Launching an interval or tender offer fund is like playing a multi-level chess game. There is a great deal of complexity in taking advanced investment strategies and designing, maintaining, and selling these 40 Act investment vehicles. Intensive strategy and deliberate planning are needed to grapple with their specific idiosyncrasies. It is important to note that there is nothing magical about these fund structures that inspires a Field of Dreams “if you build it, they will come” response and, oftentimes, it becomes a challenging period between fund registration and reaching $100 million in assets under management, otherwise known by some as the “Valley of Death”.
Despite these challenges, the interest and number of fund launches have been increasing with Interval Fund Tracker now reporting on a total of 83 Interval Funds with over $63 billion in assets. This is a group of funds that essentially did not exist a decade ago that have attracted assets at a 32% compounded annual growth rate since 2017. So, there is something bigger going on here.
To learn more about this specialized area of the asset management industry, we reached out to Todd Werner, SVP Retail Alternatives Product Specialist and Nick Darsch, SVP Business Development of Ultimus Fund Solutions - a leading independent, tech-enabled provider of full-service fund administration, accounting, and middle office services provider for RIAs. We asked them questions to better understand this vehicle that is providing more access to alternative investments and being hailed for leading the democratization of institutional investment strategies.
Hortz: What exactly are interval and tender offer funds? What were their origins and how have they been evolving?
Todd Werner: Interval and tender offer funds are continuously offered registered closed-end funds that provide investors access to illiquid alternative investment strategies that are generally uncorrelated to market returns while providing liquidity through the periodic repurchase of shares. Historically registered funds were organized under Section 5 of the 1940 Act: which strictly defined management companies as either open end or closed end companies.
Open end companies continuously offer shares that are redeemable by the management company at the current NAV on demand. Due to the unpredictable nature of redemption requests, open end fund managers generally invested a high percentage of a fund’s assets in liquid investments. Closed end fund companies typically offered non-redeemable shares through an IPO process at launch. Because closed end funds did not need to be managed for potential redemptions, managers could pursue alternative investment strategies that typically included investing in illiquid assets. Liquidity for investors in these funds was made possible through share sales to other investors on an exchange. For various reasons, shares of these closed end funds often traded at a discount to the NAV, which caused issues for both investors and fund sponsors. These discounts were viewed as one of the reasons closed end funds failed to gain significant attention from investors.
To address this issue, closed end companies began to offer shares continuously at NAV pursuant to Rule 415 under the Securities Act of 1933. While shares issued by these funds did not trade on an exchange, liquidity was offered by the fund through a periodic share repurchase pursuant to Section 23(c)(2) of the ’40 Act. The market continued to evolve in the early ‘90s when the SEC recommended rules to guide managers on how to repurchase shares on set intervals, which led to the adoption of Rule 23(c)(3) and the introduction of the interval fund.
However due to various reasons including new product innovation such as the introduction of ETFs and robust market returns throughout the 90’s and early 2000’s, these funds failed to gain in popularity. That all changed in the late 2000’s. During the financial crisis of 2008, investors saw market declines across both domestic and foreign markets. This led investors to seek portfolio diversification through alternative investment strategies that were not correlated with the markets.
Over the next decade, the SEC changed the regulatory framework to make it easier for closed end funds to invest in private companies and reduce regulatory hurdles while making it more challenging for mutual funds to make similar investments. At the same time, investors in private funds were becoming interested in some of the safety features prescribed by ’40 Act funds as well as the preferential tax treatment that comes with being organized as a RIC (1099 vs Schedule k1). A combination of investor demand and enhanced product features made possible through changes implemented by the SEC created an opportunity for interval funds to gain in popularity.
Hortz: What are the benefits of using an interval fund structure for investment managers versus other fund structures?
Todd Werner: From an investment manager perspective, there are many benefits to using an interval fund wrapper for an alternative investment strategy. The first is that an interval fund is not required to invest a large percentage of a fund’s assets in liquid securities to satisfy unscheduled redemption requests from investors. Managers of interval funds must invest a percentage of the fund’s assets in liquid securities equal to the value of the outstanding shares that are offered to be repurchased (5%-25%) at scheduled intervals (typically quarterly).
Many alternative investment strategies involve investing in assets that are considered illiquid. Not having to invest a large percentage of assets in liquid securities that do not align with the investment strategy creates an opportunity to achieve the desired investment performance return. Mutual funds offer to repurchase shares daily at the NAV from the investor and therefore must be managed to support the redemption outflows that could come at any time. Therefore, mutual funds must invest at least 85% of the fund’s assets in liquid securities as defined by rule 22e-4. This restriction makes it challenging for mutual funds to achieve performance returns that are uncorrelated to the market.
Interval Funds also provide an opportunity to charge higher fees, specifically performance fees on income earned, increasing the attractiveness of these products for fund advisors.
Hortz: What are some of the largest challenges that investment managers need to be aware of and plan for in launching interval and tender offer funds?
