3 considerations for investing in interval funds

The primary benefit of interval funds is that they allow you to access private markets, but that doesn’t necessarily mean you should. Specifically, your due diligence must consider track record and liquidity.

Track Record

While it is common knowledge and practice to evaluate the track record of investment managers, it is also important to understand the track record of the asset class itself. One important fact regarding private markets is that often there is not a relevant benchmark to evaluate. When there is a benchmark, it is important to understand if the investment manager is selecting assets that are relevant for comparison. Within private markets, each deal can be different and unique such that the consistency that typically exists in the public markets is absent. While there are some private markets such as real estate that are relatively more institutionalized and give potential investors a better starting point, other, more niche, private asset classes have recently emerged. For example, private credit has grown over the past decade, therefore it is of paramount importance to have an understanding of the positions, and more importantly the businesses that take on private debt.

Liquidity

One of the most important factors around private markets is understanding when and how liquidity is available. Interval funds should not be considered liquid investments, but the structure does allow for some liquidity each quarter. Investors should be aware that meeting the 5% quarterly repurchase offer, which is required by regulation, may still be problematic in certain asset classes. This is where having a historical perspective to point to can provide some comfort for potential investors. For example, having a track record that can be evaluated throughout different economic cycles is helpful. Two items we have come across that warrant extra attention have to do with

• the liquidity terms of the underlying private investment funds (usually private partnerships), and
• the use of publicly traded securities for liquidity purposes.

As it relates to investing in private funds, understanding the terms at that level is important. We have observed some interval funds will invest in private funds that lock up capital for periods of 12-18 months. While this is not concerning when markets cooperate, it does in fact matter in times of volatility.

Additionally, we have observed many interval funds marketing an allocation to public securities to meet “liquidity needs”. Interestingly, those same interval funds have now gated every time there has been any stress in the market. While we agree gating is a part of investing in private assets and should be expected in order to protect all shareholders, what is not appropriate is being sold on an idea that having public exposure ensures liquidity. Investment managers that hold public securities don’t necessarily want to sell those assets in a market downturn and impair performance, which is logical from an investment perspective, but they should then never imply that having public securities will provide more liquidity. Perhaps holding public securities outside of the interval structure is more appropriate for wealth managers seeking to maintain liquidity for their clients.

Private markets offer diversification and in some cases outperformance relative to their public counterparts, but it is important to understand the particular expense structures so as not to overpay for those benefits. Most interval funds gain exposure to the asset class through a diversified set of private funds or by investing directly in private assets. Those private funds also charge fees, and often those fees can be very high and come with performance incentives. While we acknowledge paying for outperformance is perfectly acceptable and a trade many of us would happily make, no asset class can overcome an expense load that is too high. That is why it is important for RIAs and investors to evaluate the expenses at both the interval fund and underlying fund levels.

For example, if an interval fund has an annual expense ratio of 2% and the underlying funds also have an annual expense ratio of 2% (not including any performance fees, normally applied at relatively low hurdle rates), that is quite an expense burden to overcome for outperformance. A private credit instrument that offers investors a yield of 10%—which until recently was remarkable—would earn a seemingly less desirable 6% return after accounting for the almost 4% in fees between the fund and the actual instrument. To achieve returns that are compelling to investors, either fees have to remain reasonable or the level of risk that must be taken must be high.

Risk ≠ standard deviation

Speaking of measuring risk, evaluating standard deviations and Sharpe ratios can be helpful but does not fully quantify the level of risk in private markets. While some, perhaps less transparent, interval fund asset managers love to tout their Sharpe ratio as a proof point, it should be taken in conjunction with the other factors. Indeed, private assets absolutely enhance a portfolio’s overall Sharpe ratio, primarily by decreasing its standard deviation, however not to the extent that is often purported. Private investments may have non-linear returns, which means they may not follow a normal distribution like traditional asset classes and as such do not allow for a straightforward apples-to-apples comparison. Therefore, while the metric is still informative, it should not be used in isolation. Rather than just relying on the typical metrics, understanding the investments and the environments that could present issues, their valuation practices, and the terms around such investments is just as important, even though there is not a simple and single “metric” to evaluate.

One of the most frustrating data points that we come across is the “distribution yield” set by interval funds at well above average market rates, specifically within real estate. This is nothing more than a gimmick that unfortunately has become an accepted practice in the space. When we evaluate the underlying funds’ investments, which are comprised of assets that we know have on average about a 4% income yield, we ask ourselves how it is possible for interval funds to deliver a 6% yield, especially while charging 2% in fees. The fact is that the math simply does not add up and the distribution must be supplemented by a return of shareholder capital, a reliance on continued gains, or a combination of both.

That said, we acknowledge two points on this topic. First, some private investments, such as real estate, offer tax-advantaged yields and a portion of the distribution should be classified as a return of capital. Second, setting an annual distribution yield does require some subjectivity, and targeting a longer-term yield average is an acceptable practice. However, RIAs and investors should be extremely wary of the long-term sustainability of products that offer yields at 150% of market rates by managers that charge high fees.

RIAs should consider the following additional questions to ask interval fund sponsors during the due diligence process:

Liquidity

How do you determine how much liquidity to offer in the repurchase offer? Have redemption requests exceeded the offer and did you ever pay out more than 5% if liquidity was available in the portfolio? Do you have a line of credit and how does that influence the repurchase offer amount?

Risk management

How has the asset class held up in different market cycles? In what circumstances would the investment not perform well? Who are the other investors in the Fund? Have they typically demonstrated a long-term investment perspective in their allocation, or have they tried to exit at the first sign the asset class may underperform?

Fees

What is the expected return of the underlying asset class over a full market cycle i.e., excluding the interval fund fees? (For example, the expected return of core private real core estate is approximately 6-8% over a full market cycle.) What is the total net operating expense of your fund and how do you seek to overcome those fees?

Distribution rate

How do you set your distribution rate? What percentage is return of capital? Is that return of capital derived from the underlying investments or is it because you set your distribution rate above that of the underlying investments?

Risk Disclosures

Union Square Capital Partners, LLC is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Past performance does not guarantee future results.

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