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First a confession: This article’s title should have been, “A Proposal to Save the Semi-Liquid and/or Interval Fund,”1 but you wouldn’t have clicked on that, so here we are. Besides, private credit is the investment villain du jour. And evergreen vehicles, with their 5% gates, are the epicenter of agony in the absence, at least so far,2 of any systemic waves of actual loan default.
Motivation
It’s fashionable to rail against panicky retail investors and their foolish bank run behavior. But the truth is that a bank run has always been the natural result of uncoordinated rational actors in the aftermath of a relatively minor tipping point.
With interval funds,3 here’s how this works:
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Step 1: Something bad. An over-concentrated fund breaks the buck after years of pretending their NAV goes up a penny every day. Somebody double-pledges some assets. A bored financial journalist anonymously quotes his Aunt Gertie’s barber about how everyone is worried about private credit. Whatever.
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Step 2: Minor panic or rational front-running: You make the call. The gates go up. Everybody only gets 75% of what they asked for. Roll forward to the next quarterly tender window.
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Step 3: The completely rational part. Retail investors, or their advisors, responding to their failure to complete a simple rebalance last time around, put in for maybe 1.5 times the actual need. And guess what?! Everybody only gets half of what they asked for.
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Step 4: Take a wild guess. This cycle doesn’t have to repeat too many times for investors to conclude, “What the heck, I’ll put in 100% sell orders. If I get back more than I need, I can always just buy right back in.”
And before you know it, the majority of shareholders are storming the 5% gates with proxy pitchforks, while the Stewards of Evergreen Gondor pointedly hold firm on their management fees and redeploy capital, claiming they’re defending the return profile for the minority of shareholders, who may be as loyal as the managers assert — or may just be exhausted by the whole thing.
The only winners here are Gertie’s nephew and the see-I-told-you so types, who… Look, they may have had a point, but the valid point wasn’t “private credit doesn’t belong as a small, diversifying holding in someone’s portfolio.” Instead, it was “interval funds have structural issues.”
I’m not so naïve as to think that death spiral risk can be engineered out of the interval fund altogether. Nor am I making any claim that the “risk” part of “higher risk/higher return fixed income diversifier” can, or should, be eliminated. But any method of mitigating exogenous, uncompensated, fund structure-specific risks would be an improvement. Here are a few ideas.
A Better Structure: Form an Orderly Queue
Of course, one could argue that drawdown funds or closed-end BDCs are the solution, but a drawback with both of these structures is that it is significantly more difficult for 10% of 40%4 of Rhonda Retiree’s rollover IRA to get anything like sufficient deal-level diversification that way. And it can take years for an investment to reach the size you wanted. And if you think interval fund bank-run liquidity is bad… Under normal circumstances, the ability to buy and sell at NAV on occasion is an advantageous feature in support of non-panicky actions such as portfolio construction, rebalancing, and systematic withdrawals.5 So how do we support that better?
“You Can Get 5%”
Interval funds guarantee liquidity of 5% of fund assets every quarter. Yet under the current structure, the only way to guarantee that you can redeem at least 5% of your position is to put in a 100% sell order.
That is excruciatingly flawed design.
A better structure would coordinate this process, so that if you ask for a 5% redemption, you know you will get 5%.
This could be accomplished by a rule that says the first 5% of every account’s fund holding is eligible for liquidity every quarter. Any spare redemption capacity can then fulfill sell orders above 5% on a pro rata basis. Notice that this still allows a fund to hold to a 5% gate if needed, but in a far more intelligent manner.6
Better yet, set this rule at the advisor level. If Bob needs a 30% redemption to support a change of plans, Fred needs 10% for a portfolio rebalance, but every other client’s fund holdings are fine, then the RIA may only want 5% total redemptions, or less, across its practice. But the death spiral means putting in much higher redemption requests for Bob, Fred, and — eventually — everyone, just in case.
By contrast, if advisors knew that 5% would be available to deploy across their asset base as needed, then they would be incentivized not to put in extra orders! (Granted, this may be a more difficult regulation to craft at the advisor level than at the investor level. However, the advantages for all investors, if we reduce death spiral risk, could be huge.)
Raise the Entry Gates Also
For the political economy buffs, think of this as Chilean-style capital controls7 for interval funds. The asymmetry of “buy as much as you want whenever you want” and “sell only quarterly with potentially gated redemptions” is an open invitation to “hot money” behavior. Notice the part of the death spiral above where the investor says, “Hey, I can always just buy back in.”
Of course, the sober implementation of a symmetric quarterly subscription model — let alone one where inflows are gated to prevent the degradation of deal quality — is a big ask when the hot money is flowing in. And by the time we reach bank run mode, it will no longer make much difference. But when the tidal river initially reverses, this may be part of the difference between BCRED meeting 7.9% redemptions and Cliffwater cutting 14% redemption requests in half.8
Expand the De Minimis Exemption
By this I do not mean, “make the de minimis exemption bigger,” though that might not hurt either. I mean, “make the de minimis exemption a universal minimum sell order size.” Right now, if you hold, say, 100 shares or less in your account, fund rules will allow full redemption. But if you hold 101 shares and you try to sell 40 of them, you might only get 10! Someone who needs to exit might pay a string of $20-$40 trade tickets to reap a string of $1,000, $700, $300 orders on the way to a guaranteed $3,000 liquidation.
This is also excruciatingly flawed design.
