Retail and open-ended funds
The democratization of private markets has led to a surge in retail alternative investment funds — investment vehicles that provide individual investors with access to private equity, real estate and other alternative investments once exclusively reserved for institutions. These funds are structured as partnerships due to their tax efficiency, operational flexibility and scalability.
Structuring such funds as partnerships allows them to satisfy the goals of various stakeholders — including fund managers, institutional investors, family offices, US taxable and foreign investors, and high-net-worth individuals — while also providing the ability to pursue larger and more diverse investment opportunities. This, in turn, increases the potential for higher returns.
The flexibility inherent in partnership structures is also particularly appealing to retail investors. Open-ended private equity funds, which allow for regular capital inflows and outflows, benefit from the partnership model as it accommodates varying investment horizons and liquidity preferences. This flexibility enables funds to adapt to changing market conditions and investor needs, making them more resilient in volatile environments.
Moreover, partnerships often emphasize alignment of interests among stakeholders. Fund managers often invest their own capital alongside that of their investors, creating a strong incentive to maximize performance. This commitment to the partnership’s success can lead to more prudent investment decisions and a focus on long-term value creation.
Additionally, partnerships can enhance access to exclusive investment opportunities. Individual investors are typically unable to enter traditional private equity funds because of high minimum investment thresholds or lack of access to proprietary networks. Open-ended funds allow retail investors to gain exposure to high-quality investments that would otherwise be out of reach. This democratization of access is particularly appealing in today’s investment landscape, where retail investors are increasingly seeking alternatives to traditional asset classes.
Continuation funds
In recent years, private equity funds have also employed continuation funds with increased frequency, a trend that balances the funds’ need or desire to hold investments beyond the fund’s life with their need to provide liquidity to investors.
Underpinning this trend is the increasing demand for liquidity and flexibility in private equity investments. Traditional private equity funds often face fixed lifespans, typically 10 to 12 years, after which they must liquidate their portfolios. However, funds may not be ready to dispose of all their investments within this period (e.g., because an investment has not reached its potential yet or the market is soft, and the fund managers do not believe they will receive a fair price for the investment). Investors may also seek continued exposure to high-performing assets beyond the typical fund lifecycle. Continuation funds, structured as partnerships, provide a solution by allowing fund managers to extend the holding period of select portfolio companies. This enables funds to capitalize on growth opportunities that may not have fully materialized within the original fund’s timeframe, while also divesting from other assets and providing liquidity to those investors who do not want to participate in the continuation fund.
The attractiveness of the partnership structure in this space is further amplified by the ability to pool investments into the continuation fund in a tax-deferred manner and to structure the transactions so that gain or loss is recognized only by investors who are exiting their investments and not participating in the continuation fund (thereby avoiding “phantom” gain recognition for those who are “rolling over”). Continuation funds also can be tailored to meet the specific needs and preferences of investors, whether they seek income generation, capital appreciation or a combination of both. This flexibility allows fund managers to craft strategies that align with market conditions and investor expectations, making partnerships a versatile option in the private equity landscape.
Key considerations
While the partnership structure has proven attractive and effective in the private equity space, fund managers must still navigate considerable challenges.
One of the primary challenges for open-ended funds is maintaining liquidity while adhering to long-term investment strategies. Fund managers must balance the need for liquidity with the investment horizon of the underlying assets, which can complicate capital calls and redemption processes, especially during times of market volatility. Other significant challenges include managing complex fee structures and addressing the significant administrative burdens created by those structures, as well as the ongoing admission and exit of investors.
Further, while partnerships allow for flexible profit (and loss or expense) allocation arrangements, this can often lead to structural complexity. Ensuring that profit-sharing arrangements are equitable and transparent among partners while complying with IRS guidelines can be challenging. Misalignment between profit allocations and cash distributions can lead to tax inefficiencies and phantom income or gain, which in turn can lead to disputes and investor relations issues.
Accurately valuing assets in a partnership structure can also be difficult, particularly for illiquid investments. Establishing fair valuations is crucial for determining the price at which investors may enter or exit the fund. Discrepancies in valuations can lead to investor dissatisfaction and erode trust in the fund manager.
