Are Investment Advisors Sleeping on Interval Funds?
- Mar 5, 2021
A vehicle not too widely thought of by most private equity managers is an interval fund. With the current demand by both institutional and retail investors for more access to alternative investments and illiquid securities not widely offered through open-ended funds, an interval fund could be the right vehicle to satisfy the demand.
What Is an Interval Fund?
An interval fund is a closed-end investment company that is registered with the SEC under the Investment Company Act of 1940 (1940 Act).
There are currently under 100 active interval funds in the U.S., with approximately 16 new funds launched between Q1 2019 through Q1 2020. (1)
Key Characteristics of an Interval Fund
- Portfolio make-up – No restriction on the amount of illiquid investments held;
- Investor eligibility – No investor eligibility requirements if the shares are registered under the Securities Act of 1933 (33 Act), otherwise participants are limited to accredited investors;
- Continuously offered – Interval funds can continuously offer shares to investors based upon the net asset value (NAV) of the fund.
- Pension Plans - Not subject to rules under the Employee Retirement Income Securities Act (ERISA) or Unrelated Business Taxable Income (UBTI) regulations;
- Investor liquidity – offers periodic repurchase of shares;
- Regulated Investment Company (RIC) Taxation – The ability to elect RIC status for tax and issue annual 1099s;
- Distribution channels – Available to be sold through a variety of platforms unavailable to private funds.
Let’s explore each of the key considerations:
Private equity managers and other advisors managing more illiquid portfolios have avoided the public arena as their investment strategies didn’t meet the requirements of an open-ended 40 Act fund. Open-ended funds, also known as mutual funds, must limit their illiquid investments to 15% of its total assets. The SEC defines an “illiquid investment” as a security that cannot be sold or disposed of in the ordinary course of business within seven calendar days at approximately the value ascribed to it by the fund.
Obviously a private equity fund, real estate, distressed debt, structured finance and other funds focused on more illiquid securities would not meet the qualifications to be a mutual fund. However, in an interval fund there generally is no limitation on the amount of illiquid investments that can be held, making it a viable vehicle for private equity funds and other more illiquid strategies.
“An alternative asset manager may be able to broaden its investor base by offering its strategies in an interval fund wrapper, which can be publicly offered to retail investors without the same liquidity burden as traditional mutual funds,” said Christopher Carlson, counsel at Seward & Kissel.
One drawback is that interval funds are required to calculate an NAV on a weekly basis.(2) Additionally, during the five days prior to the repurchase offer period (described below), the NAV must be calculated daily. This could prove challenging and costly where funds hold a significant number of illiquid securities.
For interval funds that elect to register their shares under the 33 Act, the shares can be sold to the retail public. This opens up a whole new market to private fund managers, who previously were limited to offering interests in their funds to accredited investors.(3) Some interval funds choose not to register under the 33 Act and are content with offering their shares to accredited investors only. If the fund can ensure that all investors are “qualified clients”(4) the fund can charge a performance fee similar to a private fund. This creates a kind of “regulated hedge fund” as it allows for continuous subscriptions, has limited share repurchase offerings, management fees and incentive fees assessed, and no restrictions on the type of investments purchased, yet the fund is registered with the SEC.
Unlike traditional closed-end funds, which raise capital through a one-time initial public offering (IPO) or private equity funds, where investors commit capital during the initial investment period, interval funds will continuously offer shares at the NAV of the fund typically on a monthly or quarterly basis. This helps lengthen the time period for raising capital into perpetuity.
Private funds limit ERISA and IRA investors to 25% of the fund’s assets in order to avoid the fund’s assets from being considered “plan assets” and subject to the restrictions under the ERISA rules. This can prove frustrating for pension plans who are forced to limit their investments into certain private funds in order to circumvent being subject to the ERISA rules.
40 Act funds are exempt from the ERISA rules so they are not limited to the amount of ERISA investments they can accept.
Additionally, since private funds are typically pass-through entities for tax purposes, they can potentially generate UBTI which is passed through to investors on Schedule K-1s. Pension plans are tax-exempt entities but are subject to taxation on UBTI. Due to 40 Act funds taking a corporate form and electing to be taxed as a RIC for tax purposes (see further discussion below), there is no pass-through of UBTI to investors.
When considering the above two facts coupled with the regulatory oversight from the SEC, it makes an interval fund a very attractive vehicle for pension plans seeking access to private equity or other illiquid type investments. Considering there was approximately $32 trillion in U.S. retirement plans as of December 31, 2019,(5) this is a huge market to have the ability to tap into.
Traditional closed-end funds have no mechanism to allow for investor redemptions from the fund. Since closed-end funds are listed on an exchange, investors have liquidity by selling their shares on an exchange. Shares of closed-end funds will not always trade equal to the NAV per share of the fund so investors seeking to sell shares might have to sell shares at a discount to the NAV per share.
