Happy Friday, Funds Family!

Today we’re going to answer a key decision investment managers (GPs) must face when forming a fund:

Should your fund be closed-end or open-end?

What’s the difference?

What’s better?

Quick Note: Starting this week, we will begin listing potential investment opportunities at the bottom of the newsletter. 👇️ 

⚠️ We do not receive compensation for listing these opportunities, we do not specifically endorse any of the GPs or investments, and we are not providing legal or investment advice.

We just thought it might be helpful for you to evaluate funds and syndications currently in the market. 📊 

Back to the newsletter!

🔒️ Closed-end investment funds

We go into many of the points below in our article on the timeline of a closed-end investment fund. Check out the article for a deep dive into closed-end funds.

1. Defined fundraising period

In closed-end funds, you typically have 12-18 months to fundraise after the fund’s initial closing date 📆 (the day you admit your first investors).

After the 12-18 months (or longer if approved by LPs) 🕜️ is over, the final closing date occurs and the fund can no longer accept new investors.

As of the final closing date, the die is cast. No more fundraising (which can be a good thing 😅).

2. Defined investment period

Closed-end funds have an investment period when the fund can make investments in new properties, businesses, etc. The investment period is typically the first half of a fund’s life.

➡️ Calling capital after the investment period ends

After the end of the investment period, the fund can still call capital for limited purposes, such as:

• Paying fund expenses (including repaying debt)

• Follow-on investments in existing companies

• Repairs or improvements to existing properties

• Exercising options or warrants the fund already holds

• Investments that were in process as of the end of the investment period

➡️ Other consequences of the investment period ending

There are a few other things that typically happen when the investment period ends:

• The management fee is reduced (check out this article for more on this)

• The GP can start the next fund

• The GP’s "time commitment” requirement decreases

  Want to work with our law firm?

3. Defined fund term

Closed-end funds have a set life. 🪦 

Many funds last ~10 years. Typically, the GP can extend the fund’s life for a year or two, and the LPs can further extend the fund’s life. 🔀 

In some funds, the LPs can terminate the fund early. For example, (i) 80% of the LPs could pull the plug for any reason or (ii) 51% could terminate if the GP committed a “bad act” 🚨 as defined in the LPA.

4. Limited partners (LPs) can’t withdraw their money

In a closed-end fund, the LPs are locked in! Subject to narrow exceptions (or the good graces of the GP), investors aren’t allowed to withdraw money. 🙅 

They’ll get their money back over time as the fund makes distributions (hopefully).

And, in any case, the fund will distribute its assets to the LPs at the end of the fund’s term. 💸 

5. Fund economics are “distribution-based”

This is a technical point 🤓, but economics like carried interest (promote) are based on “distributions.”

For example, a profit split might look like this:

1. First, LPs get their money back

2. Second, LPs get a preferred return

3. Thereafter, the GP gets 20% and LPs get 80%

The splits are based on actual transactions (e.g., sales/refis or cash flow). If the value of fund assets rises but nothing else happens (such as a sale), the GP would not typically earn carried interest.

♻️ Open-end investment funds

Open-end funds are an entirely different beast. 🐻

Let’s review the key differences.

1. Unlimited fundraising period

Unlike closed-end funds, open-end funds can fundraise forever. ♾️ 

New investors are often admitted monthly or quarterly, and they contribute money into their capital account.

If the fund has units, the fund will have a mechanism for determining how many units an investor gets upon contributing capital.

For example, a fund may determine the price per unit by dividing the fund’s net asset value by the number of units. Any new investors get the number of units determined by dividing their capital contribution by the price per unit. 🧮 

2. Unlimited investment period

Open-end funds don’t usually have an investment period. They can make investments in new businesses, products, or properties whenever they want.

3. Unlimited fund term

Open-end funds typically have no set term.

They can live forever. 👼 

By the way, if you like videos more than articles, you can check out this video where I discuss closed-end and open-end funds.

Now, back to the article!

