Ask Your Advisor These Questions Before Investing in Semiliquid Funds

Key Concepts

Semi-liquid Funds: Investment vehicles that offer less liquidity than traditional mutual funds or ETFs but more liquidity than traditional private market drawdown funds.
Private Markets: Investments in assets not traded on public exchanges, such as private equity, private credit, and real estate.
Interval Funds: A type of semi-liquid fund generally available to anyone through a financial advisor.
Tender Offer Funds: Another type of semi-liquid fund generally available through a financial advisor.
Non-traded REITs (Real Estate Investment Trusts): Investments focused on real estate that are not traded on public exchanges.
Non-traded BDCs (Business Development Companies): Investments focused on direct lending and private credit, often requiring at least 70% of their portfolio to be loans to middle-market companies for tax benefits.
Qualified Purchasers: Investors who meet certain net worth or income thresholds, allowing them access to a wider range of private investments.
Non-Qualified Purchasers: Investors who do not meet the criteria for qualified purchasers, often referred to as retail investors.
Democratization of Private Markets: The trend of making private market investments more accessible to individual investors.
Liquidity: The ease with which an asset can be converted into cash without affecting its market price.
Illiquidity: The opposite of liquidity; assets that are difficult to sell quickly without a significant price reduction.
Drawdown Funds: Traditional private market funds that require investors to commit capital over a period, with capital being "drawn down" by the fund manager as needed.
Net Asset Value (NAV): The per-share market value of a fund's assets.
Listed Closed-End Fund: A fund that trades on an exchange, with its share price determined by market supply and demand, not necessarily its NAV.
Incentive Fees: Additional fees paid to fund managers if they achieve specific return targets.
Leverage: The use of borrowed money to increase potential returns (and losses).
Proration: A process where investors receive only a portion of their requested redemption if demand exceeds available liquidity.
Rebalancing: The process of adjusting a portfolio to maintain a desired asset allocation.
Morningstar Rating Methodology: Morningstar's approach to evaluating investment funds, which for semi-liquid funds includes a higher weighting on the parent company's strength.

Understanding Semi-Liquid Funds

Semi-liquid funds, also known by names like "evergreen" or "perpetual" funds, represent a new category of investment vehicles designed to bridge the gap between daily liquid mutual funds/ETFs and traditional private market drawdown funds. They offer investors access to less liquid private assets without requiring multi-year lock-ups.

Key Characteristics:

Liquidity Structure: Unlike mutual funds or ETFs offering daily liquidity, semi-liquid funds do not provide daily redemptions. However, they also avoid the multi-year lock-up periods characteristic of traditional drawdown funds.
Accessibility: The focus is on making private markets more accessible to non-qualified purchasers, often referred to as the "democratization of private markets."

Types of Semi-Liquid Funds

There are four main types of funds considered semi-liquid, particularly those available to non-qualified purchasers:

Interval Funds: Generally accessible to any investor through a financial advisor.
Tender Offer Funds: Also typically available through financial advisors.
Non-traded REITs: These are not technically funds but function similarly, focusing on real estate investments.
Non-traded BDCs (Business Development Companies): These focus on direct lending and private credit. To qualify for specific tax advantages, BDCs must typically allocate at least 70% of their portfolio to loans made to middle-market companies.

Liquidity Considerations for Investors

When considering semi-liquid funds, investors must carefully assess their liquidity needs and tolerance for illiquidity.

Key Questions for Investors:

Personal Liquidity Needs: How much of your portfolio can you afford to have tied up? Longer-term goals may accommodate more illiquidity than shorter-term ones.
Fund Redemption Structure: Most semi-liquid funds offer limited liquidity, with typically around 5% of fund assets available for redemption on a quarterly basis.

Investment Focus and Popularity

Semi-liquid funds act as wrappers for portfolios of less liquid securities. Currently, private credit is a particularly popular area of investment within these funds, attracting significant inflows.

Reasons for Private Credit Popularity:

High Income Potential: Private credit currently offers attractive yields relative to public market yields, especially with the expectation of a rate-cutting cycle.
Examples of Popular Funds: Cliffwater and Blackstone Private Credit are mentioned as funds experiencing substantial inflows.

Liquidity Risks and Stress Events

The primary challenge with semi-liquid funds arises when multiple investors attempt to redeem their investments simultaneously.

Potential Outcomes During Liquidity Crunches:

Proration: Investors may not receive their full redemption amount if demand exceeds available liquidity. For example, if two investors request $10 and only $10 is available, each might receive $5 and need to reapply in the next redemption period.
Real-World Examples:
- Blackstone Real Estate Income Trust: While experiencing liquidity stress, it managed to meet its 5% quarterly redemptions and eventually exited its proration period.
- Starwood: This REIT had to reduce its quarterly redemptions from 5% to 1%.
- Blue Rock Total Income Real Estate: This interval fund is attempting to convert to a listed closed-end fund, meaning investors would trade shares on the open market at market prices rather than NAV, potentially facing downward price pressure if many try to exit.

