Launching an Interval Fund – 5 Important Audit and Tax Considerations

Interval funds have seen a surge in popularity in recent years with both investors and asset managers. According to Morningstar, new interval fund launches reached a record high in 2023 and are on pace to do so again in 2024. AUM in interval funds now reportedly exceeds $80 billion.

Launching an interval fund is a great way for asset managers to offer investors periodic liquidity while pursuing long-term strategies. However, because of the unique structure of these funds, you need to be extra mindful of audit and tax issues to stay compliant and manage your fund efficiently. Here are five key points to consider:

1. Valuation of Portfolio Assets

Getting the valuation of portfolio assets right is crucial, especially since interval funds allow investors to redeem at designated intervals. Unlike daily-valued mutual funds, interval funds entail more complex valuation scenarios, particularly for illiquid and hard-to-value assets.

• • Fair Value Measurement: Make sure you comply with ASC 820 Fair Value Measurement standards, using observable inputs (Level 1) and considering Level 2 and Level 3 inputs for less liquid investments.
  • Independent Valuation Specialists: Engage third-party valuation experts to help with assets that don’t have readily available market prices, such as private equity, real estate and other alternatives.
  • Internal Controls: Implement a robust valuation policy that includes regular reviews by the valuation committee and periodic audits to validate the methodology and assumptions used.

2. Regulatory Compliance

Interval funds must follow specific regulatory requirements under the Investment Company Act of 1940. Non-compliance can lead to serious penalties and disruptions. Pay particular attention to these compliance practices:

• • SEC Requirements: Follow SEC Rule 23c-3, which mandates that funds offer to repurchase a portion of their shares at regular intervals.
  • Disclosure and Reporting: Keep all offering documents up-to-date with the fund's repurchase policy, including the prospectus and Statement of Additional Information (SAI). Regularly file Form N-23c-3 with the SEC to disclose repurchase offers.
  • Compliance Procedures: Establish a compliance program with regular training for staff, periodic policy reviews and updates to stay in line with regulatory changes.

3. Tax Structuring and Compliance

Proper tax structuring optimizes tax efficiency for both the fund and its investors. However, interval funds must navigate complex tax regulations to avoid negative consequences.

• • RIC Qualification: Ensure that the fund qualifies as a Regulated Investment Company (RIC) under Subchapter M of the Internal Revenue Code. Qualified RICs can benefit from pass-through taxation by meeting income and asset diversification tests.
  • Diversification Testing: Funds are subject to strict diversification rules and quarterly asset diversification testing. Failure can result in the fund being taxed at the higher rate of a C Corporation. Familiarize yourself with IRS code section 851(b)(3)(A), as well as the “cure” remedies for insufficient diversification.
  • 90% Income Testing: At least 90% of the gross income for the fund in any taxable year must be derived from sources specified in IRS code section 851(b)(2). Funds are tested for compliance annually at the end of the fund’s fiscal year.
  • Subsidiary Blocker: Look into utilizing a subsidiary blocker, either domestic or foreign, to invest in alternative investments that the fund would not be allowed to invest in directly since they could produce non-qualifying income or be considered a non-qualifying asset for diversification testing purposes.
  • Distribution Strategies: Manage distribution requirements to ensure the fund distributes at least 90% of its taxable income, avoiding corporate-level taxes. Pay attention to the timing and character of distributions (ordinary income or capital gains) for tax efficiency.
  • Excise Tax Avoidance: Funds must meet annual distribution requirements of 98% of ordinary income and 98.2% of capital gains to avoid a 4% excise tax on undistributed income.

For a more detailed discussion of tax requirements that new interval fund managers must be aware of before launching, download our "Understanding the Tax Requirements for Interval Funds" whitepaper.

4. Repurchase Offer Accounting

Periodic repurchase offers, a key characteristic of interval funds, require precise accounting to ensure accurate financial reporting and regulatory compliance.

• • Repurchase Policy: Develop a clear policy for handling repurchase requests, including share pricing and allocation. Communicate this policy to investors and staff.
  • NAV Calculation: Maintain robust systems to calculate NAV accurately during repurchase periods, accounting for accrued expenses, income, and pending transactions.
  • Transaction Audits: Regularly audit repurchase transactions and verify the accuracy of pricing, allocation and payments to ensure compliance with fund policies and regulatory requirements.

5. Audit Readiness and Financial Reporting

Interval funds must be prepared for audits and deliver transparent financial reporting to build investor confidence and comply with regulatory standards.

• • Experienced Auditors: Engage auditors with specific experience in interval funds and familiarity with ASC 946 (Financial Services—Investment Companies).
  • Detailed Record-Keeping: Keep meticulous records of all financial transactions, including valuation reports, repurchase offer documentation and compliance logs.
  • Comprehensive Financial Statements: Prepare financial statements with detailed information on performance, asset valuations, repurchase activities, and compliance with regulatory requirements. Be transparent in reporting material risks or uncertainties.

Launching an interval fund involves navigating complex audit and tax considerations. Focusing on accurate asset valuation, regulatory compliance, effective tax structuring, precise repurchase offer accounting and audit readiness can set your interval fund up for success. Partnering with knowledgeable audit and tax professionals can simplify your planning and strengthen your compliance posture, providing a solid foundation for your fund's growth. Understanding the intricacies of interval funds as well as the tax and regulatory framework can help you create a robust and compliant fund that meets investor needs and stands out in a competitive market.

For more detailed insights and expert guidance on tax and regulatory matters, download our "Understanding the Tax Requirements for Interval Funds" whitepaper or connect with us today. For a comprehensive overview of the workings of interval funds, download our "Navigating Interval Funds: Bringing Alternative Strategies to the Mass Affluent Market" whitepaper.