Investment Insights

•

November 29, 2024

The Quiet Revolution in Private Markets

November 29, 2024

The Quiet Revolution in Private Markets

Investment Insights

The Quiet Revolution in Private Markets

November 29, 2024

Key Points

Innovative fund structures in private markets have opened the once closed door to alternatives investing to the intermediary and wealth management channels.
These structures, known as semi-liquid funds, offer a number of key advantages for wealth investors with features designed to meet their unique liquidity, risk and performance needs.
In our view, private credit is an asset class that exhibits essential liquidity, diversification and valuation features that are well suited to a semi-liquid fund structure.

Democratizing access to alternatives
A recent report projects that alternatives AUM will rise to $29.2 trillion by 2029, up 74% from 2016.¹ As alternative asset investing continues to see robust growth, the investor base is inevitably broadening out as fund providers innovate to meet a more diversified set of investor needs.

In particular, the wealth management segment is fast emerging as a key private markets growth area. McKinsey projects that private markets allocations will comprise 3-5% of U.S. wealth management assets by 2025 from 2% in 2020, a rise of $500 billion to $1.3 trillion in assets.² Investor requests for increased liquidity and accessibility has been a an increasingly important feature of the alternatives’ quiet but steady take-off in the wealth channel.

Asset managers are responding to these needs by developing new fund structures and adjusting strategies to help address their varied requirements. In short, they are “democratizing” access by taking a range of private markets asset classes that have historically been the preserve of institutional investors and making them available to a wider investor audience.

Often called semi-liquid funds, these innovative structures offer several advantages for professional and non-professional investors catered to in the wealth management channel.

There are also important liquidity and performance considerations to which investors should remain aware. In this paper, we walk through the main features of semi-liquid funds. We then highlight semi-liquid funds’ suitability for private credit, an increasingly in-demand private markets sector.

Investing on an ongoing basis
Traditional private market funds, known as drawdown or close ended funds, typically have a pre-defined marketing period after which the investment manager (“General Partner” or “GP”) gradually calls down investor (“Limited Partner” or “LP”) capital subscriptions, typically over four to six years. In contrast, semi-liquid funds are open ended and provide ongoing access, allowing asset owners to remain invested for as long as they choose. From the investor perspective, this is often seen as the democratization of alternatives, placing them closer to traditional investments in how they are transacted. To attract investors into these new structures, investment minimums have also been lowered by some regulators through the introduction of new types of investment vehicles.

DISPLAY 1

Calls and distributions: Semi-liquid vs. drawdown funds

Source: Morgan Stanley Investment Management. As of November 12, 2024. The statements above reflect the views and opinions of MSIM as of the date hereof and not as of any future date and will not be updated or supplemented. For illustrative purposes only and is not representative of any actual or anticipated transactions. Historical trends are not indicative of future results. All forecasts are subject to change and may not come to pass due to changes in market or economic conditions.

Beyond stop/start due diligence
Intermediaries and wealth managers spend a large part of their time performing due diligence on behalf of investors to put products “on platform.” When funds are closed-ended, the process typically requires them to perform due diligence on the fund manager and the strategy. Then, they repeat that process each time the manager comes to market.

For each closed-end fund, the allocator must engage their due diligence team in an episodic fashion and then, upon approval of the due diligence work, promote the offering within a typical short and constrained marketing window. Open-end semi-liquid solutions alleviate stop/start due diligence. Their structure allows the intermediary or allocator to underwrite upfront and then focus on monitoring and ongoing marketing rather than continuously reengaging a new process each time.

“On the shelf” product availability allows investors to gain exposure at the time of their choosing. In a way, the convenience is not unlike allocating to a series of funds over time, but in a much more efficient manner that grants investors greater choice in their given exposure and vintage diversification. Unlike closed-end funds, if conditions change, semi-liquid structures provide investors the flexibility to halt allocations as they see fit.

Operational simplification
From an operational standpoint, avoiding the demands of periodic capital calls appeals to intermediaries and end investors alike. In semi-liquid structures, capital is committed and called just once, after which time investors can opt to make additional subscriptions. For many investors, the ability to make a one-time commitment, as they would in traditional funds, is highly valued. Compare this to a typical private markets closed-end fund: Capital calls and investment occur over several years, obligating the investor to carefully manage capital that has been committed in order to meet future calls.

For intermediaries and wealth managers, semi-liquid funds are less resource intensive. The need for operational teams to monitor and communicate upcoming capital calls or past calls that an investor may have delayed or missed is far reduced in the semi-liquid format.