Portfolio Allocation and Diversification

The integration of semi-liquid funds into a broader portfolio requires careful consideration of how they are categorized and managed.

Advisors' Approaches:

"Alternative" Bucket: Often, these funds are broadly categorized as "alternatives."
Contextual Allocation: Advisors may discuss a private credit semi-liquid fund within the context of a client's bond allocation.
Underlying Asset Class: It's important to recognize that private credit is still credit, and private equity is still equity. These investments are subject to the same economic risks as their public counterparts.
Perceived Diversification: While volatility might appear understated due to less frequent pricing, these funds may not offer true diversification in the traditional sense.

Costs and Fees

Semi-liquid funds generally come with higher fees compared to traditional mutual funds and ETFs.

Typical Fee Structures:

Management Fees: Often around 2% or higher.
Incentive Fees: Common in income-focused funds, with a 12.5% incentive fee being a typical example, especially when income is relatively predictable.
Impact of Fees: These fees can significantly impact net returns.
Leverage: While funds may use leverage to offset some costs, it also magnifies losses.
Fee Pressure: While currently higher than public market funds, fee pressure is expected to emerge as these products gain more traction.

Other Risks Beyond Liquidity

Beyond liquidity risk, investors should be aware of other potential risks associated with semi-liquid funds.

Key Risks:

Leverage: Magnifies both gains and losses.
Forced Transactions: In a liquidity crunch, managers might be forced to sell illiquid assets at prices below their marked value on the balance sheet, as seen with the Blue Rock fund's situation.
Downward Spiral: A "stampede for the exits" can create a self-reinforcing downward price spiral, making it difficult for investors to exit at favorable terms.
Behavioral Risk: Predicting how other investors in the fund will behave during stress periods is a significant challenge.

Performance Considerations

The performance of semi-liquid funds is varied and depends on the underlying asset class and fund specifics.

Performance Observations:

Newness: Many of these funds are relatively new, making long-term performance analysis challenging.
Equity-Focused Funds: Have generally not kept pace with the S&P 500.
Credit-Focused Funds: Have performed well in delivering higher income.
Private Credit Advantage: The recent period has been favorable for private credit due to rising rates (benefiting floating-rate instruments) and low default rates.

Morningstar's Rating Methodology for Semi-Liquid Funds

Morningstar has begun rating semi-liquid funds, employing a methodology that differs slightly from its traditional mutual fund and ETF ratings.

Key Components of Morningstar's Rating:

Parent Company Rating (25%): This is given extra weight due to the increased trust required for illiquid and less transparent vehicles. A strong parent company is crucial for managing through volatility.
People Rating (25%): Assesses the quality and experience of the management team.
Process Rating (50%): Focuses on the fund's investment process, with a significant emphasis on liquidity management, which is considered a critical factor for success.

Standout and Concerning Funds

Based on Morningstar's ratings, certain funds have stood out, while others have raised concerns.

Standout Fund Example:

PIMCO Flexible Credit Income: This fund received a positive rating due to its decent track record (launched in 2017), allowing for observation through multiple market environments, its management of leverage and liquidity, and the skill of its manager, Dan Iverson. PIMCO is also viewed as a good steward of investor capital.

Common Traits of Funds with Lower Ratings:

Short Track Records: Lack of demonstrated performance through various market cycles makes it difficult to assess management capabilities.
Prohibitive Fees: High fees can significantly hinder potential returns.

Additional Investor Questions

Beyond liquidity, investment focus, leverage, and costs, investors should ask additional questions.

Crucial Additional Questions:

Rebalancing Plan: How will the fund be rebalanced? Liquidity is not just about withdrawals but also about the ability to reallocate capital. If public markets decline, a semi-liquid fund might grow as a percentage of the portfolio, but limited redemption windows could hinder the ability to "buy low, sell high."
Allocation Commitment: Investors may find themselves "married" to their initial allocation due to the difficulty of reducing it later.
Phased Entry: For investors new to alternatives, starting with a small allocation and gradually increasing it as comfort with redemption windows grows is a prudent approach.

Synthesis and Conclusion

Semi-liquid funds offer a compelling avenue for individual investors to access private market opportunities, particularly in areas like private credit. However, this access comes with inherent trade-offs, primarily concerning liquidity and higher costs. Investors must conduct thorough due diligence, understand the specific redemption terms, assess their personal liquidity needs, and critically evaluate the fund's underlying investments, management team, and fee structure. The recent performance of private credit has been strong, but past performance is not indicative of future results. Morningstar's rating methodology highlights the importance of a strong parent company and robust liquidity management. For those considering these investments, a cautious, phased approach and a clear understanding of rebalancing strategies are essential for navigating the complexities and potential risks.