The Unappreciated Costs and Risks of Interval Funds

Incentives matter, especially when evaluating new investment trends like interval funds.

Interval funds have become a popular way to invest in private assets, particularly for those who are not accredited investors. Since interval funds limit withdrawals, though not inflows, they have more flexibility than mutual funds to maintain positions in potentially higher-returning illiquid investments. Assets have been flowing into strategies like Cliffwater Corporate Lending CCLFX, which has grown to $28 billion since its 2019 launch.

Look carefully before joining that rush, though. Not only are interval funds more expensive and harder to redeem than exchange-traded funds or mutual funds (see our Essential Guide to Interval Funds), but some also have fees that are easy to miss and hard to understand. Such unappreciated fees can encourage interval fund managers to take additional risks that disproportionately benefit them rather than investors.

The first type of unappreciated fee channels extra income to managers rather than investors. Some interval funds charge performance fees on the income component of their total return, though it arguably does not take much investment skill to hit an income target.

At the time of its July 2024 regulatory filing, Prospect Enhanced Yield anticipated charging an annual base management fee of 1.375% plus an incentive fee on income after its yield hits 7%. The firm would reap 100% of the income between 7% and 8.235%, and 15% of any further income above 8.235%.

Source: Adapted from Page 53 of the July 23, 2024, Prospect Enhanced Yield registration statement.

Loading up on lower-rated junk bonds and private debt is one way managers could hit an income target of at least 8.235%. The option-adjusted yield of the ICE BofA CCC & Lower US High Yield Index has been above 11% since 2022’s second quarter, for example.

Another way is to invest with borrowed money, or leverage, especially for funds like Prospect Enhanced Yield. Although leverage can help it generate more income, whether the fund hits its income target is based not on the total assets put to work, including borrowed money, but just on what investors have contributed, or investor capital. For example, a $500 million portfolio matching the exposures and yield of the ICE BofA US High Yield Index could juice its annualized option-adjusted yield, which consistently has been around 7% since August 2024, by borrowing another $200 million to invest. It would then generate $49 million in cash before subtracting the management fee and 0.80% for other expenses (legal, accounting, custodian, transfer agent, and so on), leaving $47.2 million. That would translate into a 9.44% yield on investor capital, but only 6.74% on total assets invested.

Source: Authors’ calculations.

Using leverage enhances the asset manager’s fee revenue on income in more than one way. The 1.375% management fee in this example generates $673,750, and the incentive fees enrich it further. It forgoes collecting its 15% share of income on the first 7% of yield and then reaps 100% of any additional yield until it recoups all the forgone income.

In this case, that “catch-up” fee siphons off another $605,294.12. When the incentive fee drops to 15% of income from 8.235% to 9.44%, it generates $115,005.88 more for a grand total of nearly $1.8 million in fees. That’s 3.645% of the portfolio’s $49 million in gross income, a significant loss for a fund that relies mostly on income for its total return, as many interval funds do.

Yet, this simplified example only considers fees on income. It does not include the management charges on the assets themselves, which account for most of what investors pay.

The second type of unappreciated fee is based on overall assets managed, which is a further incentive to add leverage.

Although some firms apply asset-based management fees only to net assets, others, like the Prospect Enhanced Yield interval fund, apply them to total assets, including borrowed money. This can encourage managers to leverage their portfolios even if the borrowing costs are high and the expected returns of the assets they buy are low, because they earn more fees off the larger total asset base. Leverage tends to increase risks for fund shareholders, but the manager collects those fees whether the leveraged investments work out or not.

Interval funds disclose this leverage-incentive risk, but it’s seldom obvious. Prospect Enhanced Yield’s registration statement, for instance, warns that the firm “may have an incentive to increase portfolio leverage in order to earn higher base management fees” since that fee is “based on average total assets.” But as the 29th out of 35 risk factors in the document, it’s easy to miss

If you did miss it, you’d miss a big part of such funds’ potential costs. Adding fees on total assets invested to the previous example, assuming a 7.5% interest rate as the cost of borrowing and a portfolio yield of 10%, shows how big.[2]

Source: Authors’ calculations.

This is still a simplified example since funds assess fees on average daily assets and income-related fees more frequently than once per year. Interval funds also typically distribute at least 90% of their income during the year to comply with IRS requirements and maintain their status as registered investment companies. So, the $70 million in cash flow from row D would not be available throughout the year to buy more debt.

The example, however, still illustrates the lofty costs of interval funds with these fee structures. The adjusted expense ratio excludes the cost of leverage, since that’s an investment decision, but includes all other costs; here it totals 3.39%, reducing a 10% yield to a 7.36% return.

That’s hardly impressive. Several different ETFs in the high-yield bond Morningstar Category currently offer yields around 7% for less than 10 basis points per year. The leveraged interval funds’ extra 36 basis points of return may not be worth the risk.

Indeed, leverage cuts both ways, magnifying gains in one period but exacerbating losses in the next, and losses are harder to overcome. Applying the example‘s 140% leverage ratio (total invested capital/investor capital) to the investment-grade bond market’s 2022 results would have turned a 13.0% loss into an 18.2% drop. Investors would have needed just a 15.0% gain to break even after the first loss, but a 22.2% rebound to break even after the latter.

Under a variety of scenarios, the fee structure would claim a big share of returns. Under the second example‘s assumptions, the asset manager would gather nearly $12.1 million in revenue in exchange for increasing investor wealth by $36.8 million. A ratio of about 1 to 3.

The picture deteriorates with lower return expectations. Assuming a 5.88% yield on total assets invested instead of 10%, the firm would recoup all its forgone incentive fees and gather $10.7 million in revenue for increasing overall shareholder wealth by $9.6 million. A less than 1-to-1 ratio.

If the return was negative, the scales would tip further in the asset manager’s favor. That’s true of all money-losing funds with asset-based management fees, but investors might conclude the managers suffer with them because of the income hurdle rate and incentive fee structure, but that’s not even close to the case.

There may be some best-in-class asset managers that have access to cheaper leverage and are able to offer higher expected returns or unique return patterns. But the math becomes much harder to work out in favor of fundholders, and there is limited evidence of manager skill over long periods. It seems more likely that asset managers with lofty fee structures tied to leverage will be prone to borrow capital regardless of their ability to earn excess returns with that capital. It seems easier for investors to just opt for cheaper options.

[1] Morningstar principal Jack Shannon has reverse-engineered the simple formula that determines the “catch-up” percentage‘s upper bound, precisely 8.23529411764706% in this case. It is the hurdle rate times the incentive fee divided by 1 minus the incentive fee:

[2] The fees charged remain those found in Prospect Enhanced Yield‘s registration statement, while the cost of leverage and yield-to-maturity estimates are in line respectively with Cliffwater Corporate Lending’s weighted-average interest rate on its revolving loan for the six months ended Sept. 30, 2024 (Page 140 of its semiannual report) and its average yield-to-maturity as of March 2025.