Instead, guarantee the 100 shares as a minimum sell order, not just a liquidation mechanism. Again, this will raise the comfort level in holding these assets and reduce the incidence of rational over-tendering.
If You’re Keeping the Money, at Least Stop Charging on It
This is the “prove it’s not greed” provision. Funds with illiquid holdings really do require gating mechanisms to prevent fire sales. But this should be counterbalanced by a stipulation that whatever percent of the fund was gated in the last quarterly tender window will be matched by a percentage reduction in the management fee,9 or an equivalent contractual reimbursement, as is done by mutual fund managers to hold net expense ratios down when AUM is low.
If redemption requests ever exceed 50%, the management fee is permanently pinned to 50% of its original level, and the red button gets pushed.
The Nuclear Option
All provisions above should help reduce the risk of the death spiral. But it can’t be eliminated completely, and an advance directive for the termination of a fund on life support should be built into the prospectus. My thought: Once redemption requests exceed 50%, the fund immediately converts to a closed-end structure (a closed-end BDC, in the case of private credit), with a fixed term to liquidation of no more than five years, including at least a linear10 annual liquidation schedule. The closed-end conversion will enable investors who want/need out faster to sell at a discount.
And give it a rest with the “panicky retail investor” memes. This outcome is the investment equivalent of a parliamentary vote of no confidence, no different from the majority of shareholders exiting a normal, liquid 40-Act fund.
Ready, Set, Restructure
The implementation of some or all of these ideas would require modifications to existing regulations. Moreover, there’s a decent chance we’ve already crossed the redemption Rubicon for the current cycle. The sooner the mass of retail private credit managers realize they are zombies and give up the ghost, the sooner we can burn the whole thing to the ground and conjure a better model from the ashes. But there is no time like a crisis to have conversations about how to make the structure work better for everyone in the future!
I realize also that the technology to support the coordination required for the first suggestion above — likely the most valuable for reducing death spiral risk — may not yet exist.13 But in a world where someone with zero coding knowledge can build a global mass-surveillance system in two hours, we should be able to figure it out. Make it so!
In his roles as chief investment officer for Round Table Investment Strategies and portfolio manager for Torren Management, Nathan Dutzmann is responsible for applying financial science and investment research to the process of constructing portfolios tailored to the individual needs and goals of clients nationwide. Nathan was previously an investment strategist with Dimensional Fund Advisors and a partner and chief investment officer with Aspen Partners. He is also a member of the investment industry advisory council for The American College of Financial Services. He holds an MBA from Harvard Business School and a master’s degree in international political economy and a bachelor’s degree in mathematical and computer sciences from the Colorado School of Mines.
1 Also, of course, by “save,” I mean something like “at least modestly improve.”
2 If we’re in a deep, private credit-induced recession six months from now, please don’t forget that I said, “at least so far.”
3 Loooook into my eeeeyyyyeeess… When you awake, whenever I simply say, “interval funds,” you will see “semi-liquid LP, open-end BDC, and interval fund evergreen private credit structures.” Understood? Just nod. Okay. *snap*
4 In case my fastball was a wild pitch: That’s 10% of the bond portion of a 60/40 portfolio. Just a non-crazy allocation to an intermediate-risk diversifier.
5 Conversely, in not-so-normal times, like the present, the steep NAV discounts and liquidity available on many BDCs arguably makes them a more attractive purchase — notwithstanding the steep NAV discounts that accompany the liquidity.
6 To anyone who suggests this would be unfair to investors who wanted more than 10% and would get an even bigger percent reduction than they do now, I offer two counterarguments: 1. The whole point of this idea is to reduce the odds of the death spiral in the first place, thereby increasing the odds that all investors would get everything they ask for. 2. Investors (or advisors) asking for significantly more than 5% arguably should get a worse deal, on a relative basis, vs. those whose liquidity requests fit the “semi-liquid” profile. The ideal way to do so would be a haircut for demanding liquidity, but in the absence of that, a more restrictive gate for large redemption requests is second-best. (But down here, I’ll add a suggestion to allow interval fund managers who get more than 5% redemption requests to seek a market-clearing price by offering a take-it-or-leave it exit option at some price below NAV to investors who have been gated, for some portion of the remaining shares they originally requested.)
7 On a personal note, this is the first time I’ve ever had a reason to link to one of my cases from business school.
8 Granted, going first might have been helpful there too. Also this.
9 I’ll put the boring explanatory math down here: If the management fee is 1.25%, the fund gets 25% redemption requests, and 5% is fulfilled, leaving 20% unfulfilled, the management fee is now 1.25% * (1 – 20%) = 1% for the next quarter. If 10% is gated the next quarter, the fee is 1.25% * (1 – 10%) = 1.125%. If a quarterly tender is subsequently fully met, the fee goes back to its full level. If redemption requests exceed 50%, see the next subsection.
10 E.g., in the case of a five-year liquidation: 1/5h, 1/4, 1/3, 1/2, 100% liquidation in years 1-5, at minimum.
11 I realize there’s an argument for irrational, performance-chasing, market-timing behavior there too. But if anything, joining the herd is more rational in a semi-liquid structure, where the last one out the gate gets the most toxic assets and the least liquidity.
12 Do zombies have ghosts? Hmm…
13 Or maybe it does? At any rate, fund managers are already capable of keeping tabs on the assets held by each RIA they work with.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
