Many interval funds are focused primarily on generating income for investors and secondarily on maintaining a specific level of liquid investments to meet periodic repurchases. Since they do not need to provide daily liquidity, interval funds can invest in illiquid asset classes, such as those targeted by other “alternative” providers, including hedge and private equity funds. Hedge funds may even have a disadvantage in that they may be more at the mercy of redemption surges during market downturns (especially with event-driven and distressed funds). Interval funds may, therefore, offer advantages to investors and managers because they not only give managers the flexibility to invest without the threat of an unexpected redemption, but they also provide investors with the ability to trade at the NAV, compared with investors at other closed-end vehicles who will likely trade at a price different from the NAV.
Other than direct investments in debt and equity, interval funds may also invest in investment companies, such as trusts, limited liability companies, and partnerships. Such indirect investments are useful for generating excess returns but offer limited liquidity due to extended investment periods. The direct investments often targeted by interval funds include structured credit (mortgaged-backed securities and asset-backed securities), term loans, distressed debt (mezzanine and subordinated corporate debt, sovereign debt), real estate and other types of high-yielding investments. Some of these direct investments fall under Level 2 in the fair valuation hierarchy of the Financial Accounting Standards Board’s Accounting Standards Codification Topic 820 (ASC 820) — Fair Value Measurements. Level 2 considers quoted prices for similar assets or liabilities in active or inactive markets and other observable inputs (e.g., obtaining yield observability for similar debt instruments when pricing a specific issuer’s corporate debt). However, depending on the market observability of the valuation inputs for specific securities, especially for distressed investments with limited trading, an ASC 820 classification as Level 3 may be in order.
Managers of interval funds need to be cognizant of the protocols that will need to be put in place to ensure that valuations are accurate. Indirect investments, such as those in alternative funds that are, unobservable to any non-investor, are generally valued at the NAV of the underlying fund. Typically, an investment committee is established to meet on a frequent basis and evaluate the positions described above that warrant a Level 3 classification, as well as investments in alternative funds that are not valued at the NAV. Such an evaluation includes analyzing key assumptions used to internally model certain investments that do not have enough trade data or market-observable pricing.