Why are institutional investors allocating to semi-liquid funds? 

Semi-liquid funds, by which we mean funds that invest in predominantly illiquid assets and offer limited liquidity, most commonly 5% of fund value per quarter, have been growing in prevalence, both in terms of number and assets under management. Many of the recent fund launches have been private debt funds, which we believe are more naturally suited to an open-ended fund structure than other illiquid asset classes. While semi-liquid funds were initially created so that asset managers could seek to tap into demand from private wealth for private markets, other institutional investors have caught onto the benefits and are increasingly allocating to these funds, in particular semi-liquid private debt funds.

This poses the question: why are institutional investors, such as defined benefit pension funds, that have a long investment horizon and the ability to accommodate illiquidity, investing in semi-liquid funds? While each asset owner has their own individual governance and investment needs, here are four of the most common reasons that we have observed so far:

With closed-ended funds, it can take many years to build up a private markets program to a desired target allocation. Even after a lengthy ramp-up period, it is hard to precisely reach and then maintain a target allocation. To do so, investors are required to predict capital calls and distributions years in advance, which can be lumpy and vary quite materially compared to forecasts, meaning capital calls and distributions that are slower or faster than expected may cause the allocation to deviate from the intended target. Moreover, the performance of more volatile listed assets held alongside private assets may also cause portfolios to become unbalanced, particularly in periods of market drawdown. 

With closed-ended funds, it can take time to adjust allocations as changing commitment levels may not have an immediate impact. With semi-liquid funds, it may be possible to rebalance a portfolio over a single quarter, subject to gating to any other liquidity constraints, as funds typically have quarterly or more frequent subscriptions and redemptions, potentially enabling investors to maintain their desired target allocation.^[1]

An investment in a semi-liquid fund is usually invested from the monthly or quarterly dealing day, unlike closed-ended funds where there may be a lengthy wait before capital starts being called, and it typically takes several years before the full allocation of capital that has been committed has been called. This means that while semi-liquid fund investors may potentially start earning a return from the day they subscribe to the funds, closed-ended funds can take many years before returns could start to accrue. As investors building up a closed-ended program typically experience a lengthy J-Curve, investing in semi-liquid funds may deliver a return in the short term. Closed-ended funds can potentially deliver a higher return over long periods but if, or when, the return received from a program of closed-ended funds overtakes semi-liquid funds depends on various factors, such as the relative return targets and the speed of deployment within closed-ended vehicles.

Building up a program of closed-ended funds requires investors to subscribe to new vintages each year so that distributions are redeployed. This means investors need to undertake lengthy investment and operational due diligence processes before approaching investment committees or boards for approval each time, prior to selecting funds. Subsequently, tax and legal due diligence are required before implementation, with the potential for significant side-letter negotiations. A portfolio of private debt funds built up over many years will typically also have frequent capital calls and distributions that need to be operationally managed. While this is all very doable, it does require resource. 

While sophisticated investors may have the in-house infrastructure to manage such a program, there are inherent costs and risks involved in this approach. Semi-liquid funds typically avoid some of this complexity given their evergreen structure, meaning capital can remain invested, potentially benefiting from compounding of returns. In addition, given they are perpetually invested, an investor may reduce the number of fund holdings required to achieve sufficient diversification.

While some institutional investors that have chosen to invest in semi-liquid funds may have a long-time horizon, and thus do not necessarily need short-term liquidity, the ‘option’ of liquidity may still be seen as a positive feature of these funds. For pension funds, even if a buy-out is not in the short-term plan, having semi-liquid funds rather than closed-ended funds may be helpful should such a scenario arise. Unexpected events may also result in an unforeseen liquidity requirement, for example following the UK government’s “mini budget” in 2022, when pension funds needed capital to cover their liability-matching derivatives exposures. 

The recent announcement that Yale University is considering the sale of a significant portion of its private markets portfolio on the secondaries market, which would typically be executed at a discount to NAV, shows that even the most entrenched and long-term investors may at times seek liquidity from their portfolio.²

Semi-liquid funds, originally launched to serve the private wealth segment, have attractive features that may be appealing to a broad base of other investors, even those who do not anticipate short-term liquidity requirements. All types of investors can benefit from the ability to rebalance their portfolio between listed and illiquid assets, simpler administration and reduced governance burden, the potential for higher returns in the short term, and a liquidity option that may help with any unexpected events. 

While we expect long-term investors may continue to allocate to closed-ended funds, some may choose to allocate part of their assets to semi-liquid funds to seek to benefit from these features, particularly as the number of these funds being offered expands.^[2]