Morningstar’s Manager Research team has cast its gaze on a newer class of funds that aims to widen investors’ access to private markets. We discuss the process the team plies in doing its due diligence on these funds, their prospective risks and rewards, and the overarching objective of the team’s research—sending clear and actionable signals to investors.
Today’s guests are Morningstar’s Brian Moriarty and Jack Shannon. Brian is a principal, fixed-income strategies, for Morningstar. Before assuming his current role in 2015, Brian was a client solutions consultant for Morningstar Office, a practice and portfolio management system for independent financial advisors. Before joining Morningstar in 2013, he was a research assistant for DePaul University’s religious studies department. Brian holds a bachelor’s degree in political science from Michigan State University and a bachelor’s degree in Islamic world studies from DePaul University.
Jack Shannon is a principal, equity strategies, for Morningstar. He focuses on actively managed equity strategies and is the lead analyst for MFS and Artisan Partners, among other firms. Before joining Morningstar in 2020, Jack worked in commercial banking and was a consultant providing subject-matter expertise on complex financial litigation. Jack holds a bachelor’s degree in economics and history from James Madison University. He also holds a master’s of business administration in investments and corporate finance from the University of Notre Dame’s Mendoza College of Business.
Morningstar’s Guide to Public/Private Investing
Private Equity Funds Step Into the Spotlight
Private Credit Pricing: Are Prosecutors Opening Up Pandora’s Box?
If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com.
Follow Christine Benz (@christine_benz) and Ben Johnson (@MstarBenJohnson) on X, and Christine Benz, Amy Arnott, and Ben Johnson on LinkedIn. Visit Morningstar.com for new research and insights from Christine, Ben, and Amy. Subscribe to Christine’s weekly newsletter, Improving Your Finances.
If you want more Morningstar podcasts, check out The Morning Filter and Investing Insights.
(Please stay tuned for important disclosure information at the conclusion of this episode.)
Ben Johnson: Welcome to The Long View. I’m Ben Johnson, head of client solutions with Morningstar.
Today’s guests are Morningstar’s Brian Moriarty and Jack Shannon. Brian is a principal, fixed-income strategies, for Morningstar. Before assuming his current role in 2015, Brian was a client solutions consultant for Morningstar Office, a practice and portfolio management system for independent financial advisors. Before joining Morningstar in 2013, he was a research assistant for DePaul University’s religious studies department. Brian holds a bachelor’s degree in political science from Michigan State University and a bachelor’s degree in Islamic world studies from DePaul University.
Jack Shannon is a principal, equity strategies, for Morningstar. He focuses on actively managed equity strategies and is the lead analyst for MFS and Artisan Partners, among other firms. Before joining Morningstar in 2020, Jack worked in commercial banking and was a consultant providing subject-matter expertise on complex financial litigation. Jack holds a bachelor’s degree in economics and history from James Madison University. He also holds a master’s of business administration in investments and corporate finance from the University of Notre Dame’s Mendoza College of Business.
Brian, Jack, welcome to The Long View.
Jack Shannon: Thank you.
Brian Moriarty: Happy to be here.
Johnson: I want to start off our conversation at the very highest level. I think there are any number of our listeners that are unfamiliar or uninitiated with just the concept of private markets. So let’s begin at the very most basic level.
Brian, I’ll ask you to help us understand what are we talking about when we’re talking about private markets and investment opportunities in these markets, and why are we talking about them? Why has this become such a popular topic for conversation in 2026?
Moriarty: Sure. Private markets are really anything that takes place outside of the public markets, which is sort of a strange way to start, but it’s important because it means for private equity that these are equities that are not traded. They’re not listed on an exchange anywhere. Their information is not publicly available the same way a listed company is when they file their quarterly and annual filings. And in private credit, it’s credit lending that takes place outside of the normal banking system, the normal lending systems, which means information is a little bit harder to access.
