Demystifying Semiliquid Fund Fees

Semiliquid fund fees can be hard to grasp. Funds may charge incentive fees based on income or returns, pay borrowing costs for leverage, or hold other funds whose fees bubble up into their expense ratios.

Normalizing those features to make semiliquid funds’ fees comparable is already a challenge. The water muddies further because there’s no standard approach to estimating these fees in a fund’s prospectus expense ratio.

Indeed, different return or borrowing assumptions can create false impressions of a fund’s relative cost. My colleague, Jack Shannon, previously provided an example of two funds with identical fee structures whose prospectuses showed expense ratios roughly 1.5 percentage points apart. Predictably, the actual cost paid by investors in each fund ended up about the same.

There’s no way to easily compare semiliquid fund fees using prospectus expense ratios. That’s why Morningstar set out to create a new cost estimate that separates a fund’s fee structure from the fund manager’s own assumptions, replacing them with a standard set of return and borrowing-cost assumptions.

The resulting data points, Semiliquid Total Cost Estimate and Semiliquid Adjusted Cost Estimate, allow investors to make a reliable apples-to-apples comparison of fund fees when selecting a fund. Both data points are now live in Morningstar products. In the fund pages on Morningstar.com, such as the one for Pimco Flexible Credit Income, the data points are located in the overview header of the Performance tab; they are also in the screener tools on Morningstar.com.

Our cost estimates are intended to mimic the use cases of the prospectus net expense ratio and the prospectus adjusted expense ratio. The adjusted cost estimate backs out borrowing costs to make fees comparable between funds with varying leverage.

Below, we dig into the complexity of semiliquid fund fees and some examples of what’s behind our approach.

A Better Approach to Semiliquid Fund Fees

Morningstar’s approach to semiliquid fund fees can result in minor adjustments that better align peer groups. But the differences can also be substantial. About 10% of semiliquid funds’ expense ratios differ from cost estimates by over 1.5 percentage points.

Take nontraded business-development companies as an example: 18 of 24 nontraded BDCs use a fee structure that includes a 1.25% management fee and a 12.5% incentive fee when income exceeds 5% (which should be almost always). Yet the three “cheapest” nontraded BDCs by prospectus adjusted expense ratio assume no incentive fee, while the rest include them.

The institutional shares of Crescent Private Credit Income, Fidelity Private Credit, and AB Private Lending all saw their cost estimates increase by at least 50% after including incentive fees. The three cheapest share classes of nontraded BDCs according to Semiliquid Adjusted Cost Estimates—the institutional shares of Blackstone Private Credit, Oaktree Strategic Credit, and Apollo Debt Solutions—more closely align with their prospectus fees, which are transparent about the fact that investors are likely to pay incentive fees.

Standardizing cost estimates cuts both ways, too. Funds may include incentive fees based on relatively stringent expectations.

For example, ACAP Strategic’s 8.47% prospectus adjusted expense ratio includes an eye-watering 5.65% incentive fee that is not a reasonable long-term expectation for investors. The fund simply included the incentive fee it earned in its prior fiscal year, which was high because of strong performance (36% gross return for its A shares) and a hefty 20% going to the fund managers. Yet investors shouldn’t expect the fund to earn a 36% gross return each year; its A shares averaged 5% annualized gross returns over the past five fiscal years, including last year’s strong performance. Morningstar’s estimated 1.86% incentive fee (based on a 10% gross return assumption) should better reflect the long-term costs investors can expect from this fund.

Consistency, With an Asterisk

Semiliquid Adjusted Cost Estimates standardize semiliquid fund fees to make them more comparable, but they aren’t perfect. Acquired fund fees and expenses, or AFFEs, are the main challenge. A semiliquid fund that holds other funds reflects the ongoing costs of those holdings in the “acquired fund fees and expenses” line item. The issue is that different accounting rules apply for different structures.

Three scenarios paint the picture of why AFFE requirements create complexity for comparing semiliquid fund fees:

1. Owning a 1940 Act registered fund. AFFE reporting requires ’40-Act funds to disclose their full expense ratios, including borrowing costs. This inflates the expense ratio when comparing adjusted cost estimates because the underlying holdings aren’t adjusted, especially for highly leveraged investments like BDCs.
2. Owning a private fund. Private funds, such as a traditional drawdown private equity fund, are not required to include incentive fees in their parent fund’s AFFE calculations. Their long-term costs are understated in cost estimates and prospectus expense ratios.
3. Owning an operating entity. Operating companies and REITs are not funds, so they are excluded from AFFE calculations. A holding company can also bypass traditional fund rules while remaining a private pooled vehicle depending on its structure. A parent fund’s long-term costs are understated in cost estimates and prospectus expense ratios when compared with other pooled investments.

Semiliquid Cost Estimates successfully standardize semiliquid fund fees to the extent that regulations allow. But vigilance is still required; if a semiliquid fund fee sounds too good to be true, it probably is.