to have been completed in February, with the outstanding net asset value (NAV) coming to around USD 65bn – gives Sequoia a high degree of discretion. This applies not to which public stocks are retained in the open-ended portfolio and when they are sold, but also how allocations are made to closed-end sub-funds.

It is generally accepted that others would struggle to replicate this structure without scale and a reputation and track record like that of Sequoia. And those that qualify, may not want to try. “Most of the major funds are not looking to do it,” said York. “And if you spend time with LPs, they don’t like it because they are set up internally for the traditional approach to venture capital.”

Another advisor who represents some Sequoia LPs claims they acquiesced begrudgingly because not doing so would mean losing access to the closed-end funds.

There are several concerns. First, the open-ended vehicle operates like a hedge fund with gates, redemption limits, and annual caps, so exiting is not necessarily easy. Second, Sequoia doesn’t have a track record as a hedge fund. Third, a sustained downturn and a deterioration of positions in the open-ended portfolio could play havoc with allocation models.

Numerous endowments and foundations, generally understood to be among the LPs most comfortable with long-horizon strategies, have come to rely on cashflows from Sequoia. One US endowment CIO with no current exposure to Sequoia said that some LPs will have to adjust liquidity expectations for their entire VC programs if proceeds are increasingly recycled rather than distributed.

Evergreen evangelists

There is a small phalanx of venture capital investors that operate under pure permanent or evergreen structures, often driven by a desire to be free of traditional fund cycles. A few managers in Asia take this approach, notably Capital Today China Group and Chengwei Ventures in China and Nalanda Capital and WestBridge Capital in India.

The Chinese managers use largely the same terms as their US brethren. A 28-year fund is divided into seven four-year activity periods. If an LP commits USD 10m at inception, at the end of year four it can re-up, which means putting in another USD 10m, liquidating its position, or being placed into a run-off account that winds down over time. An LP that re-ups every time would end up investing USD 70m.

The back-office burden is substantial. Every four years, all assets must be marked to market, with unrealised gains and losses allocated out to the capital accounts of participants, so that new entrants buy in at fair market value. The biggest challenge, though, is convincing LPs to participate.

“If anything, there has been a fallback in prominence. It takes a certain kind of LP. Endowments are the best; corporates and fund-of-funds are the worst. Corporates aren’t good long-term term players and then fund-of-funds can’t re-up – they must liquidate and invest through a new fund-of-funds,” said Jordan Silber, a partner at Cooley, who has worked on numerous evergreen structures.

“No matter how wonderful the track record, there is a serious headwind. Out of the gate, 40% of institutional LPs are not right for you.”

Even the endowment CIO has yet to commit to an evergreen fund, despite best efforts to find a structure that ensures proper alignment. The major sticking points are an inability to re-underwrite a manager every two or three years, especially given the likelihood of team turnover during a multi-decade tenor, and difficulty exiting.

Other managers have employed various fixes to address concerns about liquidity. However, this can work against them when dealing with LPs with different levels of sophistication and risk appetite. Products tend to be bespoke and securing a consensus on terms is hard unless the GP has a lot of leverage.

“There are a lot of terms GPs and LPs just accept, even though they aren’t necessarily supported by underlying global macroeconomics,” said Dolling of Kirkland & Ellis. “If you want to raise an open-ended evergreen private equity fund, there is no clear market standard. There are some models out there, but when you talk to the people who structured them, multiple decisions were made along the way on issues like new entrants, run-offs, and fees.”

Selling the future

Exs Capital, which makes PE-style investments into real estate in Asia, first looked at permanent capital vehicles in 2011-2012. It wanted a structure that could ride out cycles, having concluded that the low survival rate among regional GPs was tied to financial crises. Fundraising was easy during market peaks and difficult during troughs. This meant GPs were cash-rich when deals were scarce and discipline was required, but cash-poor when deals were plentiful and they should have been bold.

The firm devised a permanent capital structure whereby investors would renew every three years or be placed into a run-off account and pitched it 200 LPs. According to Eric Solberg, chairman and CEO of Exs, many investors admitted the cyclical thesis matched their own experiences but, at the same time, there was an element of denial and a lack of impetus to remedy the situation.

“I found it both amusing and sad,” he said. “We also had a lot of ‘This is interesting, but it flies in the face of conventional wisdom. Go do it, and if you have success with it, we’ll talk about whether we can fund it.’ If everyone says that, then it’s a difficult strategy to get off the ground.”

Exs opted to work on a deal-by-deal basis instead, although the firm is raising capital under Singapore’s new variable capital company (VCC) structure. Investors can come in at the corporate level or project level – equivalents to the fund and sub-fund levels – and the 10-year lifespan is relatively easy to extend. Solberg describes the structure as a private equity-hedge fund hybrid.

