The alternative investment industry has witnessed a significant surge in growth over the past five years, with interval funds emerging as a particularly dynamic and rapidly expanding segment within this broader trend. Kim Flynn, managing director at XA Investments, recently shared her expert insights on the remarkable success of interval funds, alongside the evolving challenges and opportunities facing their sponsors, during an appearance on The Alternative Investment Podcast.
A Decade of Expansion in Alternative Investments
The broader alternative investment landscape, encompassing private equity, venture capital, real estate, and hedge funds, has seen assets under management grow substantially. Data from Preqin, a leading alternative assets data provider, indicates that global alternatives AUM reached over $13 trillion in 2022, a substantial increase from approximately $8 trillion in 2017. This growth is fueled by institutional and retail investors seeking diversification, enhanced returns, and access to asset classes traditionally unavailable in public markets.
Within this expanding universe, interval funds have carved out a significant niche. These closed-end investment vehicles offer a unique structure that bridges the gap between traditional mutual funds and private investment funds, providing investors with periodic liquidity while allowing fund managers to invest in less liquid alternative assets.
Kim Flynn: A Driving Force in Fund Innovation
Kim Flynn brings a wealth of experience to the discussion, having spent nearly 12 years on Nuveen’s product development team, where she was instrumental in launching over 40 listed closed-end funds. Nuveen, a well-established leader in the closed-end fund market, particularly in municipal bonds, provided Flynn with a strong foundation in developing complex financial products.
"The work that we did at Nuveen, one thing that surprises people is that it was often in partnership with outside portfolio managers," Flynn explained. "When we didn’t have a capability or skill internally, we would look to partner externally." This collaborative approach informed her subsequent career path.
Upon leaving Nuveen in 2016, Flynn co-founded XA Investments, an asset management platform focused on partnering with sub-advisors to launch alternative investment products. XA Investments engages with a wide spectrum of asset managers, from small boutiques to large global wealth managers, highlighting the growing interest in specialized fund structures.
Understanding the Appeal of Closed-End and Interval Funds
Flynn elaborated on the fundamental appeal of these structures, particularly for investors seeking income. Listed closed-end funds, by their nature, are "closed to raising new capital" after their initial public offering. Unlike exchange-traded funds (ETFs) with their creation and redemption mechanisms that keep prices close to net asset value (NAV), closed-end funds can trade at a discount or premium to NAV.
Historically, the average discount for listed closed-end funds has been around 4.5%. However, current market conditions have seen these discounts widen significantly, with some IPOs from 2021 trading at 10% to 20% discounts. This presents an opportunity for secondary market investors to acquire shares at a lower price than the underlying assets’ value.
"Savvy closed-end fund investors take advantage of some of those market windows or dislocations to add to positions that they already hold, or to establish a position in a new fund," Flynn noted. A key advantage of closed-end funds, she added, is the potential for enhanced income through the use of modest leverage, a common strategy in offerings like municipal bond funds.
The Evolution of the Closed-End Fund Market
The closed-end fund market has undergone significant evolution. From its early days, largely driven by municipal bond funds, it expanded rapidly into various asset classes and strategies between 2000 and 2015. However, a pause in new IPOs occurred around 2015, partly due to the volatility experienced in certain sectors like energy MLP funds.
This shift prompted fund sponsors to explore alternative closed-end structures, leading to a heightened focus on interval funds and tender offer funds. While still technically closed-end, these structures are often continuously offered and can grow over time, making them more akin to open-ended funds in their capital-gathering capabilities. This evolution has been particularly pronounced in the last five years, with interval funds becoming a focal point for sponsors looking to house alternative strategies.
XA Investments: Facilitating Alternative Product Development
XA Investments positions itself as a facilitator for asset managers seeking to navigate the complexities of launching and distributing alternative investment products. "We set up the practice where, because we do not have in-house wealth management, we partner externally with asset managers," Flynn explained.
The firm has been instrumental in launching listed closed-end funds, including its first offering five years ago in partnership with an external sub-advisor focused on alternative credit. Their consulting practice assists asset managers in developing proprietary platforms, guiding new sponsors into the listed closed-end fund market, and advising on capital raising in the London-listed market. However, a significant portion of their work is now dedicated to the burgeoning interval fund space.
