Private Credit SemiLiquid Funds May Be Quietly Understating Their Fees

What's New

Morningstar's The Many Problems of Incentive Fees in Semiliquid Funds reveals that two-thirds of unlisted business development companies omit incentive fees from their prospectuses entirely, exploiting regulatory gray areas to appear cheaper than they are while collecting those same fees with near certainty.

Why It Matters

As billions flow into semiliquid private credit and private equity funds marketed to retail investors, the inability to make true apples-to-apples fee comparisons means investors are systematically underestimating their all-in costs. With total expense ratios regularly exceeding 3% annually, the illiquidity premium these managers promise must be exceptional just to break even with lower-cost alternatives.

Big Picture Drivers

• Disclosure asymmetry: Funds cite "fee unpredictability" to omit incentive fees from prospectuses, yet those same fees surface in a parent fund's acquired fund fees and expenses, creating an inconsistency that disadvantages investors trying to compare costs.

• Hurdle rates: The industry-standard 5% hurdle originated during near-zero rate environments and was never updated, meaning it no longer functions as a meaningful screen for manager skill.

• Structural predictability: At typical BDC leverage levels of 45%, funds need base interest rates to be barely above zero to collect full incentive fees. Characterizing this outcome as unpredictable understates how certain these fees are in practice.

• Unrealized gains: Semiliquid private equity funds frequently charge incentive fees on valuation markups before any cash is generated, with no mechanism to claw back fees if those markups later reverse.

• Regulatory risk: Proposed Congressional legislation would exempt BDCs from acquired fund fee reporting requirements, removing one of the few remaining disclosure checkpoints available to investors.

By The Numbers

• 12.5% — Standard income-based incentive fee charged by most unlisted BDCs above the 5% hurdle rate

• ~20% — Reduction in ending investor wealth from a 10% quarterly profit incentive fee applied to a hypothetical S&P 500 position over 20 years

• 45% — Typical BDC leverage level at which full incentive fee collection is effectively guaranteed even at near-zero interest rates

• 3 out of ~300 — Surviving large-blend Morningstar Category funds that outperformed the S&P 500 by 3% or more over the trailing 10 years, the performance threshold private funds must clear to justify their fee loads

• 80 bps — Apparent prospectus expense ratio gap between Blue Owl Credit Income and Bain Capital Private Credit that nearly closes entirely under normalized return assumptions

Key Trends to Watch

• Fee normalization is gaining institutional momentum, with Morningstar developing a methodology that applies a common gross return assumption across fund structures, which could meaningfully reshape how investors evaluate and compare semiliquid fund costs.

• Legislative developments in Congress could exempt BDCs from acquired fund fee disclosure requirements, a change critics argue would push fund-of-fund managers toward BDCs purely for the accounting advantage, not for investor benefit.

• Floating hurdle rates are emerging as a credible reform concept that would tie the performance threshold to base interest rates, ensuring managers are rewarded for risk-adjusted underwriting rather than for macroeconomic conditions outside their control.

• Interval fund leverage is approaching BDC-level fee certainty, with funds at the legal maximum of 33.3% leverage close to guaranteeing full incentive fee collection at any nonzero interest rate environment, making the broader semiliquid universe problematic on fee alignment.

The Wrap The semiliquid fund market has produced a fee architecture where incentive fees reflect leverage and interest rate conditions more than investment skill. Until regulators require uniform disclosure or reform the hurdle rate structure, prospectus expense ratios should be treated as a floor rather than a ceiling. Investors evaluating these products would be well served to request normalized fee illustrations under multiple return scenarios before committing capital.

Read Full Report Morningstar: The Many Problems of Incentive Fees in Semiliquid Funds