DISPLAY 2

Considerations

Investment Return
Traditional closed-end funds are designed for specific investment reasons. For example, by calling capital only when needed, fund managers try to maximize clients’ internal rate of return (IRR) and multiple of invested capital (MOIC) by investing in the best opportunities when they come to market. The arrangement gives investors optionality on their use of that cash in the period when their closed-end fund manager is not calling capital.

The upfront investment for semi-liquid funds may have different return implications. Responsibility for capital deployment passes to the fund manager, who must endeavor to act promptly to avoid “cash drag” on returns, i.e. the lower return of cash sitting in the portfolio diluting the overall return. But by trading off control of cash flow timings, the manager of the semi-liquid fund typically has to maintain a “liquidity sleeve,” consisting of cash and/or public market investments, to hold capital if it cannot immediately be matched with a private investment opportunity.

The untapped capital in the liquidity sleeve may affect the overall return, depending, of course, on how it performs in comparison to the private market targeted. Investors evaluating semi-liquid funds will have to consider this feature and decide if the illiquidity premium is acceptable and whether having some liquidity is justified.

Risk Profile
With upfront capital calls in semi-liquid funds, the investment manager must deploy the capital fully. As mentioned, managers unable to invest quickly into private markets may invest elsewhere, such as mainstream asset classes. Inevitably, such exposure could increase the correlation to traditional markets. Understanding how such exposure affects the risk profile warrants some consideration by investors.

Valuation
Confidence and accurately calculating valuations for both incoming and exiting investors is paramount in semi-liquid structures. For instance, issues could arise if investors exit at heightened valuations and this occurs at the expense of remaining investors. Likewise, investors coming in at undervalued entry points could disadvantage other fund participants. Valuation issues can, of course, be mitigated through appropriate valuation procedures. Investors should test the procedures through the due diligence process and select only those strategies that display a consistent ability to price investments in a fair manner for all investors.

Like semi-liquid structures, reliable valuation methods for closed-end funds are also key. However, the more synchronous nature of calling and distributing capital to all fund investors on a simultaneous basis reduces the complexity on pricing that is faced by semi-liquid funds.

Redemption Benefits
Investors will always find the ability to make redemptions at their own discretion to be an attractive feature. Semi-liquid structures facilitate choice in redemptions compared to less liquid conventional private market solutions. Specifically, semi-liquid funds feature an option that allows periodic redemptions, typically on a quarterly basis subject to fund level gates (a mechanism in place to restrict redemptions when over a set percentage). The redemption mechanism lets fund managers pay out cash in an orderly fashion, giving investors the option to adjust their exposure over time and to tap liquidity from a hitherto less liquid solution.

Other liquidity provision mechanisms include subscriptions replacing redemptions and, in some cases, credit lines; both, while helpful, should not be fully depended on.

Investors should assess the redemption options to determine what is most appropriate for their needs. They must also consider any potential trade-offs in their sought-after illiquidity premium and whether they believe they will receive a commensurate level of return and risk. Answers will vary for each semi-liquid strategy and individual investor appetite.

Other Investor Behavior
By introducing additional liquidity demands, manager behavior may change and influence the fund’s risk-and-return profile. In a semi-liquid structure, the manager may be under pressure to deploy cash quickly to avoid cash drag and in response lower underwriting standards. They may also need to satisfy redemptions by selling to meet investor orders. In contrast, more traditional structures grant managers the flexibility to deploy and liquidate as they see fit over time.

Consequently, the investment process is not as straightforward for the semi-liquid fund manager. They have to employ a disciplined approach to asset sales in order to avoid becoming a forced seller. Gating mechanisms, which allow managers to limit redemptions, do help with this. However, they may risk some client dissatisfaction if mishandled. Managers can also mitigate liquidity risks by having a diversified investor base.

DISPLAY 3

Key differences

Strategy Fit for Semi-liquid Funds
Bearing in mind these considerations, the key question centers on which private markets strategies are best suited to semi-liquid structures. Clearly, the most illiquid investments make little sense, as it would be impossible to realize the investments when needed and suggests a clear asset liability mismatch. In our opinion, strategies that are best suited to this structure should have some of the following characteristics:

Some form of scheduled consistent pay out over time
Known liquidity or term of investments
Contractual end to the investment or an end that is not subject to unknown catalysts
Plentiful availability of investible assets
Diversification opportunities
Lower susceptibility to specific vintage risk
Ability to value assets effectively and consistently using standardized metrics
Strategies with limited spread in returns between the conventional closed-end structure and the open-ended semi-liquid structure

Many of the above criteria match well with the characteristics of private credit. The asset class tends to be contractual in nature, with many of the investments paying regular coupons and self-liquidating when principal is paid back through refinancing or at the end of the loan term, thereby providing liquidity. As such, it is not surprising to see the large growth of semi-liquid solutions focused on the private credit space.

