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One of the trends in financial innovation over the past decade has been interval and tender-offer funds. While first allowed as investment products over 25 years ago, they have risen in popularity to provide greater access to illiquid, long-term investments that were previously limited to private funds. A wider opportunity set of investors and historical alpha generation has attracted asset allocators and strategy providers and positioned interval funds and tender funds as a key solution.
Raising capital has always been a critical activity for the growth of a thriving business. Apart from raising a small portion of capital from friends and family and relying on excruciatingly expensive bank loans, businesses used to dream and plan for an IPO and raising debt from a public exchange. However, over the past decades, the growth of private capital has opened new sources of financing. Private market AUM grew to almost $10 trillion dollars as of H1 2021.1 More than $1 trillion in institutional private capital has been raised per year globally across all asset classes.2
The reason for this phenomenon is simple: Public companies represent a small and shrinking part of the universe of successful enterprises and historical returns have been inferior to private offerings. There were 7,810 public companies at the beginning of 2000 in the U.S., and that number shrank to around 4,800 by the end of 2022. Investable private companies have continued to grow. In the U.S., there were only 2,600 public companies with annual revenues of more than $100 million in 2021, compared to around 17,000 private corporations of that revenue magnitude.3
The appeal of private markets is not just the sheer size of the opportunity, but the fact that institutional funds have consistently delivered alpha over the years across all asset classes. The Cambridge Associates LLC US Private Equity Index, which compiles returns from over 1400 PE funds formed since 1986, shows a net alpha generation to limited partners of more than of 470 basis points over both 20- and 25-year horizons relative to both the Russell 2000 and the Russell 3000 indices under a modified public-market-equivalent calculation.4 What is even more alluring is the consistency of outperformance. Private equity and private credit have outperformed global public markets equivalents in 21 of the last 22 years.
Economists have studied the reasons for outperformance of private offerings. Longer execution and strategic time horizons, multiple exit value creation options, higher control of operations, and the ability to attract stronger entrepreneur-oriented managers are some of the reasons that are often given for the outperformance of private equity. In private credit, stronger contract management (more rigid lender protection clauses and use of covenants), faster and easier execution, and significantly higher flexibility for capital solutions are often cited as the reasons for superiority of private debt over public market paper.
As much as private offerings seem to be a raw diamond for asset allocators, these products were narrow in reach and limited to sophisticated institutional investors with large minimum investments. They had no redemption or early exit possibility prior to the development of the still-thin secondary market. Why have interval funds and tender offer funds become such a popular way to access private offerings? The answer rests in three simple components: liquidity, transparency, and the feasibility of wider non-institutional access.
Tender funds and interval funds are extremely similar. Tender offer funds have more flexibility in when they offer to buy back shares and have fewer options for offering new share classes. Interval funds, as alluded by the name, make periodic purchase offers on a predefined (interval) schedule and based on the net asset value (NAV) in compliance with SEC Rule 23c-3 under the 1940s act. In simple terms, investors are allowed to redeem their investment on a quarterly, semi-annual, or annual basis. The frequency of repurchases varies by fund and is determined by the fund offering policies. Funds usually limit the repurchase offer to 5% of the fund’s NAV per quarter to avoid forced asset liquidation events.
Another extremely appealing attribute of interval funds is their frequent purchasing intervals. Most funds allow for monthly or quarterly purchases at NAV, and usually without a queue. Although interval and tender offer funds are technically closed-end funds, they often amend registration to increase shares. It is impossible to underestimate the importance of liquidity and the ability to participate in the product throughout time.
But the appeal of these products also comes from transparency and ease of access. Interval and tender-offer funds are registered 40-act funds. They have reporting and operating requirements that provide greater transparency and oversight on their establishment and management as compared to private funds, such as non-traded REITs. These fund report 10-Qs, 10-Ks and all other prospectus and operating filings required by the SEC. Finally, and a core reason for their appeal to the retail investors5 is that these 40-act funds have low investment minimums. They are available only to accredited investors6. Compared to the typical $5 million minimum commitment for private offerings, these products offer minimums as low as $25,000. This is a radical shift and therefore a huge appeal for asset allocators in the wealth management space that manage client portfolios in the $1 -$10 million range. Diversification is feasible with exposure to private investments.
The success of these funds is warranted and will lead to growth. According to CEFData, there was $15 billion in aggregate managed assets in 27 interval funds in 2017, a number that had grown to over 75 funds and over $80 billion by the end of 2021. Considering the growth in assets of the top funds in 2022, it is likely that figure passed $100 billion in 1H 2022. Tender offer funds have also grown, jumping from $6 billion in managed assets in 2010 to over $35 billion by the end of 2021.
Those numbers are pale when we consider the two other specialized financial vehicles that have the benefits of interval funds and make up the space of “semi-liquid” structures: business development companies (BDCs) and Real Estate Investment Trusts (REITs). Managers have understood the appeal of the share redemption and share purchase structure of interval funds and have responded by offering interval repurchase provisions in BDC and REIT structures. Although BDCs and REITs are regulated under different provisions of the 1940s Act, they are similar to interval funds in the sense that they may offer liquidity provisions in their non-traded vehicles, and the funds are registered with the SEC. Blackstone, Starwood, Apollo, Carlyle, KKR, Blue Owl, Lord Abbett, Nuveen, First Eagle, and Ares are some of the top institutional managers that have joined the space of “semi-liquid” vehicles in recent years.
Interval funds, non-traded closed-end funds, non-traded BDCs, and non-traded REITs are different and all make up the “semi-liquid” space that has captured a lot of the private offerings’ allocation from wealth management firms in recent years. These fund types are not an asset class, but rather a “wrapper” where different assets and strategies can be packaged. Therefore, investors should rely on experienced financial advisors who understand the legal structure of the vehicle, the asset composition of the portfolio, the investment strategy of the fund and the value of the management team.
Juan Pablo Villamarin, CFA, CAIA, is a senior investment analyst at Intercontinental Wealth Advisors, a global wealth management firm founded in 1981 based in San Antonio, Texas.
1Source: Preqin – Combining Private Equity, Private debt and Real Assets AUM
2Source: Preqin
3Source: Hamilton Lane report 2021
4Source: Cambridge Associated – As of March 31, 2022
5Retail market in the financial world is made up of wealth management institutions and other non-institutional asset allocators.
6An accreditor investor, as defined by Rule 501 of Regulation D, is a person who has a net worth of $1 million excluding value of primary residence or had a minimum annual income of $200k ($300k of combined income with spouse) over the last two years.
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
