Over the past several years, a number of semi-liquid credit fund structures have emerged that could be both attractive and appropriate for investors in or nearing retirement. This is because semi-liquid credit offers a compelling combination of liquidity and income. As an example of the increased adoption of semi-liquid credit funds among RIAs, one widely used fund in the RIA realm has already grown to nearly $6 billion in assets from just a few hundred million dollars at its inception in June 2019.
Semi-liquid credit can generally be classified as an alternative asset. Specifically, it refers to funds that offer an illiquidity premium, with the potential for full liquidity in normal market environments. An investor’s money is 100% invested on day one, versus a traditional capital call structure where that might happen over several years. Besides being so efficient, semi-liquid structures offer immediate income generation.
Furthermore, investors who want to raise their hand for liquidity can generally do so on a quarterly basis. This is not a stock that can be sold to access liquidity today, but it’s also not a truly illiquid private fund where there’s no mechanism to do so.
Semi-liquid credit funds typically offer a 5% fund-level liquidity option per quarter, meaning up to 20% of the fund can be redeemed in a calendar year. So if investors with a combined investment amount exceeding 5% of the fund all decide they want to cash out, there’s a risk those requests won’t be immediately accommodated. In this scenario, the investors would gain liquidity on a pro rata basis and become part of a queuing mechanism to access the rest of their money. But under normal market conditions, it’s likely that investors would be able to gain full liquidity when they seek it.
Underlying Assets
For the semi-liquid credit structures that our RIA firm recommends to clients, the underlying assets are generally loans originated to private equity-backed, upper-middle-market private companies. One primary benefit for investors is that these loans are floating rate, a key consideration in a potentially rising-rate environment.
The funds we recommend are highly diversified with typically more than 100 underlying loans, translating to position sizes of less than 1%. The loans often offer investors higher interest rates because they theoretically are riskier than those made to large-cap companies that can access traditional debt markets.
In addition, the liquidity-capping mechanism means there’s generally no forced selling of these loans. That’s an important differentiator compared to a mutual fund, which would have to sell its positions to create the (immediate) needed liquidity if many investors decide simultaneously to cash out. This could happen at a very inopportune time and lock in losses for investors who are still in the fund or potentially seeking to exit.
Emerging Appeal
Although semi-liquid credit structures have existed for a decade or more, the real growth of private debt wrapped within them is a more recent phenomenon. This is due partly to the fact that investors have now been able to see how these assets perform under different market conditions. Additionally, semi-liquid structures tend to be advantageous in the current interest rate environment.
The loans being originated are generally for five years, and many of them become refinanced sooner than the stated tenor because they are able to access cheaper financing if they hit or exceed their operating plans. So in a well-diversified portfolio, there’s often a much higher velocity of liquidity coming off the loans. This, in turn, makes them more suitable for the semi-liquid structure.
In the current inflationary environment, we expect the Federal Reserve to continue to raise interest rates in order to cool the economy and fight inflation. Since bond prices and yields are inversely correlated, and public credit is generally comprised of fixed-rate securities, increasing rates means decreasing returns.
With semi-liquid credit funds, the loans are based on a floating rate above a spread, such as LIBOR or SOFR. When interest rates increase, the yields on these products also increase because they’re spread-based. That spread is fixed, but as the base rate goes up, so does the overall yield.
Appropriate Allocations
Investors who are interested in semi-liquid credit assets should ensure these are part of a broadly diversified portfolio. Another key consideration is whether to view semi-liquid credit as part of an equity or bond allocation. Some people think of private markets as “higher risk” and therefore consider any such investments should be coming from an equity allocation. Others see how semi-liquid credit is yield-oriented and consider them part of a bond allocation.
Ideally, investors would only make this decision in consultation with a financial advisor because it impacts the overall risk/return characteristics of a portfolio. Overall risk would likely be reduced if semi-liquid credit assets are being pulled from equities. But if they are treated as a pure substitute for fixed income, it would likely add risk.
Many semi-liquid credit structures are also IRA-friendly, which can benefit investors due to the potential advantages of holding income-oriented assets in a tax-free account. Semi-liquid funds are not as tax efficient when held in a taxable account because the distributions are classified as ordinary income and taxed more punitively.
In summary, if you believe interest rates are going to rise, then public fixed income assets will be adversely affected. If you think rates will stay low, it means minimal rates of return and virtually no income. In either scenario, semi-liquid options could be attractive as an income alternative, as long as investors are comfortable with the specific risks, tradeoffs and related considerations.
Dan Ziznewski, CFA, is a director at Homrich Berg, a $10 billion Atlanta-based RIA, where he oversees sourcing, due diligence and manager selection for various private alternative asset classes, including private equity (buyout, growth equity and venture capital), private debt, natural resources and other opportunistic strategies.