Todd Werner: It is important to understand that the process to launch and operate an interval or tender offer fund can be time consuming and expensive. Decisions made during this stage can potentially create challenges throughout the launch of the fund. To mitigate these costs, you must align yourself with key partners early in the process to ensure you are receiving proper guidance. Some of the biggest decisions an investment manager will make involve the investment strategy, product structuring, asset raising, and distribution.
The fund’s investment strategy will play a large role in determining how the fund is structured, which impacts the frequency that 1) a fund may be valued 2) a fund can be offered for purchase, and 3) shares are repurchased by the fund. You need to select a fund wrapper (interval or tender) that is appropriate for your strategy.
It’s also important to understand that valuing Illiquid assets can be time consuming and expensive. Be sure to factor in these costs when determining the NAV frequency for your fund. If your target investor is someone who may be new to the alternative investment space, then you should tailor the product to include features that may be more appealing to those investors. These features may include predictable share repurchase schedules (liquidity) and lower fees.
It is also important to understand how the fund will be seeded (capital commitments, firm contributions) and to have a plan to grow the assets to a “break even” point from an expense perspective, which typically occurs at around the $100M mark. Understanding how you intend to distribute the fund can be key to reaching this goal. It is important to know how a fund’s structure can impact your distribution options. Some distribution platforms require daily NAVs to trade through an electronic ticketing system. Other platforms are designed to support a monthly or quarterly share purchase and typically involve a subscription agreement to be filled out by the investor. Electronic ticketing simplifies the investment process. Funds that trade on non-daily platforms tend to be more “paper” intensive, which can be discouraging to Investment Advisors, hindering sales.
These products are sold, not bought, and simplifying the investment process for the advisors can go a long way toward reaching your investment asset targets. Some clients believe they need to be on the larger distribution platforms to grow assets to reach the break-even point but cannot get on those platforms because they do not meet the minimum asset requirements. It becomes a case of the chicken and the egg and can be frustrating to the fund manager.
Hortz: What role does technology play in all this? How have you designed your technology to assist in these challenges?
Todd Werner: Having the right technology in place can be critical to gaining a competitive advantage. Whether your goal(s) are to gain access to investment/investor data, enhance the investor experience, or something less obvious, selecting a partner with a flexible technology platform can be key to your success. Our approach to platform development involves selecting the best of breed technologies and creating a process for these applications to speak to one another using APIs. This means that we can select the best tool for the job to optimize the client experience and help you stand out in a crowded marketplace.
Hortz: What trends are you seeing as to who are the groups most interested in developing these investment vehicles?
Nick Darsch: We are seeing interest in these structures from a wide variety of investment managers. They can act as a gateway for alternative managers focused on private equity, real estate, credit or even hedge funds to access a new pool of capital – specifically high-net-worth or retail investors - and diversify their business. There is typically a great deal of education that takes place for those types of sponsors who are new to the ’40 Act and the nuances of selling these products from a distribution (channel/fee) and compliance perspective. It often takes longer to implement these requirements at the sponsor level than most of these firms originally anticipate. We are also seeing interest from traditional ’40 Act sponsors who see the vehicle as an opportunity to leverage their existing distribution network (and potentially investment expertise) to introduce products with higher fees and stickier assets than mutual funds.
Hortz: How can managers determine if these vehicles are the best ones for their investment strategies and if they are prepared to launch these vehicles? How do you help in this process?
Nick Darsch: The marketplace for these products today is still maturing. Often, managers must pull together a network of resources and subject matter experts to understand the market and use these inputs to help design a successful product. We often say that it takes close to $100m product AUM to put a new fund in a position to succeed, that’s because most of the critical distribution outlets have both track record and fundraising requirements before they will even entertain an interval or tender offer fund. That’s where Ultimus can provide a lot of value. We track the pulse of the market and recent trends from a structuring, demand, and regulatory perspective. Our team can introduce the stakeholders that sponsors can engage to help create their product. The space is rapidly evolving, and it is important for sponsors to work with a partner fully invested in the space.
Hortz: Can you share some examples of different interval fund launches you consulted on to illustrate this process?
Nick Darsch: We have had the opportunity to work with many of the new, innovative launches in the past few years. From large multi-national asset managers building out a new retail alts business, to portfolio manager spinouts from some of the largest private equity and credit sponsors, to direct-to-investor/advisor digital platforms, and large alts and ’40 Act sponsors entering the market. The motivations and design of the business in each of those cases are different but the intentional aspect of product design is the same – understanding your client’s needs, how your product can solve those challenges, and marrying those demands within the regulatory framework is critical.
Hortz: Can you offer any advice or recommendations to RIAs and asset managers thinking about launching an interval or tender offer fund?
Nick Darsch: The key is to have a game plan. A ‘build it and they will come’ mentality will not work in this space. More and more products are coming to market. It is critical to design a product here with intentionality and, even though understanding of the structures and asset classes in this space has matured, there is still a huge need for education in the marketplace.