Many subsets of the alternative investment industry have a preference for either open-ended or closed-ended funds. Hedge funds tend to be almost always open-ended, whereas private equity or venture capital funds tend to be almost always closed-ended.
The life settlement industry hasn’t – yet – settled on one or the other. But anecdotal evidence suggests that, at least at the moment, the closed-ended model is increasingly finding favour.
A couple of reasons exist as to why, according to Patrick McAdams, Investment Director at SL Investment Management.
“It’s a combination of the administrative burden and cash management considerations,” he said. “A closed-ended structure makes both of these functions easier for the manager.”
The administrative efforts of managing an open-ended fund, with investors coming and going frequently, is a significant task. But particularly in the life settlement space, it’s the cash management effort that can provide a manager with sleepless nights.
Unlike, for example, a public equity strategy where the manager might receive dividends, or a credit strategy where the manager might receive interest, life settlements are a negative coupon asset, as the fund has to continue to pay the premiums for the life insurance policy after they purchase it in order to keep it in good standing – and therefore, receive the payout when the policy matures. When an investor in an open-ended life settlement fund redeems, under normal circumstances the fund will maintain sufficient cash reserves to settle an anticipated level of background redemptions. However, sometimes the fund may need to either sell policies – which may be at a discount to the NAV, making the fund’s returns worse overall – or find another investor to fund the redemption. It’s a juggling act that isn’t easy, but there are nuances to the portfolio construction function that makes the job easier.
“Effective cash management is key for an open-ended fund. It’s a good idea to have a healthy cash buffer for any potential redemption requests,” said McAdams.
“But at the portfolio level, focusing on shorter duration policies would also help. With these policies, not only are you going to be paying out less capital in premiums, but you’re also receiving proceeds from maturing policies much more frequently.”
Part of a successful cash management strategy in an open-ended life settlement fund comes with the redemption terms.
“A longer notice period – say, 180 days – for redemptions is also an important feature here. Life settlements are an illiquid asset, and so rebalancing isn’t like it is in public equity or credit markets. It’s a benefit to the investor that redemption terms are longer, because they’re going to get better results if the manager can manage the liquidation process effectively as opposed to a fire sale, which helps no-one,” said Jonas Martenson, Founder and Sales Director at Ress Capital.
A closed-ended fund does not have the same liquidity issues. But the flip side is that with a closed-ended fund, you’re locked in, which might not be a positive.
“You might raise $500m and then deploy most of the capital in the first 12-24 months. But then, you’re locked in – your portfolio is going to do what it’s going to do. And if it’s underperforming, from an LP perspective, then you can’t get your money out unless you can sell your LP stake to a third party or liquidate the portfolio – which means you’re probably taking a further discount on the NAV,” said McAdams.
Deploying the capital raised for a closed-ended fund also has nuances. Most of the policies bought by these funds would have a life expectancy equal to or earlier than the end date of the fund, something which, according to Martenson, can present a challenge.
“An open-ended fund can take a longer-term view than a closed-ended fund because they can buy policies which have longer LEs, an area of the market where there is less competition,” he said. “These policies are cheaper than shorter-term ones, and buying longer LEs can reduce the longevity risk in the portfolio because the extension risk is lower.”
Some investors don’t have a choice. The closed-ended funds tend to have higher minimum allocation sizes, which means that they are generally only available to institutions and larger family offices, as opposed to individual investors or smaller family offices. But that doesn’t mean that it’s bad news for smaller investors that are indirectly forced into open-ended funds.
“A lot of investors simply do not want to lock up capital for 10-12 years. By only offering a closed-ended fund, you’re excluding a lot of the potential investor universe from the benefits of life settlement investing,” said McAdams.
All this leads to what is ultimately, for McAdams, not a one size fits all approach.
“There may be a general move towards closed-ended funds, but it’s not accurate to take a blanket approach and say that one structure is better than the other in the life settlement space. They both have pros and cons because of the nuances of the asset class and differing types of investors. It’s not like some other assets where one structure is clearly a better fit for all scenarios,” he said.
“What’s most important is that the end investor understands the pros and cons, in particular the liquidity risk that comes with needing to sell policies prior to maturity in an open-ended structure, and the manager’s ability to manage those to deliver the returns that they say they will.”
