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

Revamped alternative investments such as nontraded or illiquid real estate investment trusts and business development companies are enjoying boom times in sales by all indications. According to a new report by Morningstar, assets in funds that offer limited liquidity and exposure to private assets rose close to $350 billion in net assets at the end of 2024, up from $215 billion just two years earlier. 

The surge in sales of alternative investments such as BDCs and REITs, which are not traded daily and offer restricted liquidity to investors, seems inevitable. Over the past decade, investment managers that in the past have focused on institutional investors like pension funds have turned to selling to wealthy retail investors via financial advisors. Those money managers include Blackstone and KKR. 

Before those managers entered the market, such illiquid investments like nontraded REITs and BDCs before 2015 were typically sold with even higher fees, and financial advisors and brokers pocketed commissions of 7% and the broker-dealer and manager often kept another 1% each.

Financial advisors are also interested in such products because their intention is to deliver a return that is not correlated to the broad stock market, an appealing pitch to accredited investors with at least $1 million to invest.

But, according to the Morningstar report, titled “The State of Semiliquid Funds: Credit is King,” such funds are still expensive, rely on leverage or borrowing to goose returns, and are not sold by financial advisors to investors, who will not fund them on the three largest investment platforms for retail investors: Charles Schwab, Vanguard and Fidelity.

“Semiliquid funds are making private markets more accessible but are much pricier than public market funds,” according to the Morningstar report, which was written by Jason Kephart, senior principal. “Fees for semiliquid funds can be 2 to 3 times higher than open-end funds when incentive fees are included.”

Fund managers charge incentive fees based on the fund’s performance. A 20% incentive fee is often charged by hedge fund managers.

“Incentive fees tied to income often include hurdle rates, but full-catch-up provisions make the hurdles more symbolic than beneficial to shareholders,” according to the report.

Private credit funds overtook real estate and infrastructure as the largest semiliquid broad asset class in 2024, with nontraded BDCs the most popular in that asset class.

Credit semiliquid funds held $188 billion in net assets at the end of the year, up from $75 billion at the end of 2022. Nontraded BDCs typically offer higher distributions to investors because of higher limits on borrowing, or leverage.

“Semiliquid funds generally have more complex fee structures than mutual funds or exchange-traded funds,” according to Morningstar. First, they usually employ leverage, which is the use of debt or debtlike instruments to increase the fund’s asset base. That leverage comes with borrowing costs.”

“Additionally, semiliquid funds often charge incentive fees, which can be material and sometimes rival - or even exceed - the management fee in terms of magnitude,” according to the report. “Finally, some funds have substantial ‘acquired fund fees,’ which are fees paid to underlying funds held in the portfolio.”