Evergreen credit funds are increasingly being adopted by sponsors to meet investor demand for greater liquidity than is typically offered by traditional closed-ended funds. However, the degree and structure of liquidity can vary significantly.

Redemption models and run-off mechanisms are central to how evergreen credit fund sponsors satisfy investor exits, whilst protecting the remaining investors and the portfolio. This note follows on from our note exploring the principal subscription models used by sponsors who adopt a “commitment/drawdown” approach.

NAV-based redemption models

In true open-ended evergreen credit funds (with a NAV-based subscription and redemption mechanism), investors can typically redeem their shares at the prevailing NAV, subject to certain fund-level liquidity constraints designed to manage liquidity at fund level (explored below). The sponsor’s ability to meet redemption requests depends on the fund’s capacity to generate sufficient cash, for example, from loan repayments, portfolio income, new investor subscriptions, or borrowing (if legally permitted). Ultimate flexibility should be incorporated in the documents to enable cash from any permitted source to meet redemptions.

To manage liquidity risk and avoid forced asset sales, sponsors often implement liquidity safeguards such as:

Redemption gates

Redemption gates limit the amount of redemptions in a given period, often set at a level that matches the anticipated time it would take for the fund’s entire portfolio to run-off in the ordinary course (for example, 5-10% of NAV per quarter). They can be set either on a whole fund basis or individual investor basis. The aim is to protect the fund from forced asset sales and help maintain portfolio stability.

If redemption requests exceed the gate, excess requests are typically placed in a queue and processed in subsequent redemption periods.

Lock-in periods

Lock-in periods aim to deter or restrict redemptions for a set period after the initial investment (commonly two to three years). Sponsors may use “soft” or “hard” lock-up periods, during which redemptions are subject to penalties or restrictions, to ensure capital stability during the initial investment ramp-up. Soft lock-up periods permit redemptions during the lock in period but subject to penalties (see “Redemption penalties” below). Hard lock-up periods do not permit redemptions during such period . A sponsor may also have numerous successive lock-in periods (e.g., an initial three year and then a subsequent two year) to assist in guaranteeing capital as it scales a fund.

Slow payout mechanisms

Slow payout mechanisms allow the sponsor to convert redemption requests into a separate class of “liquidating” shares, which continue to fluctuate in value along with the fund NAV until the sponsor determines that the fund is in a position to redeem them. Investors will continue to get exposure to the entire portfolio, including participating in new investments. This is differentiated from the “Run-off redemption model” below.

Redemption penalties

Redemption penalties seek to financially disincentivise from redeeming, most commonly applied during a soft-lock in period. This could include:

• a redemption fee which is charged as a percentage of NAV; or
• explicitly only offering a benefit to an investor if they remain in the fund. For example, offering a discounted management fee should they remain in the fund during the soft lock-in period. If they do not, then the redeeming investor must pay such amount as if the discount had not applied.

A redemption fee is usually applied at the fund level and applicable to all. For more tailored benefits linked to redemptions, these may be catered for in a side letter and offered on an investor-by-investor basis instead.

Redemption frequency

Sponsors may look to limit the frequency at which investors can redeem to provide additional safeguards against a run on the fund. The frequency will depend on investor demand, the liquidity in the portfolio and legal requirements. Typically we see quarterly or semi-annual redemptions.

Redemption notice

Any investor looking to redeem will have to provide notice to the sponsor. This usually ranges from 30 days’ notice to 180 days’ notice. This additional visibility on redemptions allows the sponsor time to pre-empt and determine how such redemption is going to be managed.

Run-off redemption model

Instead of paying out a NAV-based redemption as described above, the fund converts the relevant shares into one or more “run-off” share classes. The key difference between run-off shares and the slow payout mechanism described above is that run-off shares no longer participate in new investments made by the fund after the conversion date.

Run-off shares:

• remain exposed only to the “vertical slice” of the portfolio which existed at the time of conversion; and
• are redeemed at the then applicable NAV, in one or more tranches, as the underlying assets are realised or as liquidity permits.

This approach may be particularly attractive to institutional investors familiar with illiquid closed-ended funds, as it allows them to “switch off” exposure to new deals while waiting for their capital to be returned. It also potentially places less pressure on the valuation of the underlying portfolio as the redeeming investors may only receive amounts when the underlying assets are realised, making it more attractive for strategies which are less liquid or easy to value (such as distressed investments).

Vintage and hybrid models with run-off features

Some evergreen credit funds use a “vintage” structure, where each vintage operates like a closed-ended fund, but with the option for investors to roll commitments into subsequent vintages. The option to roll may either be automatic (known as opt out) or require a proactive commitment by the investor to roll (known as opt in).

These models may also offer a “run-off” option, allowing investors to opt out of future investments and move their interest into run-off at certain points during the investment period. This is an additional right, over and above the right to cease to participate in future vintages.

The presence of run-off features can impact the fund’s leverage facilities and borrowing base, as undrawn commitments can effectively be removed from the borrowing base when investors elect to go into run-off. It is also important to consider whether investors should remain responsible for funding costs and expenses during any period in which all or part of their interest is in run-off.

Other considerations

In addition to run-off and redemption mechanisms and using distributions or selling assets, sponsors may use the following tools to assist with meeting redemptions:

• borrowing facilities (if legally permitted). Therefore, if using a vintage model it will be important to understand if the facility is available to collateralise across the vintages; and
• undrawn commitments or new subscriptions.

Concluding thoughts

There is no one-size-fits-all approach to redemptions and run-off in evergreen credit funds. Instead, sponsors can choose from a variety of models, ranging from NAV-based redemptions with gates and lock-ups to run-off share classes and vintage structures with run-off elements.

The choice of redemption and/or run-off model should align with the liquidity profile of the underlying assets and the expectations of the target investor base. Whereas private wealth investors may expect quicker access to liquidity, institutional investors may be more comfortable with slower, staged redemptions and run-off mechanisms.