Private equity training course question

This question was asked on a recent private equity course. The question was: what's the difference between a closed end fund and an open ended fund?

Closed-ended vs. open-ended fund: a closed-ended fund will require a private equity firm to sell all of its shareholdings in portfolio companies, e.g. within 10 years, returning the proceeds to investors. An open-ended fund does not have any set date for return of funds to investors.

Most funds are closed ended with a relatively long life (e.g. the 10 years referred to above), perhaps granting investors the right to extend for a year or two. The long life is designed to give a private equity firm enough time to make investments in portfolio companies and generate returns when selling out of those same companies, hopefully without finding itself under pressure to sell stakes quickly. Any right to extend the life of the fund for 1-2 years is designed to avoid a situation where a private equity firm finds that it has not been able to sell out of all portfolio companies within the 10 years. A 1-2 year extension is designed to give investors the time they would need to facilitate an orderly winding up of portfolio companies and avoid a "fire sale" at the 10 year point.

In both a closed end and an open ended fund an investor would expect the private equity firm to be motivated to sell out of investments. Annual management fees for the private equity firm would reduce over time, and bonus fee arrangements for the private equity firm would only be triggered once investments had been sold at a high enough value. The structure of fee arrangements is designed to motivate private equity firms to sell portfolio companies at high values to generate firm bonuses, and raise fresh funds to replenish declining management fees - irrespective of the life of the fund.

Under both closed ended and open ended funds an investor would expect the private equity firm to be motivated to succeed. In practice most funds are closed-ended funds with a long life, so that the investor has the ability to get its money back e.g. if the private equity firm has failed to make successful investments.

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