So in both cases, data is much more difficult to come by, when it comes to these companies, these investments that we’re talking about. And this market has really grown astronomically over the last couple of years, especially since covid, roughly. And during that growth, or as a part of that growth, these asset managers, these private capital asset managers, started offering product to advisors, wealth, retail channel, through vehicles like interval funds, tender offer funds, and unlisted BDCs.
Collectively, we would call them semiliquid funds. And so as these asset managers started selling into these markets, this is where Morningstar steps in and really tries to explain what these are and educate the investors so that they can make informed decisions when they’re starting to allocate money to these products.
Johnson: Brian, one of the keywords you hit on there is “access.” I think, for so long, many of these investment opportunities had previously been inaccessible for all but some of the largest investors, be it institutions or ultra-high-net-worth individuals. Jack, I’m wondering if you can help us unpack some of these newer, in some cases newer, and some cases maybe just newly popular access vehicles. What Brian described as semiliquid funds, oftentimes you’ll hear terms like “evergreen funds” or “perpetual capital vehicles” getting tossed around. Why are these increasingly the preferred means of tapping into private markets for advisors and even some individual investors?
Shannon: Yeah, there’s a great name debate going on in the industry over what they should be called. We’ve settled on “semiliquid.” It sort of denotes these are less liquid than your mutual funds and ETFs that everyday people are used to.
So typically these kinds of products, there’s a bunch of different kind of structures. Brian outlined some of them, interval funds, tender offer funds, unlisted BDCs, unlisted REITs, 3(c)(7) funds, these funds that are exempt from registration. All of them provide some sort of periodic liquidity. Most of them are a quarterly basis. Some of them might do monthly. Some of them might do semiannually, depending on the asset class. But in a lot of ways, I think private asset managers, when they’re going down to more retail audiences, are looking to provide a somewhat familiar experience. And so when you think about interval funds, they kind of look like mutual funds.
I think the big thing we saw on private credit, and maybe that we’re very conscious of, at least in terms of how the industry is selling these things, is again, if they’re labeled semiliquid, how are they being really sold to retail investors or to advisors? I think the industry is starting to realize that perhaps they maybe oversold the liquidity piece, and when you see 12%, 15%, 20% of investors try to exit all in one quarter, that probably is a sign that the liquidity piece wasn’t necessarily articulated as well as it should have. Anyway, these are just vehicles that I think bear resemblance to the kinds of things that everyday advisors and everyday investors are already used to. And so I think it’s just the easiest way to get it in the hands of everyday people.
Johnson: I want to circle back to some of these all-important considerations and conversations around liquidity in a bit, but first I’d like to dig in on your team’s process. I mean, the core work product of Morningstar’s manager research team is going through all of this data, having conversations with these managers, understanding these products, and sending a signal in the form of a rating to end investors as to what’s worthy of their hard-earned investment dollar and what might not be worthy of their hard-earned investment dollar.
So I’d like to kind of follow the paces of your traditional process and have you highlight some similarities and differences when you go through what are commonly referred to within the industry as the P’s of the due diligence process, and starting, maybe, aptly, Brian, with Process. Your process is a central piece of your due diligence process of the Morningstar Medalist Rating, which you’ve begun to assign to some of these semiliquid funds.
What are the similarities and differences with respect to what you’re looking for when you’re vetting processes as plied by traditional managers of, say, a public credit portfolio versus what you’re looking at when you’re analyzing a private credit portfolio that’s wrapped in, say, a nontraded BDC?
Moriarty: The similarities are in areas like the execution of the investment process. Is it repeatable? Is it durable? Can the investment team execute this process through a variety of market cycles and provide excess return above and beyond what investors can get elsewhere? That’s just the normal ins and outs of underwriting and investment process, no matter the wrapper, no matter the strategy. The differences come around to largely the liquidity issue because these managers, many of them, especially when they’re coming from the private capital side, they’re used to managing drawdown funds which don’t need to worry about managing liquidity. It’s never an issue. They return capital when they have it and when they can. But in a lot of these semiliquid vehicles, the liquidity is mandated quarterly, annually, monthly, and they need to know, they need to be able to manage those periodic redemption windows. And so the liquidity of the portfolio is of highest importance in our opinion.