Launches of private credit investment vehicles have grown steadily in recent years, particularly over 2020 to 2023 (Display 4). The principal investment structures include BDCs, European Long-Term Investment Funds (ELTIF), interval funds and tender offers. Part II SICAV structures are also becoming recognized and available in Europe and Asia.

Private credit is a growing private markets segment with assets under management and committed dry power valued at roughly $1.7 trillion in the U.S. alone.³ Private credit is also an area where fund investing tends to be diversified in nature and where it is possible to apply consistent methods for valuation.

DISPLAY 4

Private credit funds proliferate to meet increasing investor demand

Source: Preqin, Morgan Stanley Investment Management. As of December 31, 2023.

Conclusion
The growth of semi-liquid funds is likely to continue and, as highlighted, there are many positives for investors seeking exposure to private markets through these vehicles. Importantly, there are a number of key differences when compared to traditional closed-end funds that merit investor consideration. Investors should also consider which asset classes are best suited to an open-ended structure and how an allocation could complement their overall investment strategy. In our opinion, private credit is an ideal asset class for semi-liquid vehicles, as it features several of the essential liquidity, diversification and valuation characteristics that grant these structures greater durability without sacrificing the benefits of a private markets exposure.

¹ Preqin. “Global alternatives markets on course to exceed 30$tn by 2030.” September 18, 2024.
² McKinsey. “US wealth management: A growth agenda for the coming decade.” February 16, 2022.
³ Morgan Stanley. Private Credit Tracker. As of July 29, 2024.Morgan Stanley. Private Credit Tracker. As of July 29, 2024.

Patrick Reid, CFA

Managing Director,

Private Markets Distribution

Related Insights

Alternatives

Importance of Operational Value Creation

30-Oct-2024

A successful approach to operational value creation is increasingly important today amid higher interest rates and inflation, lower levels of financial leverage, and uncertain macroeconomic growth.

Alternatives

Direct Lending Outlook

26-Sep-2024

Direct lending continues to offer compelling relative value compared to other asset classes and offers attractive diversification alternative to public fixed income. And when considered in the context of public markets, it has significant room to grow.

Media Appearance

Jeff Levin & Ashwin Krishnan on InsuranceAUM Podcast

06-Aug-2024

Listen to Head of Direct Lending Jeff Levin and Head of Opportunistic Credit Ashwin Krishnan discuss the future of private credit for insurance investors.

IMPORTANT NOTICE

The sole purpose of this material is to inform, and it in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. Investments mentioned may not be appropriate for all clients. Any product discussed herein may be purchased only after a client has carefully reviewed the offering memorandum and executed the subscription documents.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

The views and opinions and/or analysis expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively “the Firm”) and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors or the investment team. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific strategy or product the Firm offers. Future results may differ significantly depending on factors such as changes in securities or financial markets or general economic conditions.

This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.

This material is a general communication, which is not impartial, and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results.

The indexes are unmanaged and do not include any expenses, fees, or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold, or promoted by the applicable licensor and it shall not have any liability with respect thereto.

This material is not a product of Morgan Stanley’s Research Department and should not be regarded as a research material or a recommendation.

The Firm has not authorized financial intermediaries to use and to distribute this material unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this material is appropriate for any person to whom they provide this material in view of that person’s circumstances and purpose. The Firm shall not be liable for, and accepts no liability for, the use or misuse of this material by any such financial intermediary.

This material may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this material in another language, the English version shall prevail.

The whole or any part of this material may not be directly or indirectly reproduced, copied, modified, used to create a derivative work, performed, displayed, published, posted, licensed, framed, distributed, or transmitted or any of its contents disclosed to third parties without the Firm’s express written consent. This material may not be linked to unless such hyperlink is for personal and non-commercial use. All information contained herein is proprietary and is protected under copyright and other applicable law.

Eaton Vance is part of Morgan Stanley Investment Management. Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

DISTRIBUTION

This material is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

MSIM, the asset management division of Morgan Stanley (NYSE: MS), and its affiliates have arrangements in place to market each other’s products and services. Each MSIM affiliate is regulated as appropriate in the jurisdiction it operates. MSIM’s affiliates are: Eaton Vance Management (International) Limited, Eaton Vance Advisers International Ltd, Calvert Research and Management, Eaton Vance Management, Parametric Portfolio Associates LLC, and Atlanta Capital Management LLC.

