Asset managers considering interval funds will want to ensure they understand the unique regulatory, operational, and servicing complexities around this structure.
What are Interval Funds?
First developed in the 1990s, interval funds are seeing a resurgence in popularity as their unique structure complements current market conditions characterized by volatility and fee compression. While interval funds have regulatory and operational considerations similar to other registered funds, a few key differences are raising their appeal to investors and asset managers alike.
Interval funds are closed-end funds with set selling and redemption periods, making them a popular place to house less liquid alternative investments including real estate, asset and mortgage-backed securities, corporate debt, or other types of structured credit that—due to illiquid holding limitations imposed by the Investment Company Act of 1940 (1940 Act)—are challenging to hold in open-end fund structures. Unlike traditional closed-end funds, which frequently trade at a discount on the secondary market and are therefore susceptible to price arbitrage, interval funds trade at the fund’s net asset value (NAV) at predetermined intervals.
Popularity Growing with Investors and Managers
Though a relatively small overall market of $27.5 billion in assets under management (AUM) according to Interval Fund Tracker, interval funds have experienced rapid growth. Over the past year, AUM have increased 41% and 16 funds were launched in 2018 alone. Interval fund launches now account for approximately 16% of all closed-end funds according to Lipper Fund Research, and the velocity of launches is increasing. Credit remains the most popular strategy, followed by real estate, highlighting how managers are using this structure to make traditionally less liquid investments more accessible to retail investors.
Interval funds represent an opportunity for traditional US asset managers to offer investors an avenue to pursue higher yielding, less liquid alternative investment strategies. Where open-end mutual funds are prohibited from investing more than 15% of their net assets in illiquid investments under the 1940 Act, the closed-end fund wrapper provides managers the flexibility to invest a larger concentration of assets in less liquid asset classes. In fact, interval funds have no limits on illiquid asset concentration at all, other than the need to maintain sufficient liquidity to fulfill repurchase requests at the predetermined intervals. This can make these funds more attractive to sophisticated or institutional investors who are looking for longer-term liability management and the potential for higher absolute returns. These investors are also probably better-positioned to adapt to the restricted, structured redemptions that are a key feature of interval funds.
Other market factors are driving interval funds’ popularity. This structure allows managers better control over redemption flow, which can be highly valuable in periods of volatility. Additionally, the Securities and Exchange Commission (SEC)’s new Liquidity Risk Management rules have further increased the regulatory complexity and reporting associated with open-end funds. The underlying alternative assets typically found in interval funds also warrant a higher fee structure, potentially making it an appealing addition to a firm’s product line up in an environment characterized by ongoing fee compression. Lastly, no single provider has taken hold of the market. AUM are currently concentrated among the larger asset managers, presenting an opportunity for firms at a range of AUM bands to consider launching an interval fund.
Regulating Interval Funds
Interval funds operate under Rule 23c-3 of the 1940 Act and are also subject to the Securities Act of 1933 and the Securities Exchange Act of 1934. Though technically classified as registered closed-end funds under the 1940 Act, interval funds are hybrids with characteristics of both open and closed-end funds. Like closed-end funds, interval funds make periodic offers to buy back stated portions of its shares from fund shareholders at specific time periods. However, unlike traditional closed-end funds, interval funds are not typically traded on the secondary market and therefore are less susceptible to price arbitrage and activist investor pressures. Like in open-end funds, interval fund shareholders who redeem shares during a periodic repurchase do so at the fund’s per share NAV.
From a liquidity standpoint, interval funds offer less investor liquidity than open-end funds but greater liquidity as compared to traditional closed-end funds. Open-end funds are limited under 1940 Act rules in the amount of illiquid investments they can hold to no more than 15% of a fund’s total assets. Closed-end funds on the other hand, have no such limitations and can theoretically hold an uncapped amount of illiquid investments in a given portfolio. Interval funds land somewhere in the middle of these two extremes. They are not subject to open-end liquidity requirements but are required, by Rule 23c-3, to develop policies to provide a minimum level of liquidity at defined quarterly, semi-annual, or annual periods. A portion of an interval fund’s assets, therefore, needs to remain in liquid positions in order for the fund to easily convert to cash to meet redemption obligations associated with the periodic share repurchases.