By contrast, an interval fund will make periodic offers to redeem shares from investors. To qualify as an interval fund, it will have set dates established during the year where the fund will offer to investors to buy back from 5%-to-25% of its outstanding shares. These offer periods can be quarterly, semi-annually or annually. If investor requests exceed the total of the offering, the reoffered shares will be pro-rated over the investors requesting to redeem shares. So it’s possible in certain instances that investors may receive less than the amount they requested. Typically an interval fund’s board will select to offer to repurchase 5% of the shares on a quarterly basis. A fund will need to obtain approval from the SEC if it sought to offer to repurchase shares more often than quarterly. Private equity and other strategies involving highly illiquid investments may opt to allow only annual repurchase offers.
A fund that is slightly different than an interval fund is the “tender offer fund” or “discretionary repurchase offer fund.” The tender offer fund has many of the same features as an interval fund with the exception of how shares are repurchased. Under a tender offer fund, there are no specified repurchase dates, instead a tender offer fund can offer to tender shares to be repurchased at any date determined by the board. These offers can be as frequently as monthly or not at all. “Discretionary repurchase offer closed-end funds could be a more flexible alternative to an interval fund that still provides the potential to offer investors liquidity where the once-a-year, twice-a-year or once-a-quarter interval fund schedule may not align with the liquidity available from the underlying strategy,” Carlson said.
Advisors can decide which vehicle will function better with their investment strategy.
One of the big advantages of 40 Act funds over private funds is the ability to elect RIC status under Subchapter M of the Internal Revenue Code. Under the RIC rules, a fund will avoid corporate taxation provided they comply with certain requirements. A few of the key provisions are below:
- Meets a quarterly asset diversification requirement. The fund must hold at least 50% of the fair value of its total assets represented by items such as cash, U.S. Government securities, other RICs, and other securities. Securities by a single issuer are limited to 5% of the fund’s total assets in order to count as a “good asset” for purposes of the test. The fund can also not have investments from a single issue that exceeds 25% of the fund’s total assets.(6)
- Meets an annual 90% gross income test. Funds must generate at least 90% of its gross income from sources such as dividends, interest, gains from sales of stocks, options, forward contacts, etc. Examples of sources of income that do not qualify, also known as “bad income,” would be income from commodities, real estate and fees for services.(7)
- Must distribute at least 90% of its taxable income annually.(8)
For interval funds investing in private equity investments the asset diversification test could pose challenges unless the fund can sufficiently diversify its portfolio.
Unlike private funds, which are limited to selling shares/interests in their funds through private placements to accredited investors and qualified purchasers, an interval fund will sell its shares through various distribution channels. Where an interval fund shares are registered under the 1933 Act, shares can be sold to the public through a third-party distributor, who typically has a large sales force to sell shares directly to the public or to investment advisors for their clients. Since third-party distributors are unaffiliated with the advisor, they are unbiased in their sales efforts. Advisors to interval funds should be prepared to work with the distributor as the strategies incorporated by interval funds tend to be more complex than mutual funds, so clarity is needed in order explain the product to potential investors.
Quick Comparison of the Characteristics of Various Types of Funds
|Private Investment Fund
|Illiquid investment limitation
|Subject to ERISA rules
|Yes if capital exceeds 25% of total assets
|None if registered under the 1933 Act
|Limited to accredited investors and qualified purchasers
|Fund offers to repurchase a limited # of shares either quarterly, semi-annually, or annually
|Monthly or quarterly
|Only if all investors are qualified clients
|No-Fulcrum fees only
|Monthly or quarterly
|Cannot exceed 33% of gross asset value
|Cannot exceed 33% of gross asset value
|Registered with the SEC under the 1940 Act
In a nutshell, for private equity and credit fund managers looking to access the retail market or expand their exposure to retirement plans, an interval fund could be the perfect vehicle to bring their investment strategy to market.
(1) Per “Interval Fund Tracker.com”
(2) Investment Company Act Rule 23c-3(b)(7)(i)
(3) An accredited investor as defined in Rule 501 of Regulation D includes a list of eligible persons and entities, including persons with a net worth of least $1 million, excluding the value of one’s primary residence or have income of at least $200,000 each year of the last two years (or $300,000 if married), limited liability companies with $5 million in assets, and others defined under the rules.
(4) Definition of a qualified client is (1) an entity or natural person with at least $1 million under management with the advisor or (2) an entity or natural person who has a net worth of more than $2.1 million, excluding their primary residence.
(5) As of December 31, 2019 per the Investment Company Institute
(6) IRC Sec. 851(b)(3)(A) & 851(b)(3)(B)
(7) IRC Sec. 851(b)(2)
(8) IRC Sec. 852(a)(1)
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Frank Attalla is a Partner in the Financial Services Group, with over 30 years of experience in the field of public accounting and 20 years focused in the financial services sector.
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