In plain sight: How asset managers can obscure the real cost of semiliquid funds

Semiliquid private credit funds have become something of a staple in model portfolios pitched to affluent US households, promising institutional-style access, steady income and a smoother ride than public markets.

But the way many such funds charge and disclose incentive fees can leave advisors and their clients with an incomplete picture of what they actually cost, according to a new report by Morningstar.

As the research report argues, incentive fee structures in semiliquid funds are more pervasive than prospectus tables suggest, particularly in private credit. On top of already hefty management fees, the analysis concluded many funds charge performance fees that have little to do with manager skill.

Some managers may also play coy with their incentive fees in disclosures to investors, claiming they can't calculate those costs with certainty. But Jack Shannon, principal, equity strategies at Morningstar is pushing back against that idea.

“In practice and in reality, we know that’s not the case,” Shannon, who authored Morningstar's report, told InvestmentNews. “You’re getting [the incentive fee] all the time, no matter what.”

Incentive fees: Performance bonuses or participation prizes?

The prospectuses for many unlisted business development companies and other semiliquid credit funds don't include incentive fees from the main fee table, as the manager claims it “cannot predict” whether it could clear its pre-set performance hurdle.

But according to Shannon, that logic breaks down when one looks at how these funds actually generate income. Private credit portfolios typically lend at several percentage points over a base rate such as the Secured Overnight Financing Rate and layer on significant leverage. With standard structures that use a 5% hurdle, he said managers effectively start with the odds stacked in their favor.

"Unless you’re [a] bad underwriter, you’re going to always clear it,” he said.

In his modeling, a typical unlisted BDC using around 40% leverage does not need base rates to be meaningfully above zero to earn its full incentive fee; as rates move higher, collecting the maximum performance fee becomes close to a given. The upshot is that incentive fees in many semiliquid credit funds act less like a reward for outperformance and more like a second layer of recurring compensation.

Read more: Spiffed up BDCs, REITs, are pricy, lean on leverage: Morningstar

Management fees in private credit semiliquid funds often run in the range of 1.25% to 1.5%. But by getting easy buckets on the yields they market, Shannon argues many managers get to layer income-based incentive charges on top, which can roughly double the effective cost for investors across a range of share classes.

With a base interest rate of zero and assuming the maximum leverage ratio of 33.3% allowed by law for interval funds, his analysis determined that such funds would be close to collecting their full incentive fees. When base interest rates are 2% or higher, those easy layups turn into slam dunks, as managers would be virtually guaranteed to clear their hurdles no matter the leverage amount.

“What is the ‘incentive’ here?” Shannon said in the report. “Simply not being bad at one’s job doesn’t seem like that high a standard to earn a bonus.”

Blue Owl vs. Blackstone

Advisors may not see the full fee picture from the prospectus alone. Of the roughly two dozen unlisted BDCs he reviewed, Shannon found two-thirds left incentive fees out of their fee tables, even though they all shared very similar structures and all collected those fees in practice.

One section of the report highlighted Blue Owl Credit Income and Blackstone Private Credit, two large unlisted BDCs with nearly identical fee structures. Those two managers have recently come under pressure from investors, with Blackstone facing a torrent of redemption requests in one of its BDCs and Blue Owl forced to sell assets to fulfill payout demands for several of its BDCs.

Based only on the prospectus expense ratios adjusted for borrowing costs, Shannon said Blue Owl looks cheaper because it does not build incentive fees into that headline number, while Blackstone does. Yet in their most recent financials, both funds ended up with nearly the same all-in costs once incentive fees were included. That kind of gap, he said, is exactly the sort of “hidden in plain sight” issue that can trip up even the most diligent advisors.

“I read the prospectus. I see there’s no incentive fee in the fee table,” he said. “Now there’s going to be a footnote that says we charge it, but [that won't register] to the everyday person.”

Is private credit stress about credit risk or liquidity promises?

For critics, the growing cracks in private credit carry more than a whiff of risk, including potential fraud, lax underwriting, and broader economic challenges weighing on certain areas of direct lending. But for Shannon, the takeaway from examples such as Blue Owl should be around how such strategies are sold, and whether investors really understood the kind of bets they're making on the potential for liquidity.

“The Blue Owl lesson, to me, is how are these firms actually selling this to people?” he said. “Are [they] being upfront about the liquidity?”

While many products are branded as semiliquid with regular quarterly distributions, managers also have the discretion to shut off redemptions if flows turn. If advised investors don't realize that going in, Shannon argues, it counts as "a failure of the asset manager or the advisor, or maybe both." 

That's not to say semiliquid private funds as a whole are a bad investment. For RIAs and broker-dealers recommending them as portfolio diversifiers, Shannon sees the research as call for more rigorous due diligence on both cost and structure. On the fee side, he encourages advisors to look beyond the prospectus table, especially when it comes to funds-of-funds or vehicles that own BDCs and other registered products.

“Everything is high cost in this space,” he said. “It might look relatively reasonable, but it rarely is.”