October 29, 2024 - Last week the LSTA hosted Joshua Deringer, partner of Faegre Drinker, and Robert Collins, partner at Partners Group, in their presentation “Unpacking Interval Funds and Tender Offer Funds.” These two structures are close siblings and commonly referred to collectively as nontraded closed-end funds. They have been gaining traction in the last few years and, as our speakers explained, offer both evergreen opportunities and traps for the unwary.
Evolution of Nontraded Closed-end Funds
The last five years have seen an explosion of interval funds and tender offer funds, which now number more than 240 funds, with 27 new fund sponsors in 2024 alone. While the lion’s share of these funds is focused on private equity and private credit, these structures have emerged across the alternative investment universe. Both closed-end fund structures are evergreen funds offering periodic liquidity at NAV. This feature works well for less liquid investments. (In the private fund world, these structures would be considered perpetual or open-ended.)
As discussed below, these structures require a robust infrastructure to operate but offer an attractive wrapper for the “mass affluent” through investment adviser (“IA”) channels as well as wirehouse and other brokerage channels. These funds are registered closed-end investment companies, but their shares are rarely listed on an exchange. (As unlisted funds, they are not susceptible to some of the challenges seen in traded closed-end funds.)
Tender Offer Funds vs. Interval Funds
The two types of nontraded closed-end funds share much in common but do have several key distinctions. Interval funds are the newer structure of the two and came about after the SEC adopted Rule 23(c)(3) in 1993. Tender offer funds existed for decades, but neither structure gained popularity until the early 2000s. Since then, tender offer funds became the vehicle of choice for PE strategies, while interval funds were home to real estate and credit strategies. That distinction has largely blurred now but the speakers highlighted that the target investor channel has generally led to tender offer funds for brokerage firms, wirehouses and private wealth channels and interval funds for the retail channel. This is primarily because of the rules regarding repurchases applicable to each structure.
In a tender offer fund, the fund’s board determines the tender offers, which are typically 5% of NAV), and there is no guarantee an investor can redeem the number of shares it desires in a certain tender offer. This means that if there are more tenders in that period than the fund will buy the investor will have to wait until the next offer. In an interval fund, the repurchase offers are set out in its fundamental policy (meaning changes are subject to shareholder vote). The vast majority of funds elect quarterly repurchases with 5% of NAV being common, although the purchase can range from 5-25% of NAV. Tender offer funds need only strike a NAV at the time of the tender offer, however, interval funds must strike a NAV on a weekly basis and on a daily basis at certain times around their intervals. Practically, most interval funds do strike a daily NAV because it is a requirement for the IA platforms on which they are offered.
As noted, these evergreen structures are more alike than different. Both structures are registered investment companies regulated under the ’40 Act and thus subject to its robust reporting requirements and other regulatory requirements. Like most closed-end funds, both structures are RICs which enables the fund to avoid double taxation. With respect to fees, the same management fee must be paid by all investors. Incentive fees on realized capital gains are permitted only if all investors are “qualified clients” under the ’40 Act, which is one reason why most of these funds rely on the SEC’s exemptive relief to issue multiple share classes. In practice, a fund will have a share class for each of the investor channels it is offered to – an institutional share class, an IA share class and a brokerage share class. The different classes allow for fees to be charged in the manner most suitable for the channel type. Finally, both fund structures require investors to meet the accredited investor standard if the fund invests 15% or more in private funds.
Robust Infrastructure Needed
Despite the growing popularity of these structures, the operational demands of these funds and the robust infrastructure needed to support them cannot be underestimated. These funds are overseen by their board of directors with the manager hired as an independent contractor. This is very different from the GP role managers have with respect to their private funds. When forming an interval fund or tender offer fund the selection of the board is critical and can be more or less resource intensive depending on how bespoke one’s needs are. Engagement with the board is frequent and the board is involved in all key aspects of the fund – in particular, valuation of portfolio assets. In addition, the fund manager faces a significant number of operational challenges – the repurchase/tender process, valuations, accounting and financial reporting and ongoing compliance obligations to name a few.
Looking ahead, our speakers suggested we will likely see a continued proliferation of these structures, analogizing to the explosive growth of ETFs in recent years. In fact, we may see these structures adopted as a core component of institutional investor portfolios as they are a simpler alternative than the traditional drawdown fund. As well, they provide retail investors greater optionality and access to private markets. For now, funds in this universe are young with only 60% of funds estimated to have a three-plus year track record.