This material has been issued by any one or more of the following entities:

EMEA:

This material is for Professional Clients/Accredited Investors only.

In the EU, MSIM and Eaton Vance materials are issued by MSIM Fund Management (Ireland) Limited (“FMIL”). FMIL is regulated by the Central Bank of Ireland and is incorporated in Ireland as a private company limited by shares with company registration number 616661 and has its registered address at 24-26 City Quay, Dublin 2, D02 NY 19, Ireland.

Outside the EU, MSIM materials are issued by Morgan Stanley Investment Management Limited (MSIM Ltd) is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.

In Switzerland, MSIM materials are issued by Morgan Stanley & Co. International plc, London (Zurich Branch) Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland.

Outside the US and EU, Eaton Vance materials are issued by Eaton Vance Management (International) Limited (“EVMI”) 125 Old Broad Street, London, EC2N 1AR, UK, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority.

Italy: MSIM FMIL (Milan Branch), (Sede Secondaria di Milano) Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy. The Netherlands: MSIM FMIL (Amsterdam Branch), Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. France: MSIM FMIL (Paris Branch), 61 rue de Monceau 75008 Paris, France. Spain: MSIM FMIL (Madrid Branch), Calle Serrano 55, 28006, Madrid, Spain. Germany: MSIM FMIL (Frankfurt Branch), Grosse Gallusstrasse 18, 60312 Frankfurt am Main, Germany (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Denmark: MSIM FMIL (Copenhagen Branch), Gorrissen Federspiel, Axel Towers, Axeltorv2, 1609 Copenhagen V, Denmark.

MIDDLE EAST

Dubai: MSIM Ltd (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). This document is distributed in the Dubai International Financial Centre by Morgan Stanley Investment Management Limited (Representative Office), an entity regulated by the Dubai Financial Services Authority (“DFSA”). It is intended for use by professional clients and market counterparties only. This document is not intended for distribution to retail clients, and retail clients should not act upon the information contained in this document.

This document relates to a financial product which is not subject to any form of regulation or approval by the DFSA. The DFSA has no responsibility for reviewing or verifying any documents in connection with this financial product. Accordingly, the DFSA has not approved this document or any other associated documents nor taken any steps to verify the information set out in this document and has no responsibility for it. The financial product to which this document relates may be illiquid and/or subject to restrictions on its resale or transfer. Prospective purchasers should conduct their own due diligence on the financial product. If you do not understand the contents of this document, you should consult an authorized financial adviser.

NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT

Latin America (Brazil, Chile Colombia, Mexico, Peru, and Uruguay)

This material is for use with an institutional investor or a qualified investor only. All information contained herein is confidential and is for the exclusive use and review of the intended addressee and may not be passed on to any third party. This material is provided for informational purposes only and does not constitute a public offering, solicitation, or recommendation to buy or sell for any product, service, security and/or strategy. A decision to invest should only be made after reading the strategy documentation and conducting in-depth and independent due diligence.

ASIA PACIFIC

Hong Kong: This material is disseminated by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this material have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this material shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This material is disseminated by Morgan Stanley Investment Management Company and may not be circulated or distributed, whether directly or indirectly, to persons in Singapore other than to (i) an accredited investor (ii) an expert investor or (iii) an institutional investor as defined in Section 4A of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); or (iv) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This publication has not been reviewed by the Monetary Authority of Singapore. Australia: This material is provided by Morgan Stanley Investment Management (Australia) Pty Ltd ABN 22122040037, AFSL No. 314182 and its affiliates and does not constitute an offer of interests. Morgan Stanley Investment Management (Australia) Pty Limited arranges for MSIM affiliates to provide financial services to Australian wholesale clients. Interests will only be offered in circumstances under which no disclosure is required under the Corporations Act 2001 (Cth) (the “Corporations Act”). Any offer of interests will not purport to be an offer of interests in circumstances under which disclosure is required under the Corporations Act and will only be made to persons who qualify as a “wholesale client” (as defined in the Corporations Act). This material will not be lodged with the Australian Securities and Investments Commission.

Japan:

For professional investors, this document is circulated or distributed for informational purposes only. For those who are not professional investors, this document is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”). This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions. All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.20% per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This document is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: The Japan Securities Dealers Association, the Investment Trusts Association, Japan, the Japan Investment Advisers Association, and the Type II Financial Instruments Firms Association.