Credit Funds: 1940 Act Interval Funds

In this podcast, Sarah Clinton and David Sullivan discuss interval funds registered under the Investment Company Act of 1940, an increasingly common vehicle for credit strategies. As interval funds have risen in popularity recently, with the number of interval funds and amount of AUM having essentially doubled in the past two years, credit fund managers may be considering using this alternative strategy for the first time. This podcast explains what interval funds are and outlines advantages and challenges to these funds to provide credit fund managers a quick view into why they may want to consider registered interval funds.

Transcript:

Sarah Clinton: Hello, and thank you for joining us today for this Ropes & Gray podcast, the latest in a series of podcasts aimed at credit funds. I’m Sarah Clinton and joining me here is Dave Sullivan. We are both partners in the asset management group at Ropes & Gray. We are here today to discuss registered interval funds, which are becoming an increasingly common vehicle for credit strategies. We’ll explain what interval funds are, discuss their rise in popularity and use by credit fund managers, and outline some advantages and challenges to these funds. Dave, to set the stage, can you tell us a little bit about interval funds?

Dave Sullivan: Sure, Sarah. Interval funds are a type of publicly-offered registered product, regulated by the 1940 Act, that combine features of both traditional closed-end funds and open-end funds. Their classification as a closed-end company gives them more investment flexibility than open-end funds in that they can invest without regulatory limit in illiquid securities and can utilize greater financial leverage, including by issuing preferred shares. However, like open-end funds, interval funds have the flexibility to offer shares on a continuous basis, can offer daily pricing at net asset value, and can have multiple share classes, subject to obtaining what is fairly standard SEC exemptive relief. In this respect, from a distribution perspective, interval funds can look and feel a lot like traditional mutual funds and be sold through similar channels and platforms. With respect to investor liquidity, interval funds are typically not listed on a securities exchange or publicly traded like typical closed-end funds, nor are they redeemable on each business day like an open-end mutual fund. Instead, they must conduct periodic offers to repurchase only a limited percentage of their outstanding shares from shareholders, and in that sense, an interval fund investment is significantly less liquid in the hands of the shareholder than an open-end or exchange-traded fund.

Sarah Clinton: There are specific regulatory requirements around the process and terms of a interval fund’s repurchase offers, as set forth in Rule 23c-3 under the 1940 Act. The Rule requires an interval fund to have a fundamental policy that provides for periodic offers every three, six, or 12 months. I would note, however, that we have recently seen some funds obtain relief from the SEC to conduct monthly offers. The repurchase offers, which will be made at the fund’s net asset value, must be for between 5-25% of the fund’s common shares outstanding. The offers are made through formal written notice sent by the fund to its shareholders describing the terms of the repurchase. In addition to mailing these notices to shareholders, the fund must file a copy of the notice with the SEC. During the period from when the fund sends this notice until the repurchase pricing date, the fund must maintain liquid assets equal to 100% of the repurchase offer amount. This is important because it sets a practical limit on the amount of illiquid securities held by the fund – at least during the repurchase periods. That said, these funds do have quite a lot of leeway to invest in illiquid investments – particularly compared with registered open-end funds, which need to provide daily liquidity for redemptions, can’t invest more than 15% of their assets in illiquid investments, and are subject to the additional burdens of the SEC’s new liquidity rule. Dave, can you talk a little bit about how the greater flexibility to invest in illiquid assets might be impacting the recent interest in these funds?

Dave Sullivan: Sure, Sarah. Interval funds have gained significant traction in the market recently and we started to see them reemerge four or five years ago after a significant hiatus. And just in the past couple of years, they have really blossomed and have essentially doubled to about 50 funds with about $28 billion in assets under management in the industry, and we see it as part of a larger trend toward providing retail investors with access to alternative strategies. As you mentioned, Sarah, the interval fund structure allows for a larger pool of illiquid investments than an open-end mutual fund and after years of low interest rates, managers are seeking to generate higher returns through more alternative, less liquid strategies. And the rise of interval funds also corresponds to the slowdown over the past few years in the number and size of listed closed-end fund IPOs. The traditional exchanged-traded closed-end fund can also invest in illiquid securities and utilize leverage like an interval fund. However, exchange-traded closed-end funds often trade at a persistent discount to NAV, including relatively shortly after shares are sold in the IPO at NAV, which is a significant negative for intermediaries and investors seeking total return. So, although an interval fund does not offer continuous liquidity to shareholders through exchange trading, the structure does ensure that the long-term investor will eventually receive the full NAV of their shares and the investment will not decline in value due to market sentiment and other factors beyond the control of the manager. Interval funds have emerged as a useful hybrid, offering beneficial aspects of both open- and closed-end funds, and managers like PIMCO, Voya, CION, and Oppenheimer have successfully brought interval funds to the market in recent years – many of those funds have a credit focus. Sarah, can you elaborate on why these funds might be appealing to credit fund managers and what the drawbacks might be in that respect?