And we’ve seen people manage it not well. There has been some examples, for example, the Bluerock real estate interval fund converted to a listed CEF because seemingly they couldn’t meet the redemptions that investors were expecting them to provide. For us, that’s sort of a worst-case scenario. And so we’re really paying attention to the liquidity of the underlying assets relative to the liquidity of the wrapper, like what liquidity they’re providing to the investors, what have the asset managers promised to their investors, and based on the portfolio, will they be able to deliver that liquidity? That’s really the core of underwriting these products from a process perspective.
Johnson: And Brian, what are some of the trade-offs that are involved in managing more toward maintaining a certain liquidity profile vis-a-vis what one might have to do managing a traditional public portfolio in an open-ended fund, or where many of these especially specialist private markets or alternative managers are coming from is the circumstance you described before, which was liquidity on a particular schedule or maybe a lesser expectation of liquidity in a traditional drawdown fund?
Moriarty: They really need to consider, and I think the investor needs to make this consideration as well, you’re going to need to own some level of liquid assets, whether that’s cash or broadly syndicated loans in the case of a direct lending portfolio—assets that you can trade more easily than a private credit loan. Now, that requires, we would assume, giving up some level of return in exchange for that liquidity. And so there’s this fine line between needing to carry enough liquidity to meet the investor redemptions, what you expect, versus giving up the return. And I think this is not a small trade-off that asset managers are making because the managers that own less liquidity are going to have higher returns most of the time. And so they’re going to attract most of the capital from investors, and then you’re going to end up with a situation, or you risk ending up in a situation, where the largest, most successful funds are also the ones least likely or least able to end up having the ability to meet their investors’ redemptions when those investor redemptions come around, and they will.
Jack has done some research on this, showing that most public mutual funds, ETFs have at least some extreme or focused redemption activity, where they might have 15%, 20%, 30% outflows in a given year, which is at or above most of these semiliquid funds’ liquidity levels. And so to think that they won’t have that experience, I think, is a little bit of potential hubris on their part.
Johnson: Jack, I’m curious how that translates to what you’re doing, as your specialty is more so within the realm of equities. And Brian alluded to interesting work that you and team have done, which underscores that any sort of liquidity event, a big call on liquidity from the fund on investors’ part, if the experience with traditional funds, open-ended funds and ETFs, is any guide, that it should be an expectation that that will happen and not necessarily an exception.
How does all of this manifest with respect to what you’re looking at, what you might be concerned about within the context of, say, a venture capital or private equity-focused portfolio, or not even arguably, actually, liquidity and liquidity events are far fewer and further between than they might be in private credit markets?
Shannon: Yeah. It’s definitely—in equity, when we’re rating these equity funds, we’re probably a lot more focused on that liquidity sleeve than maybe someone like Brian or someone on our credit team who’s looking at the credit funds, because the credit stuff is naturally spinning off liquidity, right? Loans are prepaying, they’re repaying, you’re getting interest, you’re generating liquidity from the underlying assets. Whereas if you go to the equity side—venture, we know is very lumpy, right? When the company actually IPOs, who knows, like people have been sitting on SpaceX SPCX for 10 years, that’s a long time you might have to sit on an investment before you actually get any cash in the door. On the traditional private equity, the buyout type stuff, a lot of these are structured as fund to funds. So you’ll have a manager who just goes out and buys all these interests in underlying private funds, and then those underlying funds are, when they realize an exit, they’ll kick the cash back to their investors.
But if you look at the numbers, it’s not that much cash, right? They’re getting, if you look historically, maybe 12% to 15% of their NAV returned every year via these underlying fund distributions. If you have 12% to 15% coming back every year but you’re obligated to pay out 20% potentially, there’s a gap there that needs to get funded. And so a lot of them will have these lines of credit they’ll make available to themselves. A lot of them say it’s sort of a last-ditch effort. We’ll only pull on it when we need to, but it’s top of mind, right? Because, to Brian’s point, we’ve done a lot of research on this. We know that outflows come for everybody. And so, when you look at which funds could be most exposed to outflows, it’s those funds that are not generating that organic liquidity. And on venture, there’s really a concern. On private equity,
it’s also a concern. Credit, it gets less of a massive concern as in some of the others. So definitely a liquidity spectrum, and the equity side is definitely more on the risky side.
