9 minute read 1 Jul 2018
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Why are interval funds experiencing a rightful rebirth?

By

Eyal Seinfeld

EY US Financial Services BDC Markets Leader

Deep knowledge and experience with BDCs. Married father of two. Passionate about coaching my children in basketball.

9 minute read 1 Jul 2018

Interval funds present a great opportunity for managers to provide investors with a vehicle that can potentially generate higher returns.

Active managers, facing significant fee pressures, understand the importance of being able to differentiate themselves in an uber-competitive market by innovating their product offerings to investors. This search has brought increased interest in the use of interval funds. As a cross between registered open-end and closed-end funds, interval funds are designed to provide investors with the benefits of both. Interval funds are vehicles with the ability to enter into illiquid investments while providing investors of the fund with increased liquidity.

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Executive summary
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Chapter 1

Executive summary

Interval funds are designed to provide investors with the benefits of open-end and closed-end funds.

The interval fund structure was first established in 1993 via SEC Rule 23c-3 in response to complaints about the very large market discounts to the net asset value (NAV) that closed-end funds often have. Closed-end funds generally are attractive because they allow investment managers to take advantage of a stable portfolio to achieve the potentially higher long-term investment returns that may be expected to accrue from illiquid investments. To achieve this stable portfolio, closed-end fund investors typically can’t redeem or sell their shares back to the fund, as is the practice with open-end funds. Instead, closed-end fund investors must look to sell their interests on the secondary market for potential investment liquidity. Closed-end funds often trade at a discount from the NAV on the secondary market. By agreeing to make periodic repurchase offers to repurchase (and to offer) investor shares on a quarterly, semi-annual or annual basis at the NAV, interval funds trade at NAV. Aside from periodic repurchase dates, interval funds can also continually offer their shares at the NAV.

Administratively, a registered interval fund is similar to a typical open-end or closed-end mutual fund. As they similarly are registered under the Investment Company Act of 1940, all three types of funds have many of the same regulatory, operational and tax requirements. Implementing robust controls, especially around the repurchase process, will provide potential investors with redemption offers that will be executed efficiently and without error. Interval funds are required to be priced at least weekly, but many price daily. While the redemption requests are significantly less frequent than the daily offering available to investors in open-end funds, interval fund managers still need to consider the ability to convert fund investments into cash to correspond to potential interval asset inflows and outflows. This consideration may cause an investment manager to make investment decisions to increase portfolio liquidity above what might be seen with closed-end funds. However, with proper portfolio management, the impact of this on investment returns can be minimized.

Formation

The first step in creating an interval fund is to file a registration statement with the SEC on Form N-2, which is the same form used by closed-end funds when they first register to operate under SEC rules. Once the SEC has approved the fund to commence operations, the manager typically will seed the fund (subject to the minimum capital requirements per Section 14(a) of the Investment Company Act of 1940) and focus on fundraising.

Portfolio composition and management
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Chapter 2

Portfolio composition and management

Interval fund managers must adopt the right procedures at the onset of launching the fund.

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.

Governance and administrative structure
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Chapter 3

Governance and administrative structure

As a qualified tax RIC, an interval fund would need to follow various income requirements.

Interval funds are similar to other investment companies registered under the 1940 Act (registered investment companies, or RICs) when it comes to governance protocols and mandatory filing requirements. They are required to have a board of trustees or directors that serves subject to the fund’s governing documents, and the majority of this board cannot be interested persons of the fund or the advisor. This board must also appoint an audit committee, with at least one member from the committee being a “financial expert.” The annual audited financial statements are structured similarly to other RICs, with additional disclosure around each repurchase offer made during the period (the repurchase offer amount and amount tendered), and a disclosure of the extent to which the fund repurchased stock when there are excess repurchase requests in any repurchase offer (as explained in the Operating protocol section below).

Typical service providers for interval funds include:

  1. An administrator that performs accounting and financial reporting for the fund (although these functions can be separated)
  2. An investment advisor
  3. A custodian (required by the 1940 Act) with whom the fund assets are maintained
  4. Legal counsel
  5. An independent auditor (independent under SEC rules)
  6. A transfer agent that processes dividends, maintains the shareholder register, and sends periodic tax and holdings statements to shareholders
Operating protocol
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Chapter 4

Operating protocol

The timing of repurchases has to be built into a policy document at the initiation of the fund.

As described previously, one of the main selling points for investors investing in interval funds instead of other closed-end vehicles is the increased investor liquidity provided via periodic repurchase offers. Repurchases can happen on a quarterly, semi-annual, or annual basis and the exact date of repurchase is communicated periodically, including the date of expiration of such an offer. Such timing of repurchases has to be built into a policy document at the initiation of the fund and can only be changed by shareholder vote. The exact date of repurchase is also important to shareholders because the repurchase price will equal the NAV per share of the fund on that date. Because of the importance of NAV as the price of the repurchase, the SEC mandates that interval funds calculate the NAV during each of the five business days preceding the repurchase request deadline. Further, per Rule 23c-3, the fund must also calculate the NAV at least weekly (the date and time of calculation will be determined by the board), each day investors purchase shares in the fund (because shares are continually offered and not necessarily aligned with repurchase dates) and also on the repurchase date. NAV calculations could be challenging, depending on the ability to determine the fair value of certain investments.

Rule 23c-3 states that interval funds cannot offer less than 5% or more than 25% of the outstanding common shares when making a repurchase offer. Because some funds stick to the minimum required offer of 5%, investors in these funds may be disadvantaged if total redemption requests exceed the offered number of shares. Excess repurchase requests are allocated on a prorata basis if the manager decides not to repurchase additional stock (limited to 2% of the outstanding common stock as of the repurchase deadline). The SEC allows interval funds to deduct a redemption fee from repurchase proceeds (not to exceed 2% of the proceeds) as compensation for expenses related to the repurchase. Interval funds are allowed to charge these redemption fees in addition to management fees.

Key statistics
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Chapter 5

Key statistics

Statistics clearly show that the number of active interval funds could significantly increase.

An interval fund database, Interval Fund Tracker (IFT), noted 436 interval funds that were registered with the SEC and had active investment portfolios. The AUM of these funds range from $2.1m to $5.0b. These stats show not only how sparse the current interval fund landscape is, but also how managers, both large and small are offering them. Despite the small numbers, interval funds are undoubtedly gaining in popularity. In 2017, 10 new funds were approved by the SEC.

IFT: Active funds
IFT: Pending registration

Summary

There are a number of incentives for fund managers to create an interval fund, including the inherent benefits of being early adopters of new investment products (first to market). Knowing the repurchase offer schedule in advance allows managers to better plan for fund outflows and invest in less liquid, and potentially higher risk, investments.

About this article

By

Eyal Seinfeld

EY US Financial Services BDC Markets Leader

Deep knowledge and experience with BDCs. Married father of two. Passionate about coaching my children in basketball.