We have witnessed the explosive beginning of a new revolution in markets over the past five years.
The financial industry has consistently astounded participants by its ability to deliver innovative products throughout history.
The creation of the Chicago derivate exchange in the 1800s, the design and formation of regional and industry benchmarks in the early 1900s, the evolution of securitization from home mortgages in the 1970s, and the proliferation of junk bonds in the 1980s are just a few important examples of the masterpieces delivered by the juggernaut that is the financial industry.
One of the rising beasts 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 wider access to illiquid, long-term investments that were previously limited to term private funds.
A wider opportunity set of investors and historical alpha generation from private offerings 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 the potentially powerful milestone of having an IPO and raising debt from a public exchange.
However, things have changed drastically over the past decades. The growth of private capital has been exponential, with private markets AUM growing to almost $10 trillion dollars as of H1 2021.
The institutional private markets industry is now raising over $1 trillion per year globally across all asset classes.
Shrinking public companies
The reason for this phenomenon is not complex: public companies represent only 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 US, and that number shrank to around 4,800 by the end of 2022. The number of public companies has been shrinking for the past two decades, while investable private companies have continued to grow.
In the US there were only 2,600 public companies with annual revenues of more than $100m in 2021, compared to around 17,000 private corporations of that revenue magnitude.
The appeal of private markets is not just the sheer size of the potential opportunity set, 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 north of 470 bps in both 20- and 25-year horizons relative to both the Russell 2000 and the Russell 3000 indices under a modified public market equivalent calculation.
This is impeccable outperformance. What is even more alluring is the consistency of outperformance. Private equity and private credit have outperformed global public market equivalents in 21 of the last 22 years.
The reasons for potential outperformance of private offerings are a deeply studied field in financial economics.
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 prevalent reasons that are often quoted for the outperformance of private equity.
Private offerings a ‘raw diamond for asset allocators’
In private credit, the ideas of 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 quoted as the pillars of 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, as products were limited to sophisticated institutional investors with large minimum investments and had no redemption or early exit possibility prior to the development of the still thin secondary market.
So 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.
Before we proceed, we should highlight that tender funds and interval funds are extremely similar.
Tender offer funds simply 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 basis 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 pull out 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.
Importance of liquidity
Although interval and tender offer funds are technically closed-end funds, they offer shares continuously and often amend registration to increase potential shares.
It is impossible to underestimate the importance of having potential liquidity and the ability to participate in the product throughout time. But the appeal of these products also encompasses transparency and ease of access.
Interval funds fall and tender offer funds fall under the legislative cornerstone of the Investment company act of 1940, and therefore are registered 40-act funds.
As such, their funds have reporting and operating requirements that provide greater transparency and oversight on their establishment and management. These fund report 10-Qs, 10-Ks and all other prospectus and operating filings required by the SEC.
The success of these funds is therefore highly warranted, and it is inevitable to forecast continuous growth in this space.
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 very likely that figure passed $100 billion in 1H 2022. Tender offer funds have also enjoyed critical mass growth, jumping from $6 billion in managed assets in 2010 to over $35 billion by the end of 2021.
These numbers however seem pale when we consider that there are two important and different specialized financial vehicles that have emulated the fundamental benefits of interval funds and make up the space of “semi-liquid” structures: Business Development Companies, known as BDCs, and Real Estate Investment Trusts, known as REITs.
‘Semi-liquid’ space
Managers have understood the appeal of the share redemption and share purchase structure of interval funds and have continuously chosen to offer interval repurchase provisions in BDC and REIT structures.
Although BDCs and REITs are technically regulated under different provisions of the 1940s Act, they end up being very 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.
It is therefore very important to understand that interval funds, non-traded closed end funds, non-traded BDCs, and non-traded REITs are all slightly different, and all make up the “semi-liquid” structure 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 very different assets and very diverse strategies can be custodied.
Therefore, investors should rely on experienced financial advisors that can peel the onion and 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.
Intercontinental Wealth Advisors has devoted and will continue devoting significant efforts in understanding and mastering the options in this space.
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.