Johnson: Brian, I want to circle back to something you mentioned in passing before just with respect to some of the trade-offs when measuring or managing, rather, liquidity in these portfolios. The biggest one, really, being very clear and oftentimes direct trade-off between the level of liquidity and returns, that there’s at least conceptually almost an illiquidity premium. So extra returns you get for investing in less-liquid stuff. The other increment of returns that certainly is notable in some private credit products comes from oftentimes a degree of leverage. I’m wondering where leverage sits in your analysis.
Does it reside in the P that is process, and how do you view managers use of leverage in these products?
Moriarty: That’s a great question. We’ve done some preliminary research that, at least in some instances, some funds, not all, in some of them it seems to look like that leverage accounts for effectively all of the excess return of these products over what’s available to an investor in the public markets, an ETF or mutual fund. There are some instances where there seems to be some illiquidity premium or alpha, but in other cases, depending on the time period, leverage accounts for all of the excess return.
And that’s a very interesting dynamic because there is this instance of this situation where the BDCs, for example, unlisted BDCs can lever themselves to a greater degree than an interval fund, which is limited to the same leverage, statutory leverage limits as a listed closed-end fund. And so BDCs can have more leverage, therefore, all else equal, they should outperform an interval fund with the same portfolio but a lower leverage level.
And then you wonder, I ask myself the question is—set aside the illiquidity premium, everything else, is this just potentially a better mousetrap for leveraged returns than a mutual fund or an ETF that can have daily liquidity? Because the issue with leverage is not the upside, it’s the downside. When you have a couple of down days, the leverage exacerbates that terribly, and then investors want to pull their money, and it creates this spiral, this death spiral of a fund. That is, to a certain extent, limited in these products because the limited redemptions mean, or at least potentially mean, that that death spiral can get cut off before it becomes a death spiral and instead it’s just a couple of, a quarter or a month of negative returns and outflows.
And so there’s this interesting dynamic where, like I said, all else equal, it’s just a better mousetrap for leverage. That doesn’t mean it’s a good process. That doesn’t mean it’s a good investment, and it doesn’t mean that investors should allocate to it just because they can access leverage.
At the same time, we’ve seen a lot of strategies, a lot of these funds, use leverage not just as a return amplifier, but also as a way to manage their redemptions, like Jack mentioned earlier, where you look at the liquidity waterfall—that these funds often call it—and it will list six, eight, 10, 12 sources of liquidity that they can use to help meet redemptions, but when you actually unpack them, often more than a few of them are just forms of leverage. And so when you’re adding leverage to manage liquidity, and then you’re leveraging to manage returns, it’s just a leveraged hodgepodge at the end of the day, not always, but in some cases.
Johnson: Jack, I want to move to another process-related—at least in my book, and please correct me if it doesn’t rightly reside under the process P—but a topic that comes up oftentimes in the context of all private market portfolios, but I think most notably in the case of portfolios that are investing in venture capital and/or private equity is valuation.
These are, by definition, as we covered at the onset, markets where there’s just less transparency. There’s not regular pricing because these entities aren’t publicly listed stocks. What are some of the things that you’re looking at when you try to understand exactly who and how different positions in these portfolios are being marked?
Shannon: Yeah. Valuation is a huge piece for us on the leverage topic. The reason why leverage works in these also is because there’s infrequent valuation changes, and so you don’t have that downside that Brian mentioned. Once you put leverage on a traded asset, we have volatility decay pop up everywhere. We see it with all the leveraged ETFs that are out there. And so to really maximize a leveraged portfolio, you need to keep the valuation changes very muted, but it’s a topic that we spend a lot of time on. I would say that the approaches vary by firm. Some take very market-based approaches where they’ll say, “Hey, we own, whatever, 20% of our book is software. We just saw software sell off often in the public market. We’re going to beta-adjust our software book, bring it down a little bit.” Now, none of them really market truly to market because a lot of these are sold as diversifiers, meaning lower volatility.
