On this episode of The Long View, I chatted with Morningstar’s Brian Moriarty and Jack Shannon. Moriarty is a principal, fixed-income strategies, and Shannon is a principal, equity strategies, for Morningstar. We talked about private market funds, their risks and rewards, and due diligence. Mousetraps and wolves also entered the conversation.
Listen to the Full Episode
Here are a few excerpts from my conversation with Shannon and Moriarty, whose report on semiliquid funds published last week.
Semiliquid Fund Fees Are High and Not Always Straightforward
Ben Johnson: Curious, Jack, what you’re looking at with respect to fees in [the semiliquid fund] space, which always have rightly earned primacy in a lot of our analysis, and what’s there from a data perspective, what isn’t there, what sort of forensics you’re doing, and what investors just need to be aware of.
Jack Shannon: Let’s just start with these are very expensive products. So if you think about these relative to mutual funds and ETFs, you’re looking at paying multiples more just on the management fee. Now the management fee is just one piece of what these funds charge usually. Now some of them do have pretty simplified structures, and we applaud those that do. However, most of them have pretty complex structures, and so they’ll have a management fee, though a lot of them will layer on an incentive fee.
Now this incentive fee can come in a lot of different forms. On the credit side, it’s usually, we’re going to take a percentage of profits above a hurdle rate, except this hurdle rate is generally very easy to clear, and we have a full catch-up clause in there, which allows us to basically take our full incentive fee across all the return.
And so for investors, if you’re thinking about buying one of these, you have a management fee, you have an incentive fee. The incentive fee is essentially a doubling of the management fee. Well, it’s another management fee. You combine the two, you get a doubling of the management fee. And then you have a lot of other associated costs in these that you don’t have in mutual funds. Like we talked about leverage earlier. Leverage comes at a cost.
Now we at Morningstar tend to back out the leverage cost when we’re looking at expense ratios. I think if an everyday investor pulled up a fact sheet or a prospectus, they would see that debt cost in there. We back it out. We think it’s just part of the strategy they’re implementing and, provided they’re actually earning a return above their cost of debt, it should work out. But I think one of the most important parts is that, sometimes, if you’re looking at a prospectus, sometimes the fees aren’t actually all disclosed there.
So on the incentive fee piece, if you look at some of these unlisted BDCs, some of them will not include the incentive fee in their prospectus fee table. So they’ll have the management fee, they’ll have a line item for the incentive fee, but it’ll be dashed out, and it’ll say something along the lines of, “Because the incentive fee is effectively a conditional fee, we cannot predict the future, and therefore we cannot say that this fee’s going to actually be charged.” Now they’re being very coy there. They’re going to collect this fee pretty much every time unless rates go to zero and unless their leverage goes to zero, which neither … Well, maybe rates might go to zero, but they’re going to run these things with leverage kind of no matter what. So what that creates, though, is, if you’re looking at two funds with identical fee structures, their prospectus fee ratios might actually show two different fee numbers at the end result.
And so what we’re doing at Morningstar is we’re creating a fee methodology in which we’re standardizing all this. So we’re just taking the raw fee structures, so the management fee, the incentive fee, all the different, the hurdle rates, the borrowing costs, all this, we’re just flowing through the exact same gross return assumption. So, say, everybody makes 10% gross on their assets, what flows through to the end investor? And we think through that, investors will actually be able to see what truly is cheap versus expensive and gets away from this sort of selective disclosure issues. And on top of that, you can also see if a manager is charging more than another, that’s a higher hurdle, fee hurdle that they’re going to want to clear. And so it allows an investor also to say how much more risk does this fund need to take in order to match this fund, especially in credit where it’s a more 1-to-1 ratio in terms of risk than maybe on the equity side.
So we’ve got some products coming out. They’re not in Direct yet, but they are coming soon.
A Scenario Where a Fund Won’t Collect an Incentive Fee? It’s Rare
Johnson: What you’re describing, Jack, sounds to me like effectively a more apples-to-apples means of comparing the total cost of ownership effectively of some of these products inclusive of, as you’ve done research on some incentive fees that oftentimes look maybe more like participation trophies than they are actually properly incentive fees.
Shannon: Yes. We put some research out that actually tried to break down what kind of scenarios it would take for them not to earn an incentive fee. And it’s just a fringe case. So we’ve been talking about the semiliquid funds. These same sort of portfolios have existed already in listed versions. So you have BDCs that trade, those existed during 2021 zero-rate environments. And so you can go back and say, “Huh, let’s see, when interest rates were zero, were these funds still collecting their full incentive fee?” And it was, “Well, yes, they were.” And so for an investor, the default assumption should just be, “I’m paying that full incentive fee.”
Medalist Ratings for Semiliquid Funds
Johnson: When I see that a particular semiliquid fund earns a Morningstar Medalist Rating of Gold, Silver, Bronze, Neutral, or Negative, how should I interpret that? What is the context that that’s being set in, and ultimately, how is that actionable to the end investor?
Brian Moriarty: The Medalist Rating is intended to help investors identify the semiliquid funds that we think will be able to outperform a public market equivalence, and that depends on the category that the fund is operating in, of course. So the idea is just that something with a Silver or a Bronze or a Gold—there aren’t many of them though, and maybe we can unpack that—we would expect to outperform the equivalent ETF, index, mutual fund, etc. And that’s important because early on in this process, especially in ’23, ’24, last year, we saw a lot of these asset managers, a lot of these products were being sold as access, right? Gain access to private credit, or gain access to private equity, because now there are more private equity companies than there are public, and you’re missing out on diversification, etc. Gaining access was a major selling point. But I think I would argue that access should not be the end of this.
The investor is giving up liquidity in their own portfolio when they are investing in one of these products. And so they should expect some return, some excess return, in exchange for giving up that liquidity. And when we’ve looked at these funds, not all of them have been able to exceed that hurdle. Not all of them, we think, will do so in the future, and that can come down to cost or investment team or the firm, but in a lot of cases, these are not necessarily as compelling besides the access angle, than maybe some investors expected them to be.
“There can be investment merit in the idea of owning a private asset, but it has to be at the right price, with the right manager, with the right fund structure and liquidity provisions to ensure that investors are getting something out of the deal.”
Brian Moriarty
Johnson: Which, to your earlier point, Brian … was why it is fairly rare among the universe of these funds that have been rated by the team to date to find any positively rated or Medalist funds.
Moriarty: That’s right. And part of that has to do, to be fair to them, part of that has to do with how young so many of these funds are. And that’s not to say that we can’t get comfortable with the investment team or understand their process, but the number of observations, the amount of data we have to confidently make an argument, make a decision, is just more limited relative to the public world. And when you factor in harder-to-access data on their holdings, less transparency, higher fees, investment cultures at the parent level that are maybe not as conducive to investor outcomes in some cases as traditional public firms—I’m painting with a broad brush here, but you see my point—when you start to add a lot of these factors together, there can be investment merit in the idea of owning a private asset, but it has to be at the right price, with the right manager, with the right fund structure and liquidity provisions to ensure that investors are getting something out of the deal.
Valentina Djeljosevic contributed to this article.