Faced with lower expected returns in the equity and fixed income markets, many investors are turning to alternative credit investments in search of diversification and higher risk-adjusted returns. Investors often allocate capital to private funds in order to gain exposure to the alternative credit universe. But increasingly, they may also invest in alternative credit through various vehicles that are registered under the Investment Company Act of 1940, but unlike some other registered funds, do not trade on exchanges. Here, we discuss several types of these vehicles.

THE BASICS OF NON-TRADED REGISTERED VEHICLES

Vehicles that invest in alternatives are typically non-traded closed-end funds, which aim to fill the gap between open-end mutual funds and private funds. For closed-end funds not listed on an exchange, investors typically buy and sell shares from the investment manager at the net asset value (NAV). As a result, investors in non-listed closed-end funds are not exposed to the trading premiums and discounts that can arise with some exchange-traded closed-end funds. While exchange-traded closed-end funds in general can offer investors daily liquidity, they can also have more price volatility due to these premiums and discounts.

Unlisted funds typically have limited, defined redemption terms, and some have net worth/income requirements for investors. By limiting redemptions, unlisted vehicles can more easily invest in less-liquid securities – essentially, the structure of the offering is designed to align with the underlying alternative investments. Over the past several years, the asset managers that structure and manage these funds have become significant participants in less-liquid credit markets, stepping in as many banks and other financial institutions have pulled away due to stricter regulatory requirements.

Tax reporting for non-traded closed-end funds is an attractive feature for many investors. They generally issue Form 1099 for taxes versus the more onerous Schedule K-1 typical of partnerships, including private equity and hedge funds.

We see a number of different unlisted structures/vehicles offering exposure to alternatives today (as shown in Figure 1): interval funds, tender offer funds, non-traded real estate investment trusts (REITs), and non-traded business development companies (BDCs).

INTERVAL FUNDS

Interval funds are closed-end funds registered under the 1940 Act. They are designed to fill the gap between traditional, public open-end funds and private funds, with some features of each (see Figure 2). Interval funds offer less liquidity to investors than open-end vehicles and therefore can invest in less-liquid assets and use leverage. Typically, a percentage of shares in interval funds can be redeemed quarterly, and they price daily at NAV.

Although interval funds and tender offer funds provide limited liquidity to investors by offering to repurchase a limited amount of shares on a periodic basis, investors should consider these to be illiquid investments. There is no guarantee that an investor will be able to tender all or any of their requested shares in a periodic repurchase offer.

Among the key benefits of interval funds, a typical affluent investor can gain exposure to more-complex and less-liquid alternative securities without having to meet specific wealth/ income requirements and without having to lock up capital for several years. Interval funds typically repurchase 5%–25% of outstanding shares every quarter, although percentages vary by asset manager and fund. Interval funds also offer operational ease: They typically have lower investment minimums than private equity funds and little to no subscription paperwork (depending on the custodian), in addition to 1099 tax reporting treatment.

Over the last several years, high-net-worth investors have flocked to interval funds (see Figure 3), as the funds provide some liquidity, have the flexibility to invest across the public and private spheres, and typically pay income quarterly.

TENDER OFFER FUNDS

Tender offer funds, like interval funds, provide more flexibility to invest in illiquid investments than open-end mutual funds. They differ from interval funds in their liquidity profile, redemption process, and fund terms (see Figure 4).

Instead of a set repurchase schedule for investor redemptions, the liquidity in a tender offer fund is more subjective: The board of a tender offer fund decides when and how much liquidity to provide. A fund can conduct a tender offer at any time to the extent authorized by the board (subject to tender offer fund rules under the 1940 Act). One advantage to this approach is that it negates the need to hold liquid assets to meet frequent redemptions.

Most tender offer funds are limited to accredited investors ($200,000 in income or $1 million in assets) or qualified purchasers (at least $5 million in investments), have set terms or maturities, and target specific assets for investment.

NON-TRADED REITS

Recently, we have seen a resurgence of non-traded REITs, seemingly with better investor alignment and more transparency than the structures utilized a decade ago.

Non-traded REITs have the flexibility to own real estate, originate real estate debt, and securitize real estate assets. They aim to generate attractive and consistent dividends, along with capital appreciation, and may therefore be suited to income-seeking investors looking for a complement to their traditional fixed income holdings. They also have leverage restraints and are increasingly moving toward quarterly versus annual liquidity terms.

Non-traded REITs typically focus on core/core-plus private commercial real estate, generally investing in high-quality assets with stable income profiles, including mortgage and real estate debt; they can be exposed to housing-related risks, including supply-demand pressures, vacancy levels, and cash flow fluctuations.

Overall, we think the confluence of quality asset managers coming into the sector and the recent better alignment of fees and transparency should make these vehicles increasingly attractive for end investors.

BUSINESS DEVELOPMENT COMPANIES

Lastly, the non-traded BDC structure may be a solution for investors looking to capture opportunities in a growing segment within alternatives - lending to small and mid-sized companies.

The BDC structure was first approved by Congress in the 1980s as a way to help U.S. businesses raise capital and create jobs. Following the global financial crisis in 2008−2009, tighter banking regulation has given rise to many BDCs that lend to below-investment-grade middle-market companies by selling equity and debt (senior and junior) instruments. These debt instruments are privately negotiated and are not traded freely, which usually makes the loans less liquid and limits their size. BDCs have gained popularity with investors recently in the overall low-yield environment.

Investors can choose between private and public BDCs. Privately held BDCs are not listed on an exchange and are typically available through broker-dealers and financial advisors, while publicly traded BDCs are permanent capital structures that trade daily on an exchange, but can be subject to the higher price volatility often associated with exchange listings. Public BDCs reinvest proceeds on a continual basis, and can trade at a discount or premium to book value. Of note, private BDCs typically have the option to convert to permanent capital vehicles through an initial public offering.

BDCs are pass-through structures, distributing 90% or more of ordinary income and short-term capital gains annually to shareholders. Investors usually need to be accredited.

FINDING THE BEST SOLUTION

Asset managers are continually looking for optimal solutions for the high-net-worth marketplace, and traditional private credit managers are also moving from institutional-only products to more client-friendly structures, making alternatives more accessible than ever.

With returns in the public markets expected to be lower in the future, we think investors that can give up some liquidity may want to consider unlisted alternative strategies to complement their broader asset allocations. In our view, having flexibility to invest across credit segments and avoiding short-term redemptions can help investors realize the attractive risk- adjusted return potential that alternatives can offer.

As affluent investors consider unlisted alternative strategies, they need to understand each offering’s specific characteristics, including the legal structure, use of leverage, redemption process, asset manager history, and the fee structure. They also should be aware of the offering’s likely correlation to the public markets. Finally, prudent management of the asset-liability match between the fund structure and its underlying alternative securities is key to making unlisted funds a potentially attractive solution for high-net-worth investors.