Launching an Interval Fund? 5 Important Audit and Tax Considerations

Posted by James Kaiser on May 28, 2019 4:39:08 PM

In recent years, we have seen an increase in the popularity of interval funds.  Interval funds are hybrid products that contain characteristics of both open-end and closed-end funds.  Like open and closed-end funds, they are registered under the Investment Company Act of 1940 and generally take subscriptions daily, although some interval funds may take subscriptions less frequently than daily.

Launching an interval fundThe key difference is that while open-end funds will redeem shares on a daily basis, interval funds make periodic tenders to purchase outstanding shares, at net asset value, and generally limit the number of shares that they will repurchase at each tender date.  Additionally, unlike some closed-end funds, interval funds are not exchange traded, and shares can only be liquidated via participation in the periodic tender offers.  BBD is the auditor and tax advisor for many interval funds. Based on our experience with funds utilizing this increasingly popular structure, we recommend considering the following points:

1. Choose the fund’s fiscal year-end wisely.  The primary reason for considering the interval fund structure is generally the desire of the investment advisor to launch a product that will invest in securities with limited liquidity, such as hedge funds, private real estate funds, private equity funds, and private or lower rated debt instruments with limited or no market.  The limited liquidity of these investments will limit the ability of the fund to operate as an open-end fund and redeem shares daily.  Many of these investments are structured in ways that create both valuation challenges and tax consequences.  Additionally, many interval funds establish distribution policies that target a set distribution yield, regardless of the income actually earned on the underlying investments, which creates additional tax challenges and consequences.  Many of these operational and tax challenges and consequences can be mitigated with a thoughtful and strategic selection of a fiscal year-end.  Unfortunately, we often see funds selecting a year-end without giving much or any thought to these operational and tax challenges and consequences.                                               

As an example of how a strategic selection of a fiscal year-end can mitigate some tax challenges, consider interval funds that make significant investments in entities that are structured as limited partnerships.  Limited partnerships report items of income, expense and gain(loss) annually on Schedule K-1.  Interval funds must include items reported on K-1s in determining their net investment income and gain(loss) in the year in which they receive the K-1, unless the interval fund has a December 31 year-end.  Additionally, interval funds must report the character of the distributions paid to shareholders on Form 1099 in January of each year.  The character of the distributions paid by an interval fund is directly related to the amount and character of income and gain(loss) earned by the interval fund during its fiscal year, including amounts reported on Schedule K-1. While the timing can vary significantly among limited partnerships, we most commonly see limited partnerships issue K-1s sometime in March.  If an interval fund selects a March 31 fiscal year-end, it would have to include the items reported to it on K-1s in its calculation of taxable income for its year ended March 31, yet will have had to issue 1099s in January before having received these K-1s.  We think this creates a high likelihood of 1099 error, which can be costly.  If a fund were to select a fourth quarter fiscal year-end (other than 12/31), this 1099 reporting risk would be greatly mitigated, as the items reported on K-1s received in March would not impact 1099 reporting until the following fiscal year.  Unfortunately, we have seen interval funds select first quarter fiscal year-ends all too often.  We suspect the primary reason for selecting first or early second quarter year-ends is because audited financial statements of underlying investment partnerships are available then for the interval fund’s audit.  We believe this is faulty logic.  Collaborating on strategic year-end selection, in the pre-launch phase of product development, with an auditor (see below), administrator and legal counsel experienced with interval funds will save you time, money and headache.

