While open-ended funds offer more liquidity than closed-end funds, open-ended funds also have lower returns and the management and performance fees are often based on the net asset value of the fund—which can be hard to accurately assess for assets with unlevel cashflows.
As RIAs increasingly look to alternative assets to provide portfolio diversification in a high P/E ratio and low bond yield environment, they are increasingly looking for alternative investments like life settlements that have low correlations to market and interest rate risk.
For those who might not be aware, a life settlement is the sale of an in-force life insurance policy by the original policy owner to a third party. In return for providing the seller with a cash payment, the third-party purchaser (investor) owns the life policy, pays all premium payments going forward and eventually receives the entire death benefit at the time of the insured’s death.
Life Settlement Transaction
In a life settlement transaction the owner of the policy sells his policy to the buyer for a cash payment. The buyer then pays the premiums on the policy going forward and receives the death benefit upon maturity of the policy.
The transaction is a win for the seller and the buyer. The seller receives more for selling the policy to the buyer than they would get if they simply cancelled the policy. The buyer is a sophisticated investment company that knows that aging insureds on life insurance policies are more likely to be less healthy now than when the policy was originally purchased. By pooling enough policies together, the buyer gets an uncorrelated and diversified investment portfolio.
However, most life settlement funds available to RIAs and family offices are only available through open-ended structures that are not the best fit for the underlying cashflows since the cashflows are negative or low in the early years and highly positive in the later years. The irregularity of the cashflows make it difficult to accurately value the underlying future cash flow stream and results in high bid/ask spreads for the assets. This is particularly true of funds with a small number of policies. The smaller the number of policies in the fund, the more difficult it is to accurately value the future cashflows.
The open-ended life settlement fund prevents 3 key problems for investors:
1) A life settlement investment takes a few years to generate positive cashflows.
This means that the early year returns of the fund are low. Since it takes a few years for a new life settlement portfolio to yield positive cashflows, a fund that continues to purchase new policies essentially restarts the low-yield part of the investment process. This hurts investors who want to exit early unless the fund inflates the value of the underlying assets to boost returns.
2) Open-ended funds can hide the low early year returns mentioned above by booking the policy at the ask price instead of the bid price in order to show high unrealized returns.
As long as the fund keeps buying new policies, the fund can continue to show high unrealized paper returns by repeating this process while having low actual realized returns
3) If an investor exits the fund before cashflows turn positive, then they would only earn the low early year fund returns on exit—unless the fund has overvalued the assets in which case the low early year fund returns would be passed on to investors who exit later.
To make matters worse, any new investor who gets lucky and invests in an open-ended life settlement fund just before the large positive cashflows materialize would experience great returns that would have otherwise gone to the investors who had been there since the beginning as illustrated in the table below.
Hypothetical Open-Ended Fund Returns with Unlevel Yearly Asset Returns
| Year | |||||
|---|---|---|---|---|---|
| 1 | 2 | 3 | 4 | 5 | |
| Yearly Fund Return | 4.00% | 4.00% | 4.00% | 16.00% | 18.00% |
| Compound Annualized Return as of Year 1 | 4.00% | 4.00% | 4.00% | 6.88% | 9.02% |
The above table shows hypothetical open-ended life settlement fund returns in which the investor expects a 9% compound annual return at the end of 5 years. As seen above, the actual underlying asset returns are not a level 9% each year. They are low in the early years and high in the later years that equals 9% on a compounded basis only at the end of year 5. If an investor invests in the fund at the start of year 1 expecting a 9% return, but exits before year 4 when the cash inflows start to materialize, the investor would essentially walk away getting only a 4% compound annual return instead of the 9% return they were expecting.
Furthermore, any new investor that invests in the open-end at the start of year 4 would experience phenomenal returns on their investment even though the returns in years 4 and 5 are a direct result of the investors who invested in years 1-3.
As the above table shows, an investor expecting to earn a 9% compound annual return would need to stay for the entire five year period in order to earn the 9% since the yearly returns are low in the early years and high in the later years. If the investors exit before year four, they would only earn a 4% compound annual return.
An open-ended fund with low early year returns and high later year returns benefits later investors who invest just before the large cashflows materialize at the expense of those who invested from the beginning. New investors that come in only during the later years essentially dilute the original investors’ equity. Furthermore, if the fund continues to buy new life settlement assets with the capital they raised from new investors, the fund is essentially restarting the “low return” part of the investment profile. This lowers short-term returns for all investors in the fund. The longer the fund continues to buy new assets, the longer they delay the “high return” part of the return profile.
This is why asset classes with unlevel cashflows are better suited to closed-end funds where investors have a longer time horizon and can wait for the cashflows to materialize as opposed to open-ended funds that need to provide liquidity for investors who will miss out on the high cashflows in the later years.
While an open-end fund offers better liquidity for those wanting early exit options, there’s a premium to be paid for this in the form of lower returns for those that stay in the fund as well as those that decide to exit early. A fund that needs to meet redemption requests needs to hold a larger cash reserve to meet those redemption requests or utilize leverage. Furthermore, if large numbers of investors choose to redeem, an open-end fund has to sell assets to meet those redemptions. This can significantly hurt returns if the asset has a large bid/ask spread.