And so if you wanted them to have a pure market beta, any sort of vol[atility] benefit that they’re attempting to get would get washed away, and so it’d be a lot harder to sell these things. So they have very little incentive to like truly mark to market. There are a lot of weird nuances that pop up because of this, though, right? Let’s go back to the private equity world, where they’re buying funds, right, where it’s a fund of funds. A lot of them buy these funds from an LP, from a private equity investor, at a discount to what the fund is worth. And then they put it in their fund, and they market back up to the NAV that the private equity firm said that that portfolio was worth, and that creates these one-day gains in these secondaries funds that creates sort of phantom returns.
You cannot possibly get a phenomenon like that in the public markets where effectively investor flows create returns. If investors are looking at a fund’s performance, if something looks like it’s just blowing everything out of the water, a lot of that might be some valuation gaming going on underneath the hood. I don’t think we have a … When we’re evaluating these funds, I don’t think we say this is exactly the valuation methodology we think you should implement, but we want to see a valuation methodology that makes sense, is rooted in market reality, right? Because if you own a private software business, it is exposed to the same software risks as all the public stocks that have sold off. It has the same AI hangman hanging over its shoulder right now. We want to see some of that, but we also acknowledge that there’s plenty of ways of skin a cat, right?
It’s not like doing a DCF versus a multiple versus a beta adjustment is better than the other, but we do want to see consistent application of it.
Johnson: I’m curious, Jack, when you’re doing those forensics, what are some of the signs that you’re looking for or that you could point others to look toward of—I think your term was—“phantom returns,” right, where there might be some degree of apparent return that isn’t necessarily an actual return. It’s more of like an accounting maneuver versus a cash flow maneuver, if you will.
Shannon: We look at it through their filings, so we can see how much of their gain is unrealized versus realized. And so if your whole gain is unrealized, that could be potentially great. If you have a big, let’s say, you have a one-stock private portfolio, and it’s SpaceX, and you have this big paper gain because you bought it 10 years ago. We know it’s good IPO. We feel like that’s probably—who knows what it will actually IPO at, we’re really close, but like kind of a real return. When you get into some of the stuff that is a lot smaller, a lot less owned, where it’s fund positions and not individual companies, that’s where it’s really a game of faith, right? Do you trust this manager that they’re not keeping these valuations high because they have an incentive to keep them high. They’re earning fees on the asset base.
They don’t want to cut their valuations down if they don’t need to and then deprive themselves of their own fee money. So you can look through the filings, you can look at the unrealized portion, and if it’s a big portion, I think we just would discount that, just to say, who knows how real they really are? Depending on the asset mix, it could be more real than another, but we like to see realized returns. And the problem is these are all very young funds for the most part, especially on the equity side. So what does a realized return look like through a full cycle? We don’t have a great view of.
Johnson: We haven’t lived through a full cycle yet.
Shannon: Correct.
Johnson: That’s a good point. Brian, I’m curious how this comes to life. Certainly all form of private credit have been in the headlines recently. What are you looking at just with respect to valuation? I thought it was interesting: DoubleLine’s Jeff Gundlach was on the Bloomberg Odd Lots podcast recently and remarked that there are only two marks in private credit markets, 100 and zero, and certainly we’ve seen evidence that the marks are right until they’re not.
How do you try to get ahead of areas where what might be valued fully on paper isn’t necessarily worth par or a hundred in reality, or would be on the open market, anyway.
Moriarty: That’s a great question, and it’s not easy to do. So you sort of have to build a mosaic to understand a portfolio and look at things like the net interest coverage, the PIK exposure, is PIK rising or not, sector exposure …
Johnson: “Payment in kind,” right, Brian?
Moriarty: Thank you. Yes.
