Wednesday, November 01, 2017

The Interval Fund Folly

I was at an industry conference last month and was told that there is a double digit number of interval funds in registration. I don't know if this is true, but I have seen plenty of new closed-end funds recently.  I do not understand the enthusiasm sponsors seem to have for these products.  They have better liquidity than non-traded real estate investment trusts and business development companies, which is good.  And the purchase process is easier and the suitability standards are lower than the non-traded products, too, but many broker dealers have implemented suitability standards for interval funds that are similar to those for non-traded products. 

Interval funds offer no deals in terms of fees.  Management fees are based on net asset value and are generally between 1.50% and 2.00% per year, which do not include other fund expenses.  Some interval funds invest in other funds and non-traded products, which have management fees, and potentially carried interest, all of which are in addition to the fees and expenses that the interval funds charge.  This makes a high annual fee hurdle rate that interval funds need to overcome, like 3.00% to 5.00% or more.  Combine these fees with the reality that most interval funds' underlying investments are not high flying investments, but modest return real estate investments, high yield debt investments, and fund investments, and you do not have an outlook for a high returns before any fees. 

Sponsors should check sales figures before entering into the costly interval fund registration process.  Through September, interval funds had raised a net $975 million in 2017, putting them on pace to raise $1.3 billion for all of 2017.  Just two interval funds have accounted for 70% of all sales in 2017.  Yesterday, the DI Wire published an article that says securitized 1031 exchange programs are on pace to raise $1.8 billion in 2017, which is half a billion more than interval funds.  Even the beleaguered non-traded REIT sector, and I exclude the sales of the Blackstone REIT, is on pace to raise $2.6 billion in 2017, or double the money flowing into interval funds. 

Money is leaving interval funds.  Some funds are seeing redemption rates of more than 20% of new sales.  This poses cash management constraints that could further weigh on performance.  Interval funds, in their current form, are not the savior of alternative investments, but an expensive niche investment for clients unsuitable for more sophisticated products.  Sponsors are spending millions to learn this lesson.

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