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An option for wealthy investors who want exposure to private equity but want to avoid the volatility, and high fees, of private equity funds, is to invest in a small, but growing sector of ’40 Act funds. 

These are vehicles created under the same 1940 Investment Company Act regulations that allow for open-end mutual funds, but in the world of private equity, they are typically privately placed, closed-end funds. According to an article in Investments & Wealth Institute earlier this year, there have been an increasing number of these funds, some offered by big-name managers, such as Partners Group and Carlyle. 

Penta recently spoke with Scott Conners, managing director and president at FlowStone Partners, for insights on the emergence of this sector. 

The firm, which is a subsidiary of Cresset, a wealth management firm with US$10.6 billion in assets under management, launched FlowStone Opportunity Fund last fall to create a vehicle for investing in primary and secondary private-equity investments, and co-investments, for wealthy individuals.

A Focus on Secondary Investments

Primarily, FlowStone Opportunity invests in “secondaries,” which means it buys mature assets held by private equity limited partnerships that have already been invested in private equity funds. Instead of investing in a newly launched 2021 Blackstone or Carlyle fund, for instance, the FlowStone fund buys an interest in a 2016 fund, for example.

Secondaries are a sector that’s grown from about $20 billion in transaction volume in 2007 to about $90 billion transaction volume in 2019 last year, Conners says. 

Although it’s dominated by institutional investors, FlowStone and a few other ’40 Act funds are creating greater access to this sector, which offers the potential for private-equity-like returns, but with less volatility.

That outcome is because assets these funds buy tend to be more mature, and “closer to a liquidity event, and that implies a shorter hold period for a secondary buyer,” Conners says. “There tends to be more visibility on the timing and nature of that existing investment.”

Buying an existing private-equity interest also means an investor doesn’t face “blind pool risk,” which is the case when investing in a new private-equity fund. Private-equity fund investors may know and trust an investment manager and its strategy, but they don’t know which companies the firm will buy on day one. 

When FlowStone buys assets in a mature fund that’s been fully invested already, “we can kick tires,” Conners says, and “re-price risk” based on how the companies in the portfolio have performed. 

“As a result, secondary buyers are able to build mature, very diversified portfolios, very quickly,” he says. 

The Basics Of a ’40 Act Fund

Like many ’40 Act funds, FlowStone Opportunities is closed-end, and not listed on an exchange, and, unlike a traditional private-equity fund, it is a continuously offered tender fund offering quarterly liquidity. That means qualified investors—those with at least US$2.1 million in investable assets—can, on a quarterly basis, either invest in the fund or redeem their units. A traditional private equity fund locks an investor in for five to 10 years or more. 

The minimum initial investment in FlowStone is US$100,000, while follow-on investments start at US$10,000. The fund has a management fee of 1.25% and a performance fee of 10% of the fund’s gains (private-equity funds tend to charge a 1.5% to 2% management fee and a performance fee of 20%).

Typically, FlowStone will buy multiple fund interests a year, which allows it to build a portfolio with exposure to hundreds of different private equity funds invested in thousands of companies. 

The resulting pool is diversified not just by the type of funds FlowStone invests in, but also by industry sector, geography, and the year the funds were originated—known as vintage years, Conners says. Secondary buyers focus on assets that are four to 10 years old, he says. 

“The end result of all this diversification is that secondary funds have historically generated private-equity rates of returns, but have done it with lower volatility and lower loss ratios,” he says.

For the year through June 30—a tumultuous period for global markets—the fund posted a return of 3.8%, compared with a 3.1% loss for the S&P 500 and a 13% for the small-cap Russell 2000 index. Third quarter data hasn’t been released yet. 

As of the first half of this year, the fund had nearly US$57 million in assets. Conners says it’s on track to have more than $100 million before the end of the year. 

Flattening the “J Curve”

Private-equity returns are typically described as following a J-curve, with negative returns in the initial years due to management fees and the fact early purchases by these funds can end in losses, followed by significant returns in later years. 

Secondary buyers avoid these costs, and because they are “providing liquidity for an illiquid asset class,” they often can buy assets at a discount to either the net asset value of the fund, or at a discount to what a manager believes the assets are worth, Conners says. 

“Secondary funds, historically, have been in the black from the first transaction,” he says.