Johnson: OK. So payment in kind, if you could just spend a brief moment explaining that for the uninitiated, and by the “uninitiated,” I mean me.
Moriarty: Happy to. “Payment in kind” means that a loan, instead of paying cash interest, which a loan would normally pay, all or some of its interest instead comes in the form of additional debt. And so if I am a borrower, I’m a company, and Ben, you made a loan to me, you asked for 10% interest payments, and I go to you, and I say, “Hey, I don’t have 10%. I can’t pay that in cash, but instead I could give you all of it in additional debt and grow my loan balance, or I can give you maybe half in cash and half in additional debt, or some combination thereof.” And this has been around for a long time. It’s not unique to the private credit market of the last five years. It used to exist more frequently in the historical public high-yield market, but most of those issuers migrated into the public credit market.
So it’s not new, but it’s gotten a lot of attention because it’s become more common. And one of the reasons, which you could argue, this is what’s called “good PIK”—I’m making air quotes with my fingers—is when a big company, let’s say Meta META or Oracle ORCL or somebody, comes to the private credit market and says, “I would like you to help me finance the construction of a data center. However, this data center won’t generate any cash flow for the next three years, and it’s a 10-year loan. So for the first three years of the loan, we’re going to do PIK because I want to tie the cash flow on this loan to the cash flow that’s being generated by the data center. So I anticipate it’ll be cash flow positive in three years. We PIK for three years and then after that we switch to cash payments on my loan.”
That’s what’s called good PIK because you’re sort of matching the cash flow of the asset with the liability. Bad PIK is when a company, I go back to you, Ben, and I say, “Hey, I don’t have any cash. My business is in the toilet. I don’t know what to do.” And you say, “Well, you know what, just use PIK instead of cash, and we’ll try to figure a way out of this mess and maybe we’ll find somebody to buy you or sell you off in pieces or whatever.”
Now either way, you can argue good or bad. Either way, PIK is income that isn’t actually income, which means, as the investor in a fund, I have not received that income. You have to generate it from somewhere else. I’m still taxed on it. And so the trend of PIK in these products, the amount of PIK as a percentage of the income they’re generating, is one risk flag, and then how many “PIK-able” assets there are in the portfolio is also a risk flag.
It’s not always one-to-one. There could be plenty of PIK-able assets in the fund that are actually from very high-quality borrowers, and we don’t expect it to be an issue. So it’s not a perfect red flag, but it is A flag, and combined with things like net interest coverage, quality, nonaccruals, which is the private credit term, essentially, for defaults or borrowers going through trouble, you build the mosaic of all of those pieces, and then you try to understand what the risks are in the portfolio, and then you can wonder, “OK, this seems like it’s at risk for valuation gaming” or for evaluation risk, we’ll call it that, or jump to default risk, essentially the zero—the 100 to zero that you mentioned earlier—you can sort of intuit or learn to intuit which portfolios are at more or less risk of that, but it’s very difficult to get to like a number that way.
Johnson: Brian, in this scenario, I’m curious how you try to, for your purposes and how investors, by extension, might, reconcile traditional notions and measures of risks, something just as simple as portfolio standard deviation, like exactly how squiggly is this line, and then when you see what’s happening in the case of many of these private credit, private equity funds to maybe grossly oversimplify it, the line gets a lot less squiggly.
How do you reconcile those two? What things should investors be aware or wary of by potentially maybe overrelying on more conventional measures of risk?
Moriarty: Unfortunately, the two markets don’t really speak the same language, public and private. And I’ve experienced this firsthand over the last 18 months or so covering these managers and these funds. There is a definite learning curve for both sides, and I think that’s still going on, and it’s made it really hard. I think one of the issues, just to zoom out a little bit, is that sometimes I think the private capital managers think they’re being very transparent, but the language that they’re speaking is not the same language as public markets, which has created all of these misunderstandings, whether intentional or not. And I think both participants in both markets need to find some common language, and that’s, hopefully, what Morningstar has been trying to do—to bridge that language barrier. Because it’s real. To your point on standard deviation, that’s a reasonably useful metric in public markets, but it’s not at all in private markets, or to a much lesser degree.
