Publications

- January 1, 2018: Vol. 5, Number 1

Interval funds taking private wealth by storm: The semi-liquid, semi-illiquid investment product attempts to deliver the best of both strategies — for a price

by Mike Consol

There are a few frustrating issues private wealth advisers have faced for a long time. They have wanted access to institutional-grade products in a professionally managed fund. They wanted minimum commitments modest enough for their clients to afford. Also required was liquidity opportunities that did not stretch to five to seven years at a time. Lastly, they’ve wanted clients who were not so skittish about going illiquid with a portion of their portfolio, at least long enough to reap the premium illiquid products offered.

Along comes the answer in the form of the semi-liquid interval fund.

It is not often that a new product structure comes along that catches fire with broker/dealers, advisers and investors. The interval fund is one of those, at least thus far. Consider that since its advent in 2014 there are now nearly 40 active interval funds with $17.4 billion in assets currently under management, and billions more looking to be raised by more than 20 others currently in registration.

U.S. asset managers have wrapped their arms around the interval fund. Piling into this opportunity with their own interval funds are the likes of BlackRock, FS Investments, Griffin Capital, Invesco, Pimco and Voya Financial.

The good news is that interval fund shares are easy to buy — usually available for purchase daily at the fund’s current net asset value, though shares might be restricted to accredited investors, depending on a particular fund’s guidelines. Most interval funds are accessible to any investor willing to fork out a minimum commitment that typically ranges between $2,500 and $25,000.

But of special comfort to jittery investors and their financial advisers are the exit ramps that occur at regular intervals (hence, the name of this type of fund structure), either quarterly, semi-annually or annually, with the fund sponsor offering to repurchase investors’ shares at current NAV. The majority of interval funds offer quarterly share buybacks and specify a maximum percentage of outstanding shares available for repurchase during each buyback period, ranging from as little as 5 percent of outstanding shares to as much as 25 percent. Naturally, that means an investor might not be able to redeem the investment during any given buyback period. For that reason, it is wise for advisers to make sure their clients consider interval funds a long-term investment, more illiquid than liquid.

Alan Feldman, CEO of Resource Real Estate, comments that an interval fund is “just a structure” whose main nuance is regulated, with periodic redemptions, as opposed to an open door allowing any and all investors to liquidate and exit the fund en masse. The semi-liquid nature of the interval fund is what enables fund managers to make non-liquid or less liquid positions within the fund. Feldman and his executive team liked what they saw with the interval fund structure and entered the market with two focused on income — one invests in real estate and the other credit, with AUM of $236 million and $57 million, respectively.

“We found the market for investors demanded a few things,” Feldman says. “It likes the income, it likes the predictability and the diversification of that income, and it doesn’t like a lot of volatility, but it does want the ability to get out at a more predictable and knowing time interval than just giving someone their money for five to 10 years. The interval fund structure enables a fund sponsor like us to seek investments that provide income.”

It also expands Resource Real Estate’s access to those private investors who were not in the market for the firm’s illiquid real estate investment funds with five- to seven-year hold periods. Many investors simply do not have a large enough asset pool or tolerance for a multi-year hold period, and would otherwise not do business with Resource Real Estate or other interval fund sponsors.

The semi-liquid, semi-illiquid nature of Resource Real Estate’s interval funds is achieved by stocking them with assets that are about one-third invested in private equity, where the money might be locked up for a longer period of time; one-third in bonds or other traded instruments, which can be traded daily on Wall Street; and the final third in highly liquid traded securities.

“So 30 percent to 60 percent of our portfolios are comprised of fairly liquid investments enabling the funds to provide adequate liquidity to meet potential redemptions,” says Feldman.

It is the primarily illiquid nature of the interval fund that gives its investors an opportunity for higher yields, as fund managers are free to put fund assets to work in alternatives — such as commercial real estate, energy, agriculture, debt and other illiquid asset classes — without the pressure created by constant redemptions. In return for that kind of active, diligent management, investors must pay fees that are relatively high, perhaps a 6 percent sales charge to start and ongoing annual management, service and operating fees of 3 percent or more. A well-managed fund in a good economy will exceed those fees and generate returns for investors. Then again, persnickety investors have been known to get resentful about not getting the full measure of the fund’s gains.

Such considerations have not dampened the interest of recent interval fund entrants Broadstone Real Estate and FS Investments.

Broadstone, headed by CEO Amy Tait, registered a new interval fund (Broadstone Real Estate Access Fund) on Oct. 13, and is working to raise $1 billion to invest in a portfolio of institutional-grade real estate and real estate–related assets. It will offer shares for as little as $2,500 with quarterly share buybacks. The fund will invest in direct commercial real estate investments, private real estate investment funds, publicly traded real estate–related securities, and commercial real estate debt.

FS Investments launched the FS Energy Total Return Fund, an interval fund targeting $2 billion in investor dollars with the intent to invest in the equity and debt securities of both public and private energy and energy infrastructure companies.

“We believe the energy industry has great long-term fundamentals if you have the flexibility to invest selectively across the entire sector and capital structure,” FS Investments CEO Michael Forman said when the fund’s launch was announced. Magnetar Asset Management was selected as investment subadviser for the fund, an organization with a team that has invested and manages about $4.3 billion in North American energy markets through private funds and institutional accounts.

“At the end of the day, it is about who is managing the fund,” Feldman observes. “What is their track record? What do they know about whatever they are supposedly putting into this fund? Those are the only three things that matter.”

Dana Woodbury, founder and chairman of Buttonwood Investment Services, a third-party provider of due diligence, would argue that investors considering interval funds have three other factors to take into consideration — fee structure, conflicts of interest and the source of distributions.

Interval funds are known for having higher fees than their mutual fund counterparts, he notes, but fee structures vary across the board. Interval funds are permitted to charge a redemption fee not to exceed 2 percent of the repurchase proceeds. Other fees may include upfront sales charges ranging from 0 percent to 6 percent, ongoing management fees of 1 percent to 1.5 percent, shareholder servicing fees of 0 percent to 0.25 percent, and fees associated with the underlying portfolio, which may or may not be disclosed, but are factored in to the NAV.

What’s more, Woodbury says, conflicts can arise if the portfolio manager is allowed to invest in other funds of the sponsor. Further, the fund may be permitted to loan its portfolio securities to other entities. The most transparent outcome (to ensure no conflicts) is to preclude the fund from investing in other funds of the sponsor.

There is also the source of distributions to take into account.

“Be leery of distributions that represent a return of capital,” Woodbury says. “Some interval funds will artificially inflate their distribution to attract new investors. In such instances, tracking the source of distributions is imperative to determine the impact it might have on the return of your original investment, in addition to determining if the source of distributions over time is increasingly from net operating income.

There is much to take into consideration when assessing the suitability of interval funds. The big advantage offered is higher yields than most other mutual fund options, but investors must make the sacrifice of higher fees and some degree of illiquidity. That final point is why advisers and investors must think seriously about this question: What is the investor’s tolerance for a longer term semi-liquid product — both financially and temperamentally?

Interval funds can provide a degree of liquidity that may assist financial advisers in diversifying their clients’ portfolios, without overly constraining their need for liquidity, Woodbury explains. The field of interval funds is growing, yet there are already choices ranging from real estate equity to debt, and private equity to structured credit. Investors have many choices when determining the best allocation for their specific risk tolerance.

Mike Consol (m.consol@irei.com) is editor of Real Assets Adviser. Follow him on Twitter @mikeconsol to read his latest postings.

 

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