The Difference Between Open-end Fund and Closed-end Fund

For purposes of this article an open-end fund is a fund, which invests in assets in an established trading market. A closed-end fund is a private equity, venture capital, or real estate fund. (Not to be confused with the typical open/closed-end funds which are variations of mutual funds).

The closed-end fund is an investment vehicle to invest in assets that are not freely transferable since they do not invest in assets on an established trading market, and therefore are not marked to market which is a distinction from the open-end fund.

Open-end funds are predominately structured with no specific term to the fund’s life. Whereas closed-end funds typically specify a life to the fund, which may be extended at the discretion of the general partner or with the limited partners’ consent. Open-end funds require a capital contribution upon admission to the fund, while closed-end funds require a capital commitment, which is subsequently drawn upon over time. Open-end funds use the capital and make and rebalance investments on an on-going basis, while closed-end funds have a limited period of time to make new investments.

Regarding liquidity to investors, the typical open-end fund permits the admission and redemption of capital on a regular basis. A hedge fund normally allows for subscriptions and redemptions on either a monthly or quarterly basis. While it is also normal in hedge funds for capital contributions to be tied up for an initial lock-up period, there is still the opportunity for investors to contribute and redeem their investments on a regular basis. Closed-end funds, on the other hand, have specifically defined features for the admission and redemption of funds. For example, closed-end fund investors contribute capital up-front by committing future dollars, versus funding the investment up front as a hedge fund investor would. The closed-end fund has significant penalties if the investor defaults on the commitment. Redemptions in closed-end funds are typically not permitted until the expiration of the fund. However closed-end funds typically do provide for distributions (if the fund has the cash) to cover the investor’s tax obligation with respect to undistributed taxable income.

Open-end funds charge management fees on the fund’s net asset value, or the investor’s capital account balance, which is marked to market. Closed-end funds typically have a tiered management fee over a specified period of time based on total capital commitments, followed by a specified management fee of actual capital contributions. Closed-end management fees also tend to decline over time as the investment, or portfolio company, is closer to its designed exit strategy. Generally, all fees to the general partner in a closed-end fund are typically capped by the investors, while open-end management fees are not capped.

Hedge fund investors are usually charged an annual performance fee (or allocation) payable to the general partner, which is typically measured by the increase in the marked to market value of the fund. Closed-end funds pay the general partner a carried interest, which is based on the profits realized from the exit of fund’s investment. The carried interest typically follows a defined repayment schedule which allows for the investor to first receive a return of capital, followed by the investor receiving a preferred return. Then the general partner receives catch-up distributions to attain the agreed upon carried interest on the preferred return to the investor. Finally the remaining excess profits are returned to the investors and general partner based on the carried interest percentage (typically 20-25% carried interest to the general partner). The closed-end fund typically has clawback provisions attached to any interim distributions made to the general partner if subsequent future profits do not justify the previously made payments to the general partner.

Open-end funds typically have the ability to invest in a wide array of investments within a certain investment strategy, while closed-end funds have a more detailed and narrow scope of investments that the fund is permitted to invest.

Open-end funds typically invest in assets that are available on an established market, which makes valuation of the investments more straightforward than the investments in which closed-end funds typically engage. To that end, the valuation of the open-end fund’s investment normally lies with the general partner. The valuation of the closed-end fund’s investment typically is agreed upon by a committee of investors, who are appointed by the general partner. The committee members are typically not part of management of the fund.

The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your individual facts and circumstances.