But we’ve seen some private capital managers start putting standard deviation or Sharpe ratio on their marketing materials when those are just so not useful to understand the actual risks in a portfolio. All it does, those metrics just measure volatility, but if there’s no volatility or very limited volatility in the portfolio, then why bother? Show me other metrics, show me nonaccruals, show me defaults, show me interest coverage, etc. But getting them to do that and trying to find ways that they can put their risks in terms that public market participants understand, and then vice versa, has been quite difficult. And I think, from our perspective, understanding these funds and helping investors understand them is to take everything with a little bit of a grain of salt because a lot of these numbers can be massaged or are sort of misleading depending on the time period that they’re selecting.
We’ve seen all sorts of tricks, right? They pick a certain time period. They’re cherry-picking dates. They’re using data that doesn’t really apply. They’re using the wrong index. Public managers used to do this a lot more, too, and we’re seeing the same activity from the private side. And so trying to clear the air and, like I said, bridge the language barrier has been a lot of our time the last couple of years.
Johnson: We’ve spent a lot of time, I think, mining what is a very rich vein for conversation here around the P that is process. I want to switch gears and move towards the next P, being people.
And Jack, curious to hear what your approach is when you’re sitting across the table from some of these teams that are managing these portfolios. What are the commonalities with what you might dig in on or ask managers of traditional public equity portfolios, and what are some of the nuances that you’re trying to unpack when you’re sitting across a different team that’s managing, say, a venture or private equity portfolio?
Shannon: I’d say the biggest difference is, at least on the public side, we’re kind of used to a pretty standard model of one PM or maybe two PMs and then a team of analysts. And the analysts are usually broken up by sectors, and the analysts come up with stock ideas, and the PM says yes or no and puts it in the portfolio or doesn’t put it in the portfolio. Obviously, there’s a few exceptions to that, but that’s the standard operating model in the public side.
On the private side, it is also kind of standardized. It’s not nearly the same, I guess, singular decision-maker, right? It’s more of a committee-based approach that you see. And then they also have, they have big teams of analysts, too. And so what’s interesting on the private side is some of them might break them up by sector, where you have your healthcare specialists, you have your tech specialists, and all that, but a lot of it is an investment banking model because a lot of these people came out of investment banking, and so it’s kind of a deal team, right?
They have three or four people who are going to run the deal, so to speak, and they’re the experts on that one deal that they’re looking at, and they kind of own it end to end, and then it goes to a committee who ultimately approves it. There’s just some operating differences in how things are done, but we like to see a few common things, right? We like to see people who eat their own cooking, for instance. If you’re a manager in this fund, how much of the fund do you personally own? We want to see that you believe in yourself and your own team. We like to see stable teams. We think that if you’re going to run any investment strategy, you need at least … I mean, some churn is good, right? You need to get rid of poor performers, but to really execute something well, having people coming constantly in and out of the door kind of hampers that.
And so there’s some of those things that we look for on the public side, certainly apply to the private side. Experience—have they run private equity funds before? But more importantly, what’s your experience doing these semiliquid funds? To Brian’s earlier point, this is not the same as running a drawdown fund. You need to know the liquidity piece, and you need to know it really well. You need to care about it a lot. And so we dig into that, and we’ve talked about process stuff, but talking to the managers and just getting a sense of how intellectually honest they are about this world. Are they happy to share a Sharpe ratio? I think it’s perfectly normal. That would, to me, would be sort of a sign of what is maybe not the most intellectually honest person out there. There’s just some stuff like that, some nuances that we put in, but for the most part, it’s looking at a lot of the same sort of basic fundamentals of like, is it team stable?
Are they constantly executing the same thing? Yadda, yadda, yadda.
