Introduction
Investment funds have a variety of legal structures customized to investors’ various needs and investment policies. The two main fund structures are closed-end funds and open-end funds, which differ in several material parameters, as explained below.
Investment structure
A closed-end fund operates for a fixed period, usually for approximately seven years, with optional extensions. A closed-end fund has a limited period of investment of usually three to five years, during which the fund managers invest the fund’s capital in various investments.
In contrast, an open-end fund operates indefinitely and is constantly open to new investors and to redemptions on an ongoing basis. This structure enables ongoing management of the fund without any predefined end date.
Redemption policy
One of the main differences between the funds is the redemption policy. In closed-end funds, investors are not permitted to withdraw their funds before the fund’s liquidation date or the occurrence of a defined liquidity event (except in very rare instances). This enables the fund’s managers to invest in long-term, not necessarily liquid, assets.
On the other hand, open-end funds allow investors to redeem their investments on scheduled dates – daily, monthly or quarterly, depending upon the fund’s policy. This flexibility is particularly important for investors who need liquidity in the short term.
Fundraising and capital transfers
Closed-end funds raise capital during a defined limited period (of usually 9-12 months). At the end of this period, the fund is closed to new investors, and the managers focus on investing the fund’s capital.
In contrast, open-end funds constantly accept new investments throughout the fund’s lifetime, enabling them to grow and respond to new investment opportunities.
Regarding capital transfers: investors in closed-end funds commit to invest a particular sum, but actually transfer capital according to the fund’s capital calls. In contrast, investors in open-end funds transfer their entire investment as soon as they join the fund.
Asset liquidity
Asset liquidity also depends upon the fund’s structure. Closed-end funds usually invest in illiquid assets, such as real estate, infrastructure, or private equity investments, which are compatible with the fund’s long investment horizon.
In contrast, open-end funds usually focus on more liquid assets, such as stocks and tradable bonds, which enable investors to execute redemptions more frequently.
Calculating the value of the assets
The assessment of net asset value (NAV) differs between the funds. In closed-end funds, the NAV is usually calculated on a quarterly or annual basis, based on complex valuations of non-tradable assets.
In contrast, open-end funds calculate the NAV more frequently – often monthly – based on the assets’ latest market value, which reflects the liquidity of the fund’s assets and provides transparency to investors.
Profit-distribution mechanisms
Distribution waterfall in closed-end funds
Closed-end funds distribute profits according to a predefined distribution waterfall, usually after realizing investments or selling assets. Distributions follow a set order: (1) investors get back all their invested capital; (2) in closed funds that aren’t venture capital funds, investors receive a minimum preferred return; (3) in those same funds, the general partner receives a catch-up payment based on what was distributed in step 2; and (4) any remaining amounts are shared between investors and fund managers as set out in the fund’s documents, typically in an 80/20 split.
High-water mark in open-end funds
As stated, in open-end funds, profits can be withdrawn on an ongoing basis or reinvested. Open-end funds usually use a “high-water mark” mechanism, whereby the fund manager is entitled to a performance fee only if the fund’s NAV has crossed the highest peak in value achieved in the past. Therefore, if the fund performed poorly, no performance fee is paid until the fund’s NAV recovers from the losses and reaches a new peak in value.
Conclusion
Although the term “investment fund” includes both closed-end and open-end funds, these are actually two materially different structures. Closed-end funds are illiquid products intended for long-term investments, while open-end funds are relatively liquid products. These differences are reflected in the funds’ commercial terms, operating structures and in the investors’ rights. Investment fund professionals or advisors must possess a thorough understanding of these differences.
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