US Insight: Liquidity risks loom for interval funds even as retail investors jump in

Interval funds have had explosive growth as private credit’s enticing yields draw individual investors to the asset class, a constituency that alternative lenders are increasingly targeting.

Putting direct lending investments in an interval fund structure leads to an inherent tension though: Interval funds require liquidity, but private credit is illiquid. That dichotomy highlights the importance of managing the cash needs of these funds, particularly as to how they might endure a possible surge in redemption requests.

“Some fund managers are not necessarily thinking about providing that quarterly liquidity, and they certainly may not be thinking about providing that over the long-term,” said Jason Mandinach, who leads product strategy for PIMCO’s global alternative credit and private strategies platform.

A record 50 new interval funds launched in 2024, with 55 such vehicles expected to launch in the next six months, according to XA Investments, an alternative management firm that offers closed-end fund structuring and consulting services.

Interval funds are semi-liquid vehicles that work if managers can meet their liquidity needs, which is between a 5% and 25% redemption on a quarterly basis. Since these funds are offered perpetually, cash that managers receive from investors buying into these pools of capital can be used to offset redemptions.

There’s no industry standard for overseeing these funds, and managers have yet to contend with back-to-back quarters of net outflows, as some experienced during the Great Financial Crisis.

“A lot of interval funds do not have a devoted liability management team or full-time focus, said Daniel Lepore, head of liability management at Cliffwater. “That may put their investors at risk of not necessarily receiving the promised liquidity that interval funds should support at all times and across all market conditions.”

Lepore manages the liability strategy, which includes the financing of redemptions, for the firm’s funds, including Cliffwater Corporate Lending Fund, the industry’s largest interval fund with over $29bn in total net assets.

The liquidity risks for these funds are amplified given their rising popularity among high-net-worth retail investors, according to a report by Moody’s, which notes investors might not fully grasp the lockups that come with investing in illiquid instruments.

Investors need to consider the funds’ liquidity cap as disclosed in its offering documents, according to Brian Hirshberg, a partner at Mayer Brown.

“These funds typically limit liquidity that [an investor] can reasonably expect, and that should be taken into consideration when making an investment decision,” he said.

Even though there is a cap on the amount of redemptions, managing cash inflows and outflows still requires careful planning.

“It goes back to having a disciplined and responsible approach to liquidity management and matching the investment strategy to the liquidity of the vehicle,” said PIMCO’s Mandinach, who stressed the importance of providing liquidity with assets such as public debt and asset-backed finance loans.

Redemptions are paid through inflows from loan repayments, buyers of the funds and revolving lines of credit, the terms of which are determined by the lender who provides the line to the fund.

“Only relying on inflows to meet redemptions is a real dangerous game,” said Kevin Prunty, senior managing director at Longwater Capital Solutions. “You can’t predict your inflows, while you have predetermined outflows, which is why active portfolio and liquidity management are imperative for asset managers.”

Yet, many managers of semi-liquid private credit funds rely too much on new inflows and cash from their balance sheet to meet redemptions, according to a large fund manager.

The funds have not necessarily been cycle-tested.

“Direct lenders are coming out of an incredibly benign environment, and most credit vehicles have only grown – they’ve not gone into a period of net redemptions,” said PIMCO’s Mandinach. “And so, is the industry built for an extended period of net redemptions? My answer is no.”

Interval funds’ appeal

The vehicles are attractive because of their accessibility and diversification of underlying assets.

Large institutional investors such as pension funds and endowments are receiving fewer distributions from private credit funds, making it harder for them to commit additional money to the asset class.

This dynamic has given the retail investor constituency a new importance, as it represents a new, potentially large, capital base when commitments from institutional LPs are slowing down.

The generational transition of wealth is another factor, Longwater’s Prunty said. Baby boomers are passing on their wealth to a younger generation that has a longer time horizon for investment.

“There’s a place for private credit interval funds in a younger person’s retirement portfolio if structured the right way,” he said. “The returns are just better and less volatile than the public equivalents, and this is a growing asset class that investors want to be able to access.”

Another allure of these funds is their daily NAV. Also, because they are electronically ticketed, it’s easy for investors to buy a fund online without having to sign any documents.

“That’s what has catapulted a lot of momentum in the space,” said Kim Flynn, president of XA Investments. “The interval fund has daily NAV and doesn’t require subscription documents. Plus, with a yield north of 10%, private credit interval funds are selling like hotcakes.”

Navigating the new terrain

What’s more, some regulation has been passed that may further fuel access to the asset class with broader marketing and the removal of a limitation on private assets in some investment vehicles, including interval funds.

In May, the SEC amended guidance that curtailed the amount of private credit positions in an interval fund at 15% of the portfolio. While that means individual investors can get greater exposure to private credit assets, managing fund-level liquidity may get even tougher.

“The change in the SEC’s guidance in relation to the 15% cap on fund assets in closed-end funds should also help provide many investors with more access to private credit,” said Mayer Brown’s Hirshberg.

Still, while it’s easy to get caught up in the hype, it’s important to remember that the interval fund market is still in its infancy.

“Fifty percent of funds in market today have a track record short of three years,” noted Flynn.

“The original interval funds have 20-year track records, but those are considered ‘legacy funds’ and are essentially hedge funds or senior loan funds before they got put into ETFs and mutual funds,” she added. “They wouldn’t be structured in that wrapper today.”

Assets in semi-liquid credit funds, which includes interval funds, grew to $194bn through May 31 and are projected to reach as high as $230bn this year, per XA Investments. Of the 55 interval funds in registration now, 23 are private credit funds.

Despite offering a modicum of liquidity, private credit interval funds should be treated like illiquid investments, as they cannot be traded into or out of like other investment products available to retail investors.

“There’s a risk marrying an inherently illiquid asset class with a vehicle that has been expected to have some semblance or implied liquidity,” noted Prunty. “That’s where the education piece comes in so that investors are clear these are long-term capital appreciation vehicles and not to be looked as something similar to ETFs or mutual funds.”