Consider an asset that has a bid of 90 and an ask of 100 and imagine the fund is valuing those assets on its book at the full $100 ask price because it fully expects to keep the asset for the long term. Now let’s assume the fund receives a redemption request for $100 and has to sell assets to meet the redemption request. It can’t simply sell $100 of assets to meet the cash redemption, because the bid price is significantly lower than this. In order to meet the $100 cash redemption by selling assets at the bid price it has to sell assets worth $111.11 to meet the $100 cash redemption ($100 cash redemption = $111.11 of booked assets X $90 bid price/$100 ask price). This sell-off of assets hurts the investors who are staying due to the loss of value.
So open-ended funds that invest in assets with large bid/ask spreads either have to hold large cash reserves to meet these redemption requests (which drags down returns) or sell assets at below the value on their books (which also drags down returns). These funds could also book the assets at lower values to reduce this liquidation problem, but that would result in the fund showing lower returns to their investors.
A more nefarious problem arises when the value of the assets being held on the books is subjective and can be manipulated. Consider an open-ended fund which values its assets based on third party reports. If the fund uses third-party providers or practices that allow it to inflate the value of the asset greater than what buyers are using to purchase the asset, then the fund can show great paper returns every time it purchases new assets.
Let’s go back to our example of an asset with a $90 bid price and a $100 ask price. Let’s assume a fund is able to buy the asset at around $92. Now let’s assume that it uses a third-party provider or practice that allows it to value the asset at $105—which is greater than the ask price. This means the fund can purchase the asset at $92 and immediately value it on its books at $105—a $13 gain which amounts to a 14.1% immediate gain. Even if the fund had no other gains for the remainder of the year, it would still be able to post a 14.1% return for the year.
Let’s assume that the open-ended fund posts a 14.1% return for the year and is able to attract a lot more investors in year 2 based on the strong performance. Let’s say in Year 2 the open-ended fund raises $184. Once again the bid/ask spread of the assets are at $90/$100. But this year, they’re able to buy twice as many assets at the $92 price and book it at a $105 gain for another large gain. In year 3 they use this same strategy again but with an even larger amount of assets.
Effect Of Booking Unrealized Gains on Assets With Large Bid/Ask Spreads
| Year | |||||
|---|---|---|---|---|---|
| 1 | 2 | 3 | 4 | 5 | |
| Capital Raised at Start of Year | $92 | $184 | $276 | $368 | $460 |
| Valuation of Assets at Start of Year | $92 | $289 | $591 | $998 | $1,510 |
| Valuation of Assets at End of Year | $105 | $315 | $630 | $1,050 | $1,418 |
| Unrealized Gain for Year | $13 | $26 | $39 | $52 | -$93 |
| Fund Return based on Unrealized Gain Only | 14.1% | 9.0% | 6.6% | 5.2% | -6.1% |
For assets with a large bid/ask spread, buying assets at closer to the bid and booking them at or higher than the ask price, allows funds to show great unrealized returns—which in turn allows them to raise more capital. It’s only in the later years of the fund when investors redeem—or when the fund is finally forced to write-down their assets–that investors experience a loss. But by then the fund is already large and has earned substantial management and performance fees all based on paper returns.
We can quickly see how this poses a problem. By continuing to play this valuation game, small funds can become really large funds by raising increasing amounts of capital off great unrealized paper returns while generating minimal realized returns for investors. If investors ever decide to redeem, funds that use this valuation tactic will have to sell assets at well below their booked value thereby generating losses for the fund.
However, for small funds using such tactics, the reward can be well worth the risk. The fund gets to show great returns in the early years of the fund—when capital raising is difficult—simply by booking assets at higher prices than they could sell them for. The fund can then raise more and more capital and earn management and performance fees all based on these unrealized returns. As long as these funds continue to buy new assets they can continue to show great paper returns.
By the time investors start to redeem en masse, or the fund finally writes down the book value of their assets to closer align with prices buyers will pay, the fund has already made millions of dollars in fees and established relationships in the space that will with withstand the one-time hit to their NAV. This success may not have been possible if they had not employed such tactics and posted lower returns in the early years of the fund.
Even early investors benefit from this strategy—as long as they exit before everyone else. It’s only later investors that decide to invest off these great paper returns and don’t exit in time that will pay the price.
This is not to say that all open-ended funds of assets like life settlements with unlevel/hard-to-value future cashflows are inherently bad. Open-ended funds of such assets can provide highly valued liquidity to investors who otherwise may not wish to invest in the asset class at all.
The point of this article is merely to note that difficult to value assets—particularly those with unlevel cashflows—are best suited for closed-end funds where management fees and performance fees can be based on actual realized returns and not how the assets are being valued based on a volatile future cashflow stream.
Investors that choose to allocate capital to life settlements through open-ended vehicles need to understand that there is a large premium being assessed on this liquidity they are seeking. As such, extra due diligence is required in order to ensure both the experience of the fund manager and the determination of the fund’s realized returns in comparison to its unrealized returns.