Interval Funds: Bridging Liquidity and Illiquidity
Flynn provided a detailed explanation of interval funds, differentiating them from traditional daily-liquid mutual funds. While investors can typically invest on a daily basis, redemption is limited, often to 5% of the fund’s net assets per quarter. This controlled liquidity allows interval funds to invest more heavily in illiquid securities, such as real estate, private equity, venture capital, and credit strategies, which often require longer investment horizons to realize their full potential.
"The legal closed-end fund structure would allow any closed-end fund, whether it’s listed or interval, to have 100% in illiquid securities. But practically speaking, listed closed-end funds don’t do that, because most of them have a daily NAV," Flynn stated. The ability to hold a greater proportion of illiquid assets is a key differentiator for interval funds compared to many listed closed-end funds, which often maintain more liquid portfolios to support daily NAV calculations.
However, this structure also introduces potential challenges. The intermittent liquidity means that during periods of market stress or increased redemption requests, investors may face prorated redemptions, meaning they might not receive their full requested amount in a given quarter.
"I do find that as we observe industry participants, a lot of them gloss over, and they frankly oversell the liquidity of an interval fund," Flynn cautioned. "These are not mutual funds, and they should not be sold in that fashion." She emphasized the importance of investor education regarding these liquidity constraints and the potential for prorated redemptions, especially during periods of market volatility.
Navigating Valuation and Market Dynamics
A critical aspect of interval funds and other non-traded alternative vehicles is valuation. Unlike publicly traded securities that are repriced daily by the market, the Net Asset Value (NAV) of interval funds is typically calculated internally or by third-party valuation agents. This can lead to questions about how these valuations are determined, especially during market downturns.
Flynn acknowledged the concerns around valuation, particularly in comparison to the "manic Mr. Market" that drives pricing for publicly traded REITs or BDCs. While acknowledging the potential for market over-discounting, she also highlighted the importance of robust, third-party valuation processes.
"The trend is that third-party valuation firms, which specialize… are providing daily marks," she said. However, she also raised the crucial point of "skin in the game," suggesting that valuations are more credible when backed by the conviction of fund managers and sponsors who are themselves invested in the fund. This aligns with the practice of firms like Blackstone publishing the extent of their management capital invested in their funds.
The rapid influx of capital into large interval funds also presents a potential challenge. Flynn expressed concern about the velocity of money entering and potentially exiting these large funds. "If you’re daily-in, quarterly-out, subject to prorata, you’re setting yourself up for…" she began, implying potential liquidity issues if redemption requests outpace the fund’s ability to meet them. She favors fund sponsors who implement caps and manage growth at an appropriate pace, prioritizing long-term investors who understand the liquidity constraints.
Emerging Trends in the Alternatives Space
Looking ahead, Flynn identified several emerging trends shaping the alternatives industry:
- RIAs Launching Proprietary Interval Funds: A growing number of registered investment advisors (RIAs) are considering launching their own interval funds. With direct client relationships, these RIAs aim to capture more of the fee structure and offer tailored investment solutions, competing directly with existing alternative asset managers.
- FinTech Platforms and Direct-to-Consumer Offerings: FinTech platforms are increasingly leveraging interval funds to offer alternative investments directly to retail investors. Firms like Fundrise have demonstrated success in this space, suggesting a growing trend of democratizing access to alternative assets through digital channels.
- Impact Investing Funds: Despite some ESG backlash in the U.S., there is a notable emergence of impact-focused interval funds. These funds invest in private, alternative, or illiquid securities with the aim of generating both financial returns and positive social or environmental impact, offering a distinct proposition compared to ESG-labeled ETFs.
The Imperative of Investor Education
A recurring theme throughout the discussion was the critical need for enhanced investor education. As new and complex product structures like interval funds proliferate, ensuring that investors and their advisors fully understand the underlying assets, liquidity features, valuation methodologies, and potential risks is paramount.
"The buyer base for these funds initially is largely RIAs, but it’s still fairly concentrated," Flynn observed. Expanding this buyer base requires a concerted effort to demystify alternative investments and build confidence among a broader range of financial professionals.
The journey of interval funds from a niche product to a significant force in alternative investments underscores the industry’s continuous innovation and its responsiveness to investor demand for diversification and yield. As the landscape evolves, a deep understanding of these structures, coupled with robust investor education, will be essential for harnessing their potential while mitigating associated risks.
For those seeking further information on XA Investments and their services, the company can be reached via their website at xainvestments.com.