Derivatives may be utilized by interval funds to increase the portfolio’s overall leverage. However, interval funds are subject to the Derivatives Rule that limits the amount of imbedded leverage in mutual funds and Exchange-Traded Funds. Under the rule, funds are subject to a leverage limit of 200%, based on Value at Risk (VaR) calculations of a designated benchmark or 20% of the fund’s net assets using an absolute VaR test.
Interval funds may also elect to be treated as a Regulated Investment Company (RIC) under Subchapter M of the IRS code. Managers will want to ensure their investment strategy aligns with the IRS rules that support a RIC’s favorable tax treatment.
These requirements include deriving 90% of gross income from investments like stocks or securities, meeting quarterly diversification requirements, and annually distributing all of the fund’s investment income to shareholders.
Operational Considerations and Servicing
Interval funds require the typical service provider lineup including legal counsel and an independent auditor. Further, they also require transfer agency, custodial, and fund accounting/administration support.
From a governance perspective, interval funds operate similarly to other registered funds. In line with open-end funds, interval funds must have a board of directors, a majority of which cannot be interested persons of the fund or the adviser, and a corresponding audit committee with at least one committee member who meets the definition of a financial expert. Annual audited financial statements of the funds are also required.
From a valuation perspective, an interval fund’s alternative assets may come with additional complexities. Any investments with limited trading may create a valuation challenge and firms will want to ensure they have a good understanding of the accounting and regulatory considerations around calculating a NAV for these investments. While a NAV is generally only required weekly, in practice most interval funds strike a daily NAV. Typically, interval funds also establish an investment/valuation committee to evaluate and make fair value determinations with respect to hard-to-value positions.
Comparing Fund Structures
|1940 Act Applies||Yes||Yes||Yes|
|Illiquid Investments||Uncapped||Uncapped but must have liquid assets to cover periodic redemptions||Cannot exceed 15% of total assets|
|Pricing||Exchange traded, market price||Fixed once per day at NAV||Fixed once per day at NAV|
|Offering/ Formation||One time IPO Registration on Form N-2||Continuous offering Registration on From N-2||Continuous offering Registration on Form N-1A|
|Redemptions||Intra-day||Set 3, 6, or 12 month intervals at NAV||Daily redemption available at NAV|
Adding an Interval Fund to the Lineup
Interval funds should be evaluated in the context of a firm’s overall product mix and could serve as a useful complement to traditional open and closed-end fund product lineup. To avoid cannibalizing other products, firms with other alternative offerings could consider narrowing the investment strategy of the new interval fund. Ideally, firms should be looking to attract a different pool of investors that have not yet been served by existing offerings.
Following exemptive relief by the SEC, interval funds can offer multiple share classes, which could allow managers to tailor distribution across different channels. Relatively low investment minimums also function as a differentiating feature from many other alternative fund structures, as do opportunities for streamlined tax reporting through 1099 forms as opposed to K-1s.
As firms consider distribution opportunities, they will want to prepare for what could be a lengthier process. Due to the complexity of the operational due diligence surrounding the fund’s underlying assets, it may take longer for managers to access distribution platforms. Further, asset managers will need to put additional effort into explaining the benefits and limitations of this structure. Though unlikely to ever take hold of a dominant registered fund market share, interval funds may continue to grow in popularity provided asset managers can demonstrate enhanced returns for investors.
Five Questions to Consider Before Adding an Interval Fund
- Who are the target investors that could be best served by the illiquidity premium of this product?
- How can an interval fund complement my existing fund lineup?
- Which partners will need to be aligned to address the unique operational, regulatory reporting, and administrative challenges around this fund structure?
- Which, if any, enhancements will we need to make to our existing fund governance framework?
- At what frequency should the redemption period intervals be set?