Introducing Morningstar’s Semiliquid Fund Cost Estimates

Morningstar recently released two datapoints that help investors navigate semiliquid fund fee disclosures. The Semiliquid Total Cost Estimate and Semiliquid Adjusted Cost Estimate use standardized return and borrowing costs assumptions to enable investors to make better apples-to-apples fee comparisons when considering competing semiliquid funds.

Semiliquid funds have some discretion in how they report fees in prospectuses. Incentive fees present the biggest challenge, since they are not uniformly disclosed. 

Some funds may show zero incentive fees in their prospectus fee table despite charging a fee because they argue the incurrence of incentive fees is uncertain. However, funds almost always collect them in full, especially in private credit. 

Several funds have added incentive fee estimates to their prospectus fee tables since Morningstar published its research on the topic, but some holdouts remain. 

Even among the funds that disclose incentive fees, methods vary widely. Some, for example, may use the prior year’s realized incentive fee amount, while others may use an estimate based on an assumed return, and these assumptions can differ meaningfully. 

These different methods create issues for comparing fund fees. For example, incentive fees, by their nature, increase when the fund’s return increases. So, for funds that base their fee table on the previous year’s actual costs, stronger investment performance can lead to higher fees, but investors might still come out ahead because the higher fees are offset by higher net returns. 

Sorting on prospectus fees alone could thus lead to adverse selection where investors opt for the cheaper, but worst-performing, funds. 

Using an assumed return can cause difficulty as well. If the assumption turns out to be lower than what the fund actually earns, or the fund company’s marketed return expectations, it can make the fund look cheaper than it is. That creates an opportunity to deliberately downplay potential results to look cheaper.

Both the Semiliquid Total Cost Estimate and Semiliquid Adjusted Cost Estimate are based on the same return and borrowing cost assumptions that are applied consistently to all funds in the same Morningstar category. This method isolates the true differences in cost structure between funds rather than relying on non-uniform fund prospectus disclosures. 

Return assumptions are made for income, capital gains, and total returns, as incentive fees can be charged on income, capital gains, a combination of the two, or total returns. The return and borrowing assumptions vary by Morningstar category and are based on historical data intended to be directionally accurate over a full market cycle rather than predictive. 

Morningstar’s Manager Research team will periodically review assumptions and update them when appropriate. For example, equity-focused semiliquid funds assume a standard 10% annual return, all of which is considered capital gains. Private credit returns, on the other hand, are from income and based on a 5 percentage-point spread over the Secured Overnight Financing Rate. Similarly, borrowing costs are also based on spreads over SOFR and vary by category based on historical data. 

These gross return and borrowing cost assumptions flow through each individual fund’s unique fee structure to arrive at a total cost estimate that includes the cost of borrowing and an adjusted cost estimate that excludes borrowing costs. 

Below shows an example of how an investor can use this information to better understand fee structures. The two funds below are both direct lending funds, though the Fidelity fund is a business development company and the T. Rowe fund is an interval fund. 

Fidelity does not include incentive fees in its prospectus fee table while T. Rowe does. This makes Fidelity’s fund look much cheaper than T. Rowe’s if an investor only looked at fund prospectuses. However, after normalizing the fees, it’s clear Fidelity’s fund is more expensive if the same gross return assumption is applied.

Yet, fees are just one part of the story. Fidelity’s fund uses more leverage than T. Rowe’s, and on a net return basis, it comes out ahead thanks to its higher leverage.

T. Rowe’s lower interval fund leverage means it doesn't capture as much of the difference between the rate at which it borrows and the rate at which it lends as the Fidelity BDC.

This does not mean Fidelity’s BDC is destined to outperform T. Rowe’s interval fund or that leverage is just free upside. 

This simplified framework assumes typical positive long-run returns and does not account for volatile market periods in which leverage can amplify losses. Morningstar’s assumptions are intended to create a common point of comparison that highlights each fund’s fee structure and provides the tools to help investors set their own expectations and make informed investment decisions.

While this methodology brings consistency to incentive fee reporting, it leaves something out: acquired fund fees and expenses. These are the fees of underlying funds a parent fund owns. These fees are meant to reflect the ongoing costs of owning those underlying funds, but, in practice, semiliquid funds understate them by a meaningful margin in many cases. This is largely because semiliquid funds exclude the underlying funds’ incentive fees. 

In other cases, AFFE estimates are required to include borrowing costs and can create artificially high expense ratios, depending on their source of leverage. 

Semiliquid funds complicate the matter, though. Whether and how a parent fund includes the fees of its acquired funds depends on those underlying funds’ structures. A parent fund can roll up a registered fund’s whole operating cost ratio, including incentive fees and borrowing costs, into its reported levy. 

Meanwhile, parent funds rarely roll up underlying private fund incentive fees. And for funds structured as operating companies, such as some semiliquid private equity funds, parent funds roll up none of the fees since the underlying holding is technically not a fund. 

This means semiliquid funds that own underlying funds can look cheaper than they really are; many are effectively hiding the incentive fees they pay to underlying fund managers. They can also look costlier than they are. This is a difficult issue that likely will take new regulatory guidance on AFFE reporting to fix.