What is the difference between an open-ended fund and a closed-ended fund? Either in private equity or a syndication or a real estate fund? What is it that makes that difference? We’re going to go through that in this video.
Let’s talk about the difference between an open-ended fund and a closed-ended fund. Now first, a caveat. I don’t mean the difference between a fund and a syndication. In reality, a syndication is a group of people coming together for a common purpose, where a fund is a grouping of money, a pile of money for a common purpose. So to me, they’re kind of the same thing. Whether it’s for one asset, or whether it’s for a group of assets, a pool of assets, either a blind pool or a directed pool. That’s not what we’re talking about. We’re talking about closed-ended funds or open-ended funds.
So what exactly are we talking about? And what’s the distinction? I think it’s helpful to draw it out, and I’ll provide some examples along the way. So here are two different timelines: at the top is a closed-ended fund, and at the bottom is an open-ended fund.
In a closed-ended fund, we’ve got an investor who comes in here, and maybe he’s got another investor who comes in here. And then there’s maybe another investor who comes in here. And then together, they all travel down the same path until a liquidity event here. Maybe there are different payouts and different things along the way.
A typical example is a real estate syndication. We buy the building here at time zero, maybe we are raising funds for a month or three months, then we all travel down this path until it’s time to sell the property. We sell the property, divide the proceeds, and maybe along the way, we’re paying little distributions here and there. But everybody’s staying in together, it’s all going as one piece down that line. So that is a closed-ended fund.
So what exactly is an open-ended fund? An open-ended fund is completely different. A best example of an open-ended fund is a mutual fund. In a mutual fund, you have people coming in at all sorts of different times and exiting at all sorts of different times. So let’s say you’ve got someone here, who buys in here, travels down for a few months, and exits here. And then maybe there is another person who comes in here, travels down and exits here. Totally different. And then maybe there is a third person who comes in here and travels down and then exits here.
So you’ve got these different entry and exit points. The difference, obviously, is the hold period. The challenge of an open-ended fund oftentimes is determining what we call net asset value. Net Asset Value is the price, think of it as the price per share.
For a mutual fund, maybe this time it starts at $100 a unit, maybe it’s risen to 110. And then maybe it’s gone to 120. Maybe it falls back down to 115 and then 105. But then it skyrockets back up to 130. At any given point, you can see what the profits are. For this blue line, you can see he bought in at 100 and he’s exiting at 105. So he has a gain of five. The green has bought in at 110 and exits at 130. They have a gain of 20. The red guy though, he lost five. He bought in at 120 and it went down to 115. So he lost five. But we know at any given point what everybody has, and everybody is treated the same.
But what if this was not a mutual fund? What if this was a property or a portfolio of properties? So there is an important property bought here, a property bought here, a property bought here and here. And this one sold here. This one was held all the way to here. This one was exchanged into this one, which was sold here. How are you going to figure out what sort of values the blue guy gets, the green guy gets or the red guy gets? It’s very challenging.
I’ll do another video on net asset value and how that’s done and how we handle that. But you can see for a real estate fund, that’s the true challenge. That’s why they are much more complicated and much more difficult to do. It costs more in legal fees to put it together because it’s more complicated. It costs much more in accounting fees because it’s more complicated. All of those things make it just that much trickier.
So I hope this makes it clear what the difference between a closed-ended fund is and an open-ended fund. Let’s go over the key takeaways from this:
First, open-ended funds in private equity allow investors to enter and exit positions freely. Sometimes there will be a lockup period. But basically, it lets people come in at any specific point as designated in the terms and then it provides more liquidity because we let them out at regular intervals.
A closed-ended fund involves acquiring, managing, and ultimately the aim is selling. It’s that big capital event. Now, certainly there can be profits along the way and there can be cash flow in that closed-ended fund. But the main purpose of the closed-ended fund is that appreciation, whereas an open-ended fund, the main purpose really is that cash flow.
In an open-ended fund in equity, we have more frequent payouts generally, because the purpose is that cash flow. And so it also offers a lot more flexibility in managing the investment itself, in terms of designing how cash flow gets dispersed.
Lastly, the closed-ended funds have the potential for much higher returns, because we don’t have this calculation of Net Asset Value all the time. Open-ended funds, on the other hand, provide a lot more stability because people can come and go as they want, and it gives that liquidity.
My name is Tilden Moschetti. I am a syndication attorney for the Moschetti Syndication Law Group. I help syndicators and private fund managers establish Reg D offerings for themselves by providing them the compliance documents that they need in order to be compliant with the rules of Regulation D rule 506 B and 506 C. We basically help you put these funds together, whether it’s an open-ended fund or a closed-ended fund. I would love to see if we can help you. Give us a call or visit our website and set up an appointment, and we can discuss your project and figure out a way to get you from where you’re at today to your goal as a syndicator or a fund manager.