The alternative investment landscape has experienced a dramatic transformation in recent years, with interval funds at the forefront of this evolution. These unique investment vehicles, designed to offer a blend of accessibility and exposure to less liquid assets, have witnessed unprecedented growth, mirroring the broader expansion of the alternatives industry. Kim Flynn, Managing Director at XA Investments, recently joined The Alternative Investment Podcast to delve into the success story of interval funds, the evolving challenges and opportunities for their sponsors, and the broader implications for investors.
The Rise of Interval Funds: A Strategic Evolution
The past five years have been particularly transformative for interval funds. These structures, which are a type of closed-end fund, have become increasingly popular for investors seeking exposure to alternative asset classes like private equity, real estate, and credit, while still maintaining a degree of liquidity. Unlike traditional mutual funds that offer daily liquidity at net asset value (NAV), interval funds typically allow for limited redemption opportunities, often on a quarterly basis, and are subject to potential pro-rata limitations. This structure allows fund managers to invest in less liquid assets that may require longer investment horizons, potentially leading to enhanced returns.
Kim Flynn, a seasoned veteran in product development, brings a wealth of experience to this discussion. Having spent nearly 12 years at Nuveen, where she was instrumental in developing over 40 closed-end funds, Flynn has witnessed firsthand the maturation and shifts within the closed-end fund market. Nuveen, a recognized leader in listed closed-end funds, particularly in the municipal bond sector, provided Flynn with a strong foundation in navigating complex product structures. Her experience extends to collaborating with external portfolio managers, a practice that has become increasingly common as firms seek specialized expertise.
"The work that we did at Nuveen, one thing that surprises people is that it was often in partnership with outside portfolio managers," Flynn stated. "When we didn’t have a capability or skill internally, we would look to partner externally." This collaborative approach, she explained, is central to XA Investments’ strategy.
Understanding the Appeal of Closed-End and Interval Funds
The appeal of interval funds, and more broadly, closed-end funds, lies in their ability to bridge the gap between traditional liquid investments and illiquid private markets. Traditionally, closed-end funds were often favored by investors seeking income, particularly in periods of low interest rates. These funds are "closed" to new capital after their initial offering, and their shares are then traded on an exchange. This differs from ETFs, which have creation and redemption mechanisms that generally keep their market price close to their NAV.
"Listed closed-end funds are often used by investors who are looking for income," Flynn elaborated. "And in the last 10 years, that search for yield has driven a lot of people to the listed closed-end fund space."
A key characteristic of listed closed-end funds is their potential to trade at a discount or premium to their NAV. Historically, listed closed-end funds have traded at an average discount of around 4.5%. However, current market conditions have seen these discounts widen, with some IPOs from 2021 trading at discounts of 10% to 20%. For secondary market investors, this can present an opportunity to acquire assets at a lower price than their underlying value.
"The interesting thing about listed closed-end funds is that the historical average discount is about 4.5%," Flynn noted. "And not surprising, closed-end funds used to be sold with loads that equaled 4.5%… And so, 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."
Furthermore, many closed-end funds employ leverage to enhance income generation. This can be particularly attractive for income-seeking investors. For instance, a municipal bond closed-end fund might utilize leverage to offer a higher yield compared to a similar mutual fund.
The Shift Towards Interval Funds: Addressing Market Demands
While listed closed-end funds have a long-established presence, the industry has seen a significant shift towards interval funds in recent years. This transition is partly a response to market saturation in certain listed closed-end fund sectors and the growing demand for alternative investments that are more accessible to a broader investor base.
"The one thing that’s happened in that marketplace is it’s become fairly saturated," Flynn observed regarding the listed closed-end fund market. "And so, there was a rapid expansion of the listed closed-end fund market into new asset classes, new strategies, new sectors… And one of the things that some of the fund sponsors did was they started looking at opportunities to launch non-listed closed-end funds. And so, in that category, you’ve got interval funds, tender offer funds."
Interval funds, while technically a type of closed-end structure, are continuously offered and can grow over time, behaving more like open-ended funds in terms of capital flow. This flexibility makes them an attractive wrapper for alternative strategies.
XA Investments, founded by Flynn and her colleagues, has positioned itself as a key player in this evolving market. The firm partners with asset managers to develop and launch investment products, with a significant focus on interval funds.
"I would say most of our clients are curious and most interested in the growing interval fund space. So that’s a lot of where we spend our time," Flynn confirmed.