2. Establish a valuation plan for each investment before the fund purchases it. As explained above, most interval funds invest in securities with limited liquidity.  Some of these can be difficult to value.  The “value it at cost and we will figure it out later” approach never seems to work out well when it comes time for the annual audit.  Although interval funds only make periodic tenders to purchase shares, they generally will take in money and issues shares daily.  This means the interval funds must strike daily net asset values (“NAV” or “NAVs”), and these NAVs must be determined using fair value for all of the securities.  Many investment advisors we speak with in the planning stages of an interval fund have no real plan or intention of valuing their investments daily.  Also, we see many investments made by interval funds valued using the practical expedient.  In plain English, the practical expedient is a concept within U.S. Generally Accepted Accounting Principles that states if you make an investment in an entity that calculates a NAV or an equivalent to a NAV, you may use such NAV to determine the fair market value of the investment, as long as certain requirements are met.  Many entities provide NAVs, but only do so monthly or quarterly.  Making investments in entities that only provide periodic NAVs does not alleviate the need to estimate the fair value of these entities on a daily basis.  Collaborate with your administrator, auditor and legal counsel prior to purchasing new types of investments to understand what operational and/or tax challenges might result.  Run your valuation approach by your auditors and ask them what questions they might have so that you can be proactive in your valuation approach. Consider the need to engage an independent valuation consultant to assist with the fair value process.

3. Make sure you carefully research and understand the tax consequences and accounting issues for each investment before the fund purchases it. This is very similar to the point above, but cannot be emphasized enough.  Many alternative investments frequently purchased by interval funds are structured as limited partnerships, which can create tax consequences that need to be carefully considered, especially if your interval fund has elected to be taxed as a regulated investment company (“RIC”).  Collaborate with your administrator and audit firm to make sure you fully understand the risks these investments can pose to your fund’s qualification as a RIC.  Additionally, as mentioned above, many of these investments will likely qualify to be valued using the “practical expedient.”  The practical expedient is as the name implies – very practical and easy to apply.  However, there are a number of financial statement disclosures required when this approach is employed for which you will need additional information that may not be easily obtained.  By collaborating with your administrator and audit firm prior to making the investment, you will better understand the disclosure requirements and be in a position to require the underlying fund to provide the necessary information as a condition to your investment.

4. Be mindful of the need to consider information that impacts the value of your investments, but that only becomes available subsequent to your fiscal year end, yet before your financial statements have been issued. This one confuses many of our clients.  For daily NAV purposes, interval funds must use estimation techniques to report their investments at fair value.  If information becomes available on a time lag that impacts your estimate of fair value, you would reflect that information in your NAV when it becomes available and would not be expected to go back and restate previous NAVs determined using estimation techniques.                               

For example, consider an investment in a private fund that publishes monthly NAVs on a two-week lag.  The interval fund would determine its NAV on a month-end date using an estimate of the value of the private fund in which it has invested.  If on the 15th day of the next month, the private fund publishes its NAV, the interval fund would factor this information into its NAV on the 15th, but would not go back and restate its month-end NAV.  In stark contrast, the requirements for preparing financial statements in accordance with GAAP expect the preparer of the financial statements to use the benefit of hindsight and incorporate any and all information that would affect the fair value of an investments as of the reporting date.  In the example above, the interval fund’s financial statements would be adjusted to reflect the NAV of the underlying private fund that was not reported until the 15th of the next month.  Therefore, it is quite possible, and perhaps even likely, that the NAV in the interval fund’s financial statements prepared in accordance with GAAP will differ from the NAV determined for daily subscriptions.  This difference can add aggravation to the financial reporting process.  Collaborating with your administrator and auditors prior to the financial reporting date to develop a plan for incorporating the adjustments for information received subsequent to the reporting date is critical for a smooth financial reporting and audit process. 

5. Choose collaborative service providers. In each of the points above, we noted the need to collaborate with your administrator, audit firm and/or legal counsel.  Interval funds are high touch products from a servicing standpoint.  All are unique, and need unique solutions from their administrator.  If you are only reaching out to your audit firm at the end of the year during the annual audit, the chances of a smooth audit decrease.  The most well-run interval funds (operationally speaking) regularly involve their fund counsel in operating decisions.

BBD is the boutique solution for the accounting, audit and tax needs of the investment management industry, including for interval funds.  BBD’s investment company experts have built a reputation as collaborative partners for our clients.  If you are considering launching an interval fund, please be in touch.  We’d enjoy the opportunity to be a resource for you.

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