Interval funds: Advantages and Disadvantages

Innovest Investment Committee

Once the province of only the largest institutional investors, alternative asset classes like private equity, private credit, and private real estate are becoming increasingly available to smaller investors.  The firms that manage investments in these areas have sought a way to accept investments from high-net-worth investors, as well as smaller institutional investors.  The interval fund structure has become a popular solution. 

Since the 1990s, the portfolios of many large foundations and endowments have seen outsized returns generated by private alternative investments.  The most well-known example is Yale University’s endowment, which has allocated heavily to these investments under long-time Chief Investment Officer David Swensen.  Yet minimum investments for these funds tended to be $5-10 million or more, putting them far out of most investors’ reach.  Moreover, investments in these funds often entailed commitments of a decade or more.  While that time horizon is not a problem for a portfolio expected to endure into perpetuity, it poses a hurdle for others with more limited time horizons.  Finally, the tax accounting for many private alternative investments, which are typically structured as limited partnerships, adds delays and complexity that further deter many investors.  Together, these challenges have precluded the majority of investors from experiencing the benefits that private alternative investments can offer. 

The most common professionally managed investment portfolios—open-end and closed-end mutual funds—solve some, but not all, of these challenges.  Unlike limited partnerships, mutual funds ordinarily have very low minimum initial investments and enjoy less burdensome 1099 tax reporting.  However, traditional mutual funds do not solve the private investment liquidity problem.  Private investments cannot be sold immediately to meet investor redemptions, as securities that trade daily can. Because open-end mutual funds allow investors to redeem their shares each day, they cannot invest more than 15% of the fund’s assets in illiquid investments.  Closed-end funds generally do not allow investors to redeem investments at all.  Instead, their shares are traded like stocks in the public market. Although this structure provides investors the ability to exit or reduce their investments in closed-end funds, the price at which they can sell might be meaningfully below (or above) the actual value of the fund’s assets.  

Interval funds offer a partial solution to the liquidity problem.  They may be “redeemed” at their net asset values (technically they are repurchased by the fund’s manager), but only periodically and only up to certain amounts.  Typically, investors may sell their interval fund investments back to the manager quarterly, and sometimes as infrequently as once or twice per year.  The total amount that a fund’s investors may sell each period is often between 5% and 25% of the fund’s total assets.  Interval funds also retain the benefits of much lower investment minimums and more favorable 1099 tax reporting.  

Here are some of the advantages and disadvantages of interval funds that we believe investors should understand.

Advantages of Interval Funds:

• They provide investors with access to asset classes such as private equity, private credit, and private real estate at much lower investments than traditional private investment vehicles. 

• They generally use the same 1099 tax reporting as other mutual funds, avoiding the delay and complexity of limited partnership’s K-1s.

• Unlike traditional private investment vehicles, they are structured to provide liquidity at net-asset-value ordinarily up to four times per year.

• Those that are registered under the Securities Act of 1933 can accept investments from any person or entity; they are not restricted to those with very high income or assets.

Disadvantages of Interval Funds:

• They limit each liquidity window to 5-25% of the fund’s assets.  If too many investors seek liquidity in a given window, each will receive a pro-rata amount of the repurchase amount.  For example, if the limit is 5% of fund assets and investors seek to withdraw 10% of the fund’s total assets, each will receive one-half of the amount requested.  Moreover, investors whose requests are not met in full must request their money again in the next window, which may also be oversubscribed. 

• Although they intend to provide periodic liquidity, they typically do not guarantee it. Some may charge “repurchase fees” of up to 2% of the requested amount.

• They ordinarily must invest some of their assets in more liquid securities like cash, stocks, or bonds so that they can satisfy periodic liquidity requests.  That means they cannot invest fully in private asset classes.

• Like many alternative investments, they usually charge higher fees than traditional mutual funds.

On balance, we believe that interval funds can play a valuable role in providing investors access to attractive private asset classes. However, just like very few mutual funds pass Innovest’s due diligence process, the same is true for interval funds. We thoroughly research each product and manager, focusing on the qualitative issues of organization, people, investment philosophy and process, etc., as well as historical performance, risk, and fees. Both strong due diligence and an understanding of interval funds’ advantages and disadvantages establishes a good foundation for their potential use in an investment portfolio.