Considerations for semi-liquid private debt 

The popularity and prevalence of all private market investments, but particularly private debt, has surged across institutional portfolios over recent years with investors seeking to benefit from the potential for higher returns and enhanced diversification.

More recently, shifting market dynamics have led to a change in the way many investors are accessing private debt. The term semi-liquid is commonly used to describe funds which are open ended but are mainly exposed to illiquid asset classes so offer only limited liquidity, typically up to 5% of fund assets per quarter. Most semi-liquid funds will have a cash and / or liquid asset buffer to facilitate liquidity management.

The demand for flexible structures largely originated from wealth managers servicing the private wealth channel, but has been further fuelled by some of the broader structural shifts taking place, including for example from defined benefit to defined contribution pension schemes, and the attendant move from long-term insurance guarantees to unit-linked contracts.

Relative to other private markets asset classes, private debt is comparatively well suited to investment through a semi-liquid structure. Private debt investments (i.e. loans) typically have a shorter lifecycle relative to private equity or infrastructure, and naturally pay out income, making it a more natural fit for a semi-liquid approach.

While semi-liquid funds can provide an effective route to accessing private debt for investors seeking the potential for some liquidity, we believe that these funds also offer other potential benefits to investors. Before investors select the right approach for their particular circumstances, there are a range of potential benefits and broader considerations to assess.

Semi-liquid fund structures may offer access to illiquid private markets assets for investors that are unable or unwilling to invest in closed ended funds with no liquidity. As well as the benefit of having the potential for some liquidity, these structures offer a range of other possible advantages.

One possible advantage compared with most closed ended funds is speed of deployment. Semi-liquid funds generally have monthly or quarterly subscriptions, and capital is often deployed almost immediately. This can potentially mitigate the opportunity cost that investors may pay by waiting for the best managers’ next fund raise and then waiting again for the manager to call capital which can take up to two to three years. By expediting capital deployment into underlying assets, investors have the potential to gain exposure quicker and therefore generate additional returns. Semi-liquid funds usually have a limited allocation to lower returning liquid assets, and this should be weighed against the opportunity cost of the slow deployment experienced with closed ended funds.

For investors that are willing to commit to an illiquid fund structure, the inability to rebalance assets can lead to deviation away from their target asset allocation. Semi-liquid funds offer the ability for investors with a long-time horizon to help ensure that they can manage their relative exposures more effectively, while also allowing for the compounding of capital by reinvesting income over longer periods of time.

There is an administrative burden and cost to holding traditional closed ended funds, for example to manage unpredictable capital calls and distributions, plus undertaking new diligence on each vintage. Semi-liquid funds are simpler for investors from an operational perspective as usually there is a single subscription payment, and potentially a single redemption payment. 

Despite these advantages, however, semi-liquid funds should not be treated as a panacea for liquidity. The semi-liquid label has the potential to be misleading if the underlying assets are illiquid and the funds provide only very limited liquidity. We therefore suggest that investors approach these funds in much the same way that they would a more illiquid allocation and we advocate the same guiding principles that we use for investing in private markets more broadly. We believe that a strong approach for private debt, whether it’s implemented using closed ended funds or semi-liquid funds, is to combine different managers and strategies to optimise for your desired level of return, diversification, liquidity, and ultimately for risk management purposes.

As always, we believe that investors should seek to access the best managers, through efficient structures, while negotiating the best fees possible. This typically means seeking to leverage scale and focusing on managers with demonstrable competitive advantages. It also means building a diversified portfolio by combining a range of strategies, from direct lending and speciality finance to structured credit, thereby minimising concentration risk. Liquidity must also be carefully examined and managed, whether that’s through a limited sleeve of cash and/or quickly realisable assets, a credit facility or income and loan maturities. The size of the liquidity sleeve creates a small drag on overall performance, so it’s important to find the right trade-off between liquidity and return.

Semi-liquid managers must provide regular valuation reports. Investors will be moving in and out of the portfolio at current prices, which makes it particularly important to pay attention to the valuation methodologies and frequencies employed by different asset managers. Whilst valuations and transparency are important within a traditional drawdown fund structure, at the end of the day investors are compensated in the main via resulting net cash flows driven by income and loan repayments. This contrasts with an open-ended semi-liquid fund structure where there is the potential for valuations to fluctuate over time, and importantly at the time where investors are subscribing to or redeeming from a fund.

Effectively implemented, semi-liquid funds can be an attractive way to access the private debt asset class, with greater flexibility and transparency. As always, any asset class must be viewed as part of an investor’s total portfolio, and their individual circumstances and needs will ultimately dictate their optimal allocation.

As the private debt investor base continues to grow, routes to accessing these assets through a wider array of structures will increase accordingly. Some investors will find the additional flexibility offered by a semi-liquid approach appealing, whereas some investors may elect to take a purer approach through a closed end drawdown format, which more definitively segregates illiquid and liquid asset classes. We believe semi-liquid funds can help deliver a range of potential benefits to investors, providing that investors approach them with a 360-degree perspective on the considerations and risks involved.