The past five years have witnessed a remarkable surge in the popularity and assets under management for interval funds, mirroring the broader expansion of the alternative investments industry. This growth trajectory has brought unique opportunities and challenges for fund sponsors seeking to navigate this evolving landscape. Kim Flynn, Managing Director at XA Investments, a firm specializing in alternative investment product development, recently joined "The Alternative Investment Podcast" with host Andy Hagans to offer insights into the success story of interval funds, the current environment for sponsors, and the future outlook for these complex investment vehicles.
Flynn, with a distinguished background that includes helping to develop over 40 closed-end funds at Nuveen, a recognized leader in the listed closed-end fund market, brings a wealth of experience to the discussion. Her tenure at Nuveen, which spanned nearly 12 years, was dedicated to launching new listed closed-end funds, often in collaboration with external portfolio managers to leverage specialized expertise. Upon departing Nuveen in 2016, Flynn co-founded XA Investments, an asset management platform focused on partnering with sub-advisors for alternative strategies, and has since become a prominent voice in the interval fund space.
The Rise of Interval Funds: Understanding the Structure and Appeal
The conversation delved into the fundamental appeal of interval funds and their predecessors, closed-end funds, as investment structures. Historically, closed-end funds, particularly those focused on municipal bonds, gained traction among investors seeking income. Unlike open-ended mutual funds or exchange-traded funds (ETFs), which can issue and redeem shares to track net asset value (NAV), closed-end funds operate with a fixed number of shares after an initial public offering. These shares then trade on an exchange, often at a discount or premium to their NAV, driven by market supply and demand dynamics.
Flynn explained that the search for yield, particularly in the decade preceding recent interest rate hikes, was a significant catalyst for investor interest in closed-end funds. While ETFs offer continuous liquidity and mechanisms to keep prices close to NAV, closed-end funds, due to their fixed capital structure, can sometimes trade at significant discounts. Historically, the average discount for listed closed-end funds hovered around 4.5%, a figure that coincidentally aligned with typical sales loads. However, current market conditions have seen these discounts widen, with some IPOs from 2021 trading at 10% to 20% discounts. This dislocation presents opportunities for savvy secondary market investors who can acquire shares at a discount to their underlying asset value.
A key structural advantage of closed-end funds, particularly for income-focused investors, is the ability to employ leverage. Modest leverage, when applied to income-generating assets like municipal bonds, can enhance yields by an additional percentage point compared to equivalent mutual funds. This leverage, combined with the potential for secondary market discounts, offers a compelling value proposition for certain investor segments.
The Evolution Towards Interval Funds: Bridging the Liquidity Gap
The listed closed-end fund market, while historically robust, began to experience saturation and a pause in new issuance around 2015, partly influenced by the volatility experienced in certain sectors like energy MLP funds. This led sponsors to explore alternative closed-end structures, most notably interval funds and tender offer funds.
"The shift that we’ve seen in the market in the last five years is much more focus and attention on the interval fund space," Flynn stated. While still classified as a type of closed-end fund under the Investment Company Act of 1940, interval funds differ significantly from traditional listed closed-end funds in their liquidity mechanisms.
Interval funds are designed to offer a degree of liquidity that bridges the gap between highly liquid mutual funds and illiquid private placements. Investors can typically subscribe to interval funds on a daily basis, with their NAV calculated daily. However, liquidity is constrained, with redemption requests typically limited to a certain percentage of the fund’s outstanding shares per quarter, often around 5%. This intermittent liquidity allows interval funds to invest in a broader range of less liquid or alternative assets, including real estate, private equity, venture capital, and credit strategies, which require longer investment horizons and may not be suitable for daily redemption structures.
Navigating the Challenges: Valuation, Liquidity, and Investor Education
The unique structure of interval funds, while enabling access to illiquid alternatives, also presents inherent challenges, particularly concerning valuation and liquidity management. Flynn expressed concern that some sponsors may oversell the liquidity of interval funds, potentially misrepresenting them as akin to mutual funds.
"These are not mutual funds, and they should not be sold in that fashion," she emphasized. The potential for prorated redemptions, where investors may not receive their full requested redemption amount in a given quarter, or even subsequent quarters, can lead to frustration and concern. The market for interval funds has not yet been fully tested through a prolonged period of significant redemption requests, mirroring the challenges faced by other structures during the 2008-2009 financial crisis.
The issue of valuation also remains a critical consideration. While listed closed-end funds benefit from continuous market pricing, interval funds rely on NAV calculations, often employing third-party valuation agents. Flynn highlighted the importance of rigorous and transparent valuation processes, acknowledging that while third-party agents utilize sophisticated methodologies, the absence of constant market repricing, as seen in publicly traded securities, can lead to questions about the true underlying value. The "skin in the game" principle, where fund managers and sponsors invest their own capital alongside investors, is crucial for aligning interests and building confidence in the stated NAV.
Sponsor Strategies and Best Practices in a Crowded Market
XA Investments has positioned itself as a trusted partner for asset managers seeking to navigate the complexities of launching interval funds. The firm offers consulting services, assisting clients in developing proprietary fund platforms and bringing new fund sponsors into the listed closed-end fund and interval fund markets.
Flynn noted that the interval fund market has become increasingly competitive, with over 180 funds now available. This saturation necessitates a strategic approach for new entrants. Best practices for launching successful interval funds, according to Flynn, include:
- Seed Capital and Scale: Launching with significant seed capital or the contribution of existing private fund assets helps ensure the fund is not subscale. Investors are hesitant to commit to small, unproven vehicles.
- Fee and Expense Waivers: Initial expense and management fee waivers are crucial for making new funds more attractive to investors and improving their overall expense ratios as they scale.
- Client-Centric Design: Focusing on the needs of the target investor, particularly Registered Investment Advisors (RIAs), is paramount. This involves clear communication about liquidity constraints and appropriate investment horizons.
- Channel Strategy: For many new sponsors, the RIA channel is the primary entry point. Accessing broader distribution channels like wirehouses typically occurs after the fund has achieved sufficient scale and a proven track record.
- Competitive Differentiation: In a crowded market, particularly for credit-focused interval funds, sponsors must articulate a clear competitive edge or unique strategy to attract assets.
Emerging Trends and the Future of Alternatives
Looking ahead, Flynn identified several emerging trends that are likely to shape the alternatives industry in the coming years:
- RIAs Launching Proprietary Funds: Increasingly, RIAs are leveraging their direct client relationships to launch their own interval funds. This allows them to capture more of the fee structure and offer tailored investment solutions to their clients, rather than allocating to external managers.
- FinTech Platforms and Direct-to-Consumer Offerings: Fintech platforms are capitalizing on their digital engagement with investors to launch interval funds, often targeting a broader investor base, including non-accredited investors. While still in early stages for many, the success of platforms like Fundrise demonstrates the potential of this model.
- Impact Investing: Despite some ESG backlash in the U.S., there is a growing interest in impact-oriented interval funds. These funds, by investing in alternative or illiquid securities with specific social or environmental objectives, offer a distinct return profile that may appeal to investors seeking more than just traditional ESG screening.
The growth of interval funds underscores a broader industry trend: the increasing demand for access to private market investments within more accessible structures. As the alternative investment landscape continues to mature, clarity on product structures, robust investor education, and disciplined sponsor practices will be crucial for sustained growth and investor confidence. The journey of interval funds from niche products to a dominant force reflects the ongoing innovation and adaptation within the alternative investment space.