Navigating the Nuances of Interval Funds
The distinction between listed closed-end funds and interval funds is crucial for investors. While both are under the purview of the Investment Company Act of 1940 (the same act that governs mutual funds), their liquidity features differ significantly.
"Let’s contrast the closed-end fund with a daily liquid mutual fund, where investors can get in and out at NAV on a daily basis," Flynn explained. "Most of the closed-end funds have different mechanisms for shareholder liquidity. And so, taking the interval fund as an example, you could invest on a daily basis, to the extent that that fund has a daily NAV. But the exit is typically gated or limited to 5% a quarter."
This limited liquidity is what enables interval funds to hold a higher proportion of illiquid assets, such as private equity or real estate investments. However, this also introduces potential risks and complexities.
"The legal closed-end fund structure would allow any closed-end fund, whether it’s listed or interval, to have 100% in illiquid securities," Flynn continued. "But practically speaking, listed closed-end funds don’t do that, because most of them have a daily NAV. And if, for example, you put an illiquid investment that cannot be valued daily, a large discount presumably would develop."
The valuation of assets within interval funds, especially those with less liquid underlying holdings, is a critical consideration. While third-party valuation agents are increasingly used, the lack of real-time market pricing, as seen with publicly traded securities, can lead to questions about the accuracy and optimism of NAV calculations. This is particularly relevant during periods of market stress, where a stampede for the exits could disproportionately impact remaining investors if the NAV is perceived as inflated.
"The same is true in some ways for mutual funds, the difference being you might question the valuation of an illiquid portfolio even more," Flynn stated, highlighting the potential for forced selling at unfavorable prices in stressed markets. "So, yeah, I think both structures… One of the things that you’re pointing out is the listed closed-end fund is not a forced seller, and they’re not gonna suffer from that. If you want out, you get out through selling your shares on the exchange."
Best Practices and Future Trends in Interval Funds
As the interval fund market matures, certain best practices are emerging for sponsors and investors alike. The industry has seen a significant influx of new entrants, leading to a more competitive landscape.
"There are a lot of new entrants to the interval fund market, so it is attracting a lot of attention," Flynn observed. "And, you know, there’s a lot of boutiques in the mix, too."
Successful interval funds often demonstrate a disciplined approach to scaling, managing investor expectations regarding liquidity, and maintaining robust risk management frameworks. Sponsors who are transparent about liquidity constraints and ensure appropriate asset-liability matching are better positioned for long-term success.
"The fund sponsors that we think go about it the wrong way, you know, you have to start with the client in mind, with the RIA in mind," Flynn emphasized. "The market’s now grown to 180-plus funds. So, particularly if you’re a credit fund sponsor, you know, there’s a lot of credit funds. So, you’ve gotta be thinking about how am I gonna compete with the existing funds? How am I gonna have some sort of edge or advantage?"
Looking ahead, Flynn identifies several emerging trends that are likely to shape the alternatives industry:
- RIAs Launching Proprietary Interval Funds: Independent advisors and wealth managers are increasingly looking to launch their own interval funds to leverage their direct client relationships and capture more of the fee stream. This trend signifies a growing confidence in the interval fund structure and a desire for greater control over investment offerings.
- FinTech Platforms and Direct-to-Consumer Offerings: Financial technology platforms are also entering the interval fund space, aiming to attract a broader investor base, including non-accredited investors, through crowdfunding-style models. While some platforms are further along, this trend highlights the democratization of alternative investments.
- Impact and ESG-Focused Interval Funds: Despite some recent ESG backlash in the U.S., there is a growing interest in impact investing. The launch of interval funds with an explicit focus on impact investing, often investing in alternative or illiquid securities, offers a different return profile and may appeal to investors seeking to align their portfolios with their values.
The need for investor education remains paramount. As the variety of alternative investment products continues to expand, ensuring that investors and their advisors fully understand the risks, rewards, and liquidity characteristics of each vehicle is critical for making informed decisions.
"The buyer base for these funds initially is largely RIAs, but it’s still fairly concentrated," Flynn noted. "You know, it was the RIA that understood real estate, or that had been buying BDCs, and so they were much more comfortable with alternatives."
The journey of interval funds from a niche product to a significant force in alternative investments underscores a broader trend: the increasing demand for diversified portfolios that incorporate less traditional asset classes. As the industry continues to innovate, interval funds are poised to play an even more prominent role in providing investors with access to these opportunities, provided that transparency, education, and robust risk management remain at the forefront.
For those interested in learning more about XA Investments and their expertise in interval funds, their website is xainvestments.com.
