Interval Funds vs. Private Debt Funds

When discussing the structure of interval funds, comparisons are often drawn to another niche investment vehicle: private debt funds. These funds, also called “private credit funds,” exist to give investors exposure to the premium yields generated by lending to private borrowers. It’s a large asset class; by the end of 2020, the global market for private debt had reached $880 billion.

Interval funds are a smaller category of fund, and they’re differentiated mainly by their SEC-regulated status and lower barrier to entry for investors. However, there are several other key differences between the two types of fund.

DEFINING PRIVATE DEBT

In simplest terms, “private debt” refers to contracts issued by private companies or individuals promising to repay a certain amount of money over time, plus interest. This debt can come in many forms – direct loans, mezzanine debt, distressed debt, venture debt – but at its core, it’s an IOU that can be purchased by a third party and isn’t sold on public markets like normal bonds. The holder of the debt receives both the periodic interest payments and the eventual full amount of the loan, making private debt a potentially profitable investment strategy.

Private debt funds are pools of investor capital that buy up these debts and distribute the revenue they generate to shareholders. Interval funds can hold private debt as part of their strategy, but private debt funds exist for the express purpose of accessing this asset class.

Since borrowers of private debt can be small firms with low cash flows or complicated equity structures, private debt can be complex to acquire and difficult to sell quickly. On top of that, the small size or sometimes distressed status of the borrowers can make the risk of default high. In such a case, the debt is often secured against an asset like land or infrastructure, which can be difficult to turn around and sell. To compensate for these risk factors, such debt usually demands higher interest and thus generates higher yields than can be found in public debt markets. This creates a liquidity premium for the holder of the debt – making it an appealing investment for those looking for better-than-average returns and willing to jump through some hoops to find it.

Private debt funds have similar internal structures to private equity funds, with a general partner investing capital contributed by limited partners. However, they differ from private equity funds in that they don’t invest in shares of the borrowing company – only in the debt the company takes out. But how do private funds stack up against their close counterpart, the interval fund?

SHARED INVESTMENT STRATEGIES

Interval funds and private debt funds are often confused because they tend to overlap in their investment strategies. Both funds don’t have to constantly buy their shares back from investors, so they’re ideal for investing in illiquid assets that can’t be quickly exchanged for cash. Because private debt tends to be illiquid, many interval funds choose to focus on the asset class as a way to create high income for shareholders. Private debt can also provide a portfolio with valuable diversification and low correlation to other markets, making it attractive to many types of investor.

As mentioned above, there are many types of private debt that the funds can purchase, each with their own yield and risk profile. Both types of fund will often invest in a mix of different private debt types to provide diversification.

INTERVAL FUNDS ARE REGISTERED AND REGULATED

The first key difference comes in the way the two funds are regulated. Interval funds must register with the Securities and Exchange Commission and periodically file a variety of forms to operate. This allows them to advertise publicly, and it gives them a greater degree of transparency since their holdings, strategies, and operational records are made public.

Private debt funds are private – they aren’t as closely regulated by the SEC, and they aren’t allowed to solicit public capital or advertise in any way. This gives these funds greater flexibility in the securities they can hold and the schedules they can keep for redemptions and reporting to shareholders. However, it restricts the pool of capital available to the fund.

INTERVAL FUNDS ARE MORE ACCESSIBLE

The next difference: private debt funds are only available to accredited or institutional investors, and they tend to have a buy-in cost in the millions of dollars. This can make the private debt asset class seem out-of-reach for less wealthy investors, which why the interval fund structure is seeing increased adoption as the sector grows.

Because interval funds are registered with the SEC and submit to periodic reporting and audits, they’re able to offer their shares to a broader variety of investors. Though some interval funds are privately listed and only open to institutional or wealthy investors, a growing number of them offer shares to retail investors with minimum initial investments in the hundreds of dollars.

Photo by Blogging Guide

INTERVAL FUNDS HAVE LOWER FEES

Though the fees charged by interval funds can be higher than those of some other SEC-regulated funds, private debt funds almost always charge more. Interval funds and private debt funds both charge a management fee between 1% and 3% of invested assets to cover operating expenses, but private debt funds tend to charge an additional fee on the profits the fund generates. Called an “incentive fee” or “performance fee,” it’s usually between 15% and 20% of the extra returns created by the general partner’s investment strategies that year.

BUYING AND SELLING SHARES

Interval funds are idiosyncratic in the ways they’re bought and sold, which set them apart from other funds registered under the ’40 Act. Investors can buy shares directly from the fund at any time, but they can only sell them back at set intervals throughout the year.

Private debt funds also only transact directly between the fund and investors, with no secondary market. However, they can be either open- or closed-ended, which changes how their shares are offered. If they’re open-ended, shares are continually offered and shareholders can cash out at times throughout the year as decided by the fund. If they’re closed-ended, investors must buy into the fund at its inception, and they receive regular dividends from the fund’s fixed-income investments until the debts expire and the fund dissolves.

Both interval funds and private debt funds have highly specified structures to match their targeted investment capabilities, making them ideal for investors seeking exposure to high-yield, fixed-income alternatives.

Next: Understanding Interval Fund Liquidity