Another hallmark of the Exs approach is committing its own money first and then brings in external investors. This is a common theme in the world of permanent capital. Serendipity’s vehicle was seeded by the founders, although Jesudason noted that these must be sizeable contributions to offset subsequent dilution by external investors.

“If you only have USD 500,000, you should start a fund and leverage other people’s capital. If you have substantial capital to put in, you have a relatively large shareholding upfront and this incentivises you not to over-raise,” he said. “We typically raise enough capital for the next 6-9 months. Ideally, the portfolio performs during that time, NAV goes up, and we raise again at a higher stock price.”

In addition to these initial commitments, the Serendipity team receives a salary plus share issuance based on performance. Below the holding company that issues shares, there are two wholly-owned subsidiaries, a management company and an investment holding entity. The former charges a management fee to the latter, structured so that as NAV rises, fees fall.

Meaningful founder contributions were also top of mind when Equis Funds Group, an Asia-based owner and operator of renewable energy assets, chose to establish a corporate vehicle that could run in perpetuity rather than raise a third fund in 2020. Abu Dhabi Investment Authority and Ontario Teachers’ Pension Plan injected USD 1.2bn into the structure and further fundraising is expected.

However, in this instance, there is no management fee, just additional performance-based compensation once the preferred return threshold is reached. David Russell, a co-founder and managing director of Equis, told AVCJ at the time that the absence of a management fee ensured greater alignment with external investors.

“They are investing in that manager, they are part of the assets, and part of the longevity of the assets,” he said. “We can develop strategies and platform businesses within the structure, and we may decide to exit those through a trade sale or we may continue to hold assets and harvest the yield. We will structure investments in a manner that allows us that flexibility.”

Horses for courses

Russell believed the notion of backing a manager that only raises capital through one structure – where the structure can last in perpetuity, and management are employed by it and tied to it – was without precedent in infrastructure. However, permanent capital and long-dated funds are an established part of infrastructure and real estate.

In real estate, for example, opportunistic growth funds may handle early-stage development assets and then sell them on to longer-dated or open-ended vehicles once they are mature. By this point, the risk-return dynamics have changed and so the sponsor economics must change as well. The same often applies to infrastructure and the progression from core-plus to core strategies.

“With real estate and infrastructure, there can be more stability around valuations and cash flows, so when people want to redeem, you can manage it relatively easily,” said Gavin Anderson, a partner at Debevoise & Plimpton. “That is much harder in private equity.”

Opaque private markets valuations, and how they feed into the calculation of exit prices and carried interest, are the primary obstacle. In real estate and infrastructure, comfort derives from stability. In hedge funds, it is regular mark-to-market exercises and established redemption mechanisms.

Apart from very stable operating assets that generate steady income streams – increasingly targeted by core-plus infrastructure managers – PE doesn’t have these characteristics. Whenever there is investor turnover within a portfolio holding unrealised assets, there’s a risk the valuation will be seen as too low by incumbents or incoming investors will be put off because they think it’s too high.

No structure solves for every problem. However, single-asset continuation funds have emerged as a compromise. In spinning out choice assets into standalone vehicles, GPs can hold for longer while continuing to generate management fees and carried interest. LPs can stay involved or exit.

Some alignment issues remain, specifically around how much carried interest GPs should roll over into the new entity and how early in a fund life these deals should happen. Secondary investors are also highly selective and there is a mismatch in Asia between transactions pitched and capital available.

But most industry participants expect single asset continuation activity to proliferate. Indeed, continuation funds of continuation funds are already present in the market, indicating the role they can serve in extending holding periods.

“When these longer-hold concepts were launched it was to justify doing deals that were lower return but compounding over a long period of time,” said Brian Lim, a partner at Pantheon. “The argument has moved because it’s about keeping companies for longer, not necessarily underwriting them as a long-term investment. That’s where the continuation funds are just going to take over.”

Continuation vehicles do not address the more fundamental question as to the relevance of the traditional fund model. Sequoia’s Botha observed that innovation in venture capital has failed to keep pace with the companies it backs. He compared it to operating on floppy disks while chips shrank and software gravitated to the cloud. Serendipity’s Jesudason shares this view.

“It could be argued that one of the least innovative parts of financial services is asset management. People have been relying on the 2/20 fee model for a long time,” he said. “And there isn’t alignment in terms of vintages and the cycle. If you’re so large you invest in every fund someone does, that’s fine. If not, there is potentially a problem because performance evens out across the funds.”

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• Topics
• GPs
• Fundraising
• LPs
• North America
• Asia
• USA
• Sequoia Capital
• The Blackstone Group
• KKR
• Apollo Global Management
• AlphaX Partners
• Capital Today China Group Company
• Chengwei Ventures Shanghai
• Serendipity Capital
• EXS Capital
• permanent capital