4. Limited partners (LPs) can withdraw their money

If an open-end fund lasts forever, how do LPs get their money back? 🤔 

In open-end funds, LPs can usually withdraw their money (subject to restrictions). Let’s investigate common restrictions. 🔎 

🔐 Lockup period

Open-end funds often have a lock-up period during which LPs are not allowed to withdraw their money.

• In a hedge fund, the lockup period might be a year or two.

• In an open-end fund in an illiquid asset class like real estate or private equity, the lockup period might be much longer (2-5 years or more).

This makes sense!

If you’re buying illiquid assets, you don’t want people to withdraw immediately. It might be hard to raise the cash to redeem the withdrawing investors without fire-selling 🔥 the fund’s assets.

In many funds, there is a separate lockup period for each capital contribution an LP makes. So if an LP puts in $100 on January 1, 2025, and $200 on January 1, 2026, those two investments would have separate lockup periods.

🧱 Gates

Once the lockup period ends, investors can start withdrawing money. However, most open-end funds also have a gate, which limits the amount of withdrawals.

There are two main types of gates:

• Fund-wide gates. For example, no more than 20% of the fund’s assets can be withdrawn in any calendar year.

• Investor-by-investor gates. For example, an investor may not withdraw more than 25% of their capital account in any single quarter.

Typically, any outstanding withdrawal requests (if the gate stops some withdrawals) are rolled to the next withdrawal date. ⏩️ 

As with lockup periods, illiquid asset classes tend to have stricter gates. For example, the fund-wide gate example above might be for an illiquid fund, while the investor-by-investor gate might be for a public securities fund.

🗺️ Side Quest: Open-end real estate funds and 3(c)(5)(C)

Open-end real estate funds that invest in equity and debt might have issues. To read about this in more detail, please see the “note on open-end funds” in this article on the Investment Company Act.

5. Fund economics are often “capital account-based”

In many open-end funds, the GP’s incentive fee is based on an LP’s capital account, not distributions. 💰️ 

What this means: If a fund holds shares of Apple at $100, and the shares increase to $150 📈, the GP may be able to take incentive allocations even if the fund doesn’t sell the shares (and the fund makes no distributions).

In some cases, open-end funds might still be distribution-based. Distribution-based economics may be more suitable for asset classes where valuing the underlying investments isn’t as simple as assets like public equities.

✅ What’s better…closed-end or open-end?

Neither is inherently good or bad.

However, industry standard is as follows:

• Private equity funds are usually closed-end

• Venture capital funds are usually closed-end

• Real estate funds are usually closed-end, but some asset classes (especially buy-and-hold cash flow strategies) may be open-end

• Debt funds may be closed-end or open-end

• Public equities funds are usually open-end

Summary: Illiquid strategies are usually closed-end. Liquid strategies are often open-end. 💧 

If you want an open-end fund with an illiquid strategy, you may want to impose strict lockup periods and gates.

Thanks for reading, everyone.

Have a great weekend!

• GP-Provided Description: Search Fund Ventures invests in North American small businesses alongside acquisition entrepreneurs, to provide an attractive succession path for retiring business owners and to promote sustainable economic growth.

• GP Website: searchfundventures.co

• Asset Class: Search funds (private equity)

• Vehicle Type: Closed-end multi-asset fund (10 years)

• GP Commitment: $2 million

• Minimum LP Investment: $250k

• Management Fee: 2% of commitments

• Carried Interest: 20% (up to 30% after IRR hurdles)

*Please be advised that the dissemination of information regarding investment opportunities pursuant to this newsletter should not be construed as an endorsement, recommendation, or active promotion of investments. The newsletter's function in this regard is solely to provide information about potential investment opportunities. It is incumbent upon each member of our community to conduct their own due diligence and make informed decisions regarding these investment opportunities. We expressly disclaim any liability or responsibility for the outcomes of any investments made based on the information provided. Nothing herein is investment advice, legal advice, or any other type of advice.