Why Convert to an Interval Fund?

Back in November, Flat Rock converted a non-traded BDC to an interval fund, the Flat Rock Core Income Fund.

The next month, Bow River converted a private equity fund to another interval fund, the Bow River Capital Evergreen Fund.

Then in May, Invesco cut a deal with activist Saba to commence a massive tender offer on a closed-end fund, which will convert to an interval fund pending shareholder approval in September.

And just three weeks ago we reported that Monachil had converted a private fund to the Monachil Credit Income Fund...also an interval fund.

Why are managers converting existing funds to closed-end interval funds?

Wouldn't the reporting requirements seem onerous to private fund managers? Wouldn't closed-end fund managers be concerned about restricting shareholder liquidity? Perhaps, but depending on the circumstances, converting to an interval fund could offer a range of strategic advantages.

Interval fund conversions aren't new, but with four since November, we thought you deserved up-to-date coverage on the phenomenon. In this piece we'll give a quick refresher on what makes interval funds different, then cover the reasons why managers might consider a conversion.

WHAT MAKES INTERVAL FUNDS DIFFERENT?

Closed-end interval funds feature a range of characteristics that overlap with other funds in certain areas, but when taken as a whole, make interval funds a unique fund structure. You can do a deeper dive on interval fund basics in our Learn section but we've pulled the highlights for you here.

· Interval funds are a type of closed-end fund registered under the Investment Company Act of 1940 (the "40 Act").

· Interval funds are not listed on exchanges; investors must purchase and redeem shares directly from the funds themselves.

· Interval funds may be continuously offered with no cap, and are priced daily at Net Asset Value (NAV).

· Interval funds typically offer to repurchase between 5% and 25% of outstanding shares at NAV; because there is no secondary market, shares don't trade at a discount or premium.

· This quarterly liquidity allows interval funds to put a larger share of capital into high yield illiquid assets–up to 95%–compared to open-end mutual funds which are limited to 15%.

· Interval funds have flexibility on their investment strategies, with the ability to invest in other listed and non-listed funds, public and private equities and debt, and alternative investments.

· Interval fund taxes are mercifully handled through a simple 1099-DIV, typically handled by a fund's accountant.

It's time to explore how these factors influence conversions, but if you're interested in learning more about the uniqueness of interval funds, check out our articles on how they differ from 40 Act funds, closed-end funds, hedge funds, ETFs, private debt funds, tender offer funds, and business development companies.

WHY WOULD I CONVERT TO AN INTERVAL FUND?

1. To access retail investors.

The alternative investments industry acknowledged the growing importance of retail capital years ago, and the trend is not letting up today. At all.

Private fund managers are restricted to raising capital from accredited investors, institutions, and otherwise qualified purchasers. Converting to an interval fund eliminates that restriction and unlocks a new and larger pool of capital that can scale quickly, assuming the fund takes its technology seriously.

2. To access retirement markets.

The private equity industry has spent years trying to gain access to the nearly $9T (yes, trillion) defined-contribution marketplace, and last year the U.S. Department of Labor finally issued a letter that begins to make this possible–as long as private equity strategies are incorporated into professionally managed asset allocation funds with a private equity component, that are specifically designed for ERISA-covered individual account plans.

That may seem like a major reallocation lift, not to mention the added regulatory and reporting requirements of ERISA, but if executed well it could unlock an enormous new source of capital. Many interval funds are already open to investments via retirement accounts, and some even lower their upfront minimums for investments from retirement accounts.

3. To earn trust, by embracing transparency.

If the goal is to gain access to retail and retirement capital, then the more involved regulatory, reporting, and governance requirements for interval funds may offer benefits that outweigh the administrative and compliance effort.

The explosion of ESG investing has brought with it increased investor demands for transparency and balanced governance. Depending on a fund's target investor profile, opting to convert to a structure with stronger reporting requirements could offer prospective investors a degree of trustworthiness that boosts their confidence in investing.

Another way to boost confidence is to show a strong track record. Despite a new set of advertising rules issued by the SEC this year that offers private fund advisors some flexibility in marketing, taking advantage of this flexibility still requires paying compliance officers to decipher and enforce a 430-page final rule document. Even discussing hypothetical portfolio performance at a private dinner could force a series of disclosures if any details were missed.

By contrast, interval funds report performance in regular public filings and display fund performance directly on fund websites; and during the 1990s, the SEC issued a series of no-action letters permitting 40 Act funds to include performance of converted private and institutional accounts in their registration documents (in some cases). A fund can't convert for the ostensible purpose of displaying performance data, but it's not the worst side effect for a fund that performed well historically and wants to cater to a broader audience.

4. To provide better liquidity.

In the case of the Bow River Capital Evergreen Fund (EVERX), which was seeded with $75m in May 2020, shareholders still wanted exposure to private equity strategies–but with greater liquidity and diversification.

With quarterly redemptions, interval funds might feel less liquid to somebody accustomed to trading in equities. But in contrast to private funds, which can require a cash lockup from 2 to 10 years, those quarterly repurchase offers provide exposure to similar private equity strategies with far more liquidity.

5. To de-risk monetizing NAV discounts.

This one is interesting. Invesco's Dynamic Credit Opportunities Fund (VTA) pending conversion involved some activism by Saba Capital in order to monetize VTA's discount to NAV.

Earlier this May, Saba bought over 10m shares of VTA–more than 16% of issued common stock–and became a beneficial owner. VTA's latest annual report in February showed the shares trading 8.26% below NAV.

Saba also executed an agreement with Invesco and VTA's board wherein the fund would commit to stop issuing common shares, and commence a tender offer to purchase (for cash) 20% of outstanding common shares at a price equal to 98.5% of NAV at the close of the tender offer later this September. If VTA's shareholders agree, VTA will convert to an interval fund after that tender offer closes, then proceed to offer quarterly repurchases of 10% of outstanding shares, at NAV, at least twice in 2022.

At long as VTA's NAV holds up for another two months, this could represent a nice haul by Saba with a one-year turnaround, while allowing other shareholders to promptly redeem common shares at NAV without waiting for the shares to trade at or near a premium. As of this writing VTA's NAV is up 1.12% since Saba bought in May.

CONCLUSION

Funds are unique. Converting to an interval fund could make sense for some managers, just like converting to open-end funds has made sense for interval fund managers in the past. 

But it's 2021, and with retail investors clamoring for higher yields without sacrificing downside protection, interval funds are still on track to set an all-time record for new fund registrations this year. We expect to see more interval fund conversions this year, and we'll report on them right here.

Or, you can just follow us on Twitter: @interval_funds