Sarah Clinton: Of course. As you’ve noted, credit fund managers have made good use of the interval fund wrapper in recent years. Since an interval fund doesn’t need to raise cash on a daily basis to meet redemption requests, as compared to open-end funds, it can invest in less liquid, higher yielding assets that may be more suited to longer holding periods. So the fund could invest in things like corporate loans, structured credit, high-yield debt, and commercial real estate debt, among other things. Packaging these investments into a 1940 Act product gives managers the ability to access a more retail investor base and the fact that these funds can be continuously offered makes it easier to raise equity. Additionally, with exemptive relief from the SEC, an interval fund can offer multiple classes of shares, which allow sales through different distribution channels. From an investor standpoint, these funds can be appealing because the 1940 Act wrapper provides certain protections. For example, investors know there will be frequent NAV calculations, they can take comfort in the 1940 Act’s custody, governance, and oversight requirements, and the required repurchase offers provide investors with a fairly clear line of sight as to liquidity (although there is still some liquidity risk for investors). Additionally, as compared with private funds, these funds typically have lower investment minimums and investors can enjoy the simpler 1099 tax treatment. With respect to drawbacks, from a manager’s perspective, the interval fund structure does create some complications. As mentioned, the requirement to conduct the periodic repurchase offers can result in limitations on illiquid investments, particularly since the fund must hold liquid assets in an amount that equals the offer amount during the repurchase period. Additionally, the fund must strike a NAV at least weekly, on each day shares are offered, and daily during the period preceding a repurchase request. That can be difficult if the fund holds hard-to-value, stressed assets. With respect to fees, it’s worth noting that the manager will not be able to charge incentive fees on an interval fund that are based on capital gains or capital appreciation unless the fund is limited to qualified clients. Fulcrum fees are permissible, however, as are fees that include an incentive component based on something other than capital gains or capital appreciation, such as net investment income. Finally, for managers that don’t already have registered fund platforms in place, there is a fairly high barrier to entry with respect to governance, operations, and 1940 Act investment restrictions. Dave, would you like to elaborate on that?

Dave Sullivan: Sure. One set of restrictions that I think are particularly worth flagging for private fund managers that are entering the interval fund space are the 1940 Act’s prohibitions on affiliated transactions. This is a fairly broad and complicated topic, but at a high-level, the 1940 Act limits registered funds and their first or second tier affiliates from engaging in principal transactions with one another or alongside one another -- in so-called joint transactions. Funds that are managed by the same investment manager generally are understood to be affiliates for these purposes. These restrictions can cause significant complications for private fund managers that are attempting to offer a particular strategy across multiple vehicles, including a 1940 Act fund, particularly where private, negotiated investments are involved. There is an SEC no action letter that allows for side-by-side investment involving 1940 Act funds and affiliated private vehicles in certain circumstances, but the conditions for reliance on the relief are demanding and in many cases unworkable. In part, one of the conditions is that if the manager has a material pecuniary interest in the transaction through its private vehicles or otherwise, the manager cannot negotiate the terms of the transaction other than price, which is a significant handcuff. The SEC has also issued broader exemptive relief to certain managers with respect to joint transactions in this context, but the conditions that must be observed are very cumbersome and difficult to deal with in practice, including potentially needing pre-approval of the 1940 Act fund’s Board for individual transactions. That said, the 1940 Act affiliated transaction prohibitions shouldn’t scare private managers away from the interval fund structure, as others have developed workable approaches.

Sarah Clinton: Agreed Dave – interval funds are definitely a vehicle worth exploring. Unfortunately, that is all the time we’ll have for today. For more information, please visit our website at www.ropesgray.com. And please stay tuned throughout the coming months for more podcasts on topics of interest to credit funds. Of course, if you’d like to learn more about interval funds or other registered products, please don’t hesitate to get in touch with Dave, me or another member of the Ropes & Gray asset management team. Thank you all for listening.