Interval Funds: The Growing Market That’s Turning Advisors on to Alts
July 20, 2023 | Johnathan Rickman | Blue Vault
As economic uncertainty continues to tame investment expectations, the market for interval funds and tender offer funds has grown into a fierce, $133 billion industry,1 raising over $25 billion in capital last year alone. Interval funds are an increasingly popular allocation because they solve some of the structural and regulatory limitations associated with private funds while offering the potential to generate higher total returns.
As a result, many advisors have found interval funds to be a good first foray into the complex world of alternative investments. Advisory firms have also begun leveraging the flexibility of these products to launch interval funds of their own, providing additional incentives for partners and clients alike. But that’s a story for another day. For now, let’s take a closer look at this nascent-but-booming alts industry:
What are Interval Funds?
Interval funds are a type of SEC-registered, closed-end fund that expands investor access to illiquid alternative investment strategies through low investment minimums, frequent valuations, and 1099 tax forms. Governed by the Investment Company Act of 1940, interval funds are perpetual, continuously offered, and sold by financial advisors such as RIAs, independent broker-dealers, and wirehouse advisors.
They first made their appearance in 1993 when the SEC, after calling for a new structure halfway between open-end and closed-end funds, adopted Rule 23c-3 establishing the interval fund structure under the Investment Company Act. By 2010 they were housing illiquid alternative investments.
Interval funds are not listed on an exchange, so they must be onboarded at brokerage and clearing firms. If an interval fund has a daily NAV, which most do, then advisors can purchase the fund electronically through the National Securities Clearing Corporation’s FundSERV platform — the same ticketing platform used for buying mutual funds. If the fund doesn’t have a daily NAV, then advisors must use subscription documents and have clients sign them manually or through an online subscription processing platform.
Most interval funds have quarterly tenders at NAV (i.e., up to 5% per quarter) to provide limited liquidity. Each fund’s approach to liquidity is spelled out in the prospectus but these events typically occur quarterly or at least annually. Legally, repurchases must range from 5% – 25% of the total assets within the fund per repurchase period.
Interval fund investors receive 1099 tax forms, which are less laborious than K-1 forms for private funds. Interval funds are pass-through vehicles, so the taxation of the investments is specific to the strategy or asset class of the fund’s portfolio investments.
Investment Strategies
Interval funds can house an array of investment strategies, including:
· Private credit: The primary driver behind interval funds’ rise in popularity.
· Real estate: Typically fund-of-funds structured as a registered investment company; several direct real estate funds are available and structured as a REIT for tax purposes.
· Distressed debt: These interval funds offer a more transparent alternative to private debt funds.
· Infrastructure: Many advisors see this strategy becoming increasingly more popular over time.
· Private Equity: Early- to late-stage venture capital firms as well as leveraged buyout companies.
· Venture Capital: A popular investment approach as more startups are staying private for longer.
More interval fund strategies and tax structures are emerging as the market expands. Many are moving into farmland, infrastructure, and impact investing.
Some funds combine asset types, exposing investors to a range of securities in a single package. Unlike mutual funds, interval funds may invest without limitation in illiquid assets. However, interval fund managers often allocate some assets to more liquid securities to meet periodic liquidity requirements. These securities can take the form of exchange-traded funds, cash, cash equivalents, or mutual funds.
Why Advisors Like Them
Advisors are finding that interval funds are a good way to test the alts waters compared to private funds and direct investments. The latter are typically available only to high net-worth clients, while many interval funds can be sold to non-accredited investors, making them more retail-friendly. Interval funds can also accept new investors on a daily, weekly, or monthly basis.
Because of the 1940 Act’s rules and regulations, interval funds require frequent reporting and are overseen by an independent board of directors. Because of the additional legal and accounting expenses, this can make interval funds more expensive than private funds, but it also comes with benefits. For example, it means information about interval funds is more transparent and readily available – historically the Achilles heel of the alts industry. Daily valuations also make it easy for advisors to click to buy to take advantage of daily inflows.
Additionally, interval funds are not subject to FINRA Rule 5110 for corporate financing terms and underwriting arrangements.
“Also, recognizing that non-accredited investors generally prefer 1099 income tax forms rather than K-1 partnership forms, investment managers usually work hard to meet tax diversification and ‘good income’ tests,” explains Ann Maurer, Senior Vice President, Director of Product and Pricing, UMB Fund Services.
A Growing Market
Interval funds are a fast-growing market and are already beginning to prove their worth. The industry reported approximately $84.0 billion in total assets as of March 31, 2023, up from $81.3 billion as of December 31, 2022, and $76.1 billion as of March 31, 2022. The top 10 available interval funds are $3 billion or more in size and the top 15 industry sponsors of interval funds currently manage at least two.1
Market leaders are demonstrating they can pass critical fund milestones quickly and generate returns for investors. For instance, Bluerock’s Total Income + Real Estate Fund, the largest real estate interval fund as measured by net assets, announced July 6 it has to date paid more than $1 billion in total distributions to shareholders since its inception in 2012. Miguel Sosa, Client Portfolio Manager at Bluerock, attributes his firm’s success with interval funds to investing in an asset class they believe is appropriate for the interval fund structure, and educating clients on their features and limitations.
Clearly, this is an exciting market. Today there are 193 tender offer and interval funds currently available, with 27 new funds under regulatory review and set to launch soon. There are many quality sponsors in this space, but interval funds have short track records, complex tax structures, and different strategies. As more come online, insights and analysis on interval funds will become ever more crucial. That’s where Blue Vault comes in — to educate advisors on the true performance of these and other alternative investments.
Sources
1. XA Investments, June 2023.