Johnson: You hit on, I think, a very important concept there, Jack, that Brian, I’d like to parlay into a segue into our next P, and that’s this concept of the teams almost being deal teams because, in many instances, these portfolios are not allocating to, say, things that are already out there, for lack of a better way of putting it. We’re not deciding that we want to invest in Apple AAPL stock and buying Apple stock on the stock exchange. We’re like looking to invest in maybe an Apple equivalent wholesale, taking full ownership of Apple, maybe even putting ourselves in a position where we might take the keys from the current leadership team and run Apple ourselves, etc.
How do these unique considerations, Brian, manifest in our assessment of the parent firm and its capabilities? And if we look at the private credit space, for example, that like loan origination, like we’re not looking at bonds that are already out there and trying to understand whether they’re priced attractively, like we are looking for people to actually lend money to.
Moriarty: There’s this analogy of the two wolves, right? There’s two wolves inside of you, and which one do you feed? And this is how I’ve started to think about some of these firms where one wolf is the deal team and the other wolf is the team that’s managing the semiliquid fund, let’s call it the investment team or the perpetual team. And both of these teams typically exist at all of these firms, but to a greater degree in one direction or the other. These firms have fed one wolf greater than the other, and historically the deal team is the one that gets fed, and now the investment team is the one that’s being fed, although not at the same rate across the industry.
And I think that’s important to understand these firms because if the deal team is the bigger, hungrier wolf, I think that can have an impact on the culture of the firm and how they think about managing these products and managing investor expectations, etc. Because if all they think about is the next deal, then the firm culture is rooted in the next deal rather than managing the deal that we made for the benefit of our current investors, then obviously that can flow through to the rest of the firm and how they manage existing products.
Now, all of them do have an operations team, a maintenance team. They don’t do the deal and then forget about it, obviously, but it’s a cultural question of what is important to the firm. And conversely, if they’re feeding the investment team wolf more frequently, we can see that in things like how robust are their portfolio management systems, risk management systems, trading systems. They start to look more like a traditional asset manager that operates in the public markets. And in those instances, sometimes the differences can be very stark in terms of the infrastructure that they’ve built around the investment team, as well as the prominence of the investment team within the organization.
Are they pari passu with the deal team when it comes to vetting ideas, sitting on committees, etc., or are they downstream of the deal team and just have to work with whatever they’re getting? Both of those models exist in all the sort of various combinations you can imagine, and they have very big implications to the culture of the firm, and I think ultimately the outcomes that investors are experiencing.
Johnson: That’s such an important and interesting point to me, Brian. I mean, the commonalities, right, just with respect to how you and your team have always looked at parent, and I think culture is probably the word that stands out to me the most there. And importantly, just alignment with the end investor, the end client and the end investment outcome, but now this introduction of this two wolves concept, which doesn’t really necessarily exist in more traditional asset managers and investment settings, very important point. I think the other thing, and to save maybe the best and certainly what we’ve identified as one of the most important piece just in our due diligence rubric for last, price, which I think in many ways points back to some of the things that we already covered with respect to people, process, and certainly parent and culture.
Curious, Jack, what you’re looking at with respect to fees in this 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.
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.
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.”
Johnson: Brian, I want to turn to you to bring us down the home stretch here, having gone through the paces of all of the P’s that are ultimately an input into the Morningstar Medalist Ratings that the teams are assigning to some of these semiliquid funds, help us understand what is the signal that’s being sent, and what context is it being sent in? 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?
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.
Johnson: Which, to your earlier point, Brian, which you put down, 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.
Johnson: Brian, Jack, I think that puts a wonderful bow on what’s been a tremendous conversation. Really appreciate your time and the work that you’re doing to help investors better understand this space that’s every bit as complex and costly as just about any within the current investment landscape. So thank you for your time today.
Moriarty: Thank you, Ben.
Shannon: Thank you.
Johnson: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts. You can follow me social media at @MstarBenJohnson on X or at Ben Johnson, CFA on LinkedIn.
George Castady is our engineer for the podcast. Jessica Bebel produces the show notes each week, and Jennifer Gierat copy edits our transcripts.
Finally, we’d love to get your feedback. Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at thelongview@morningstar.com.
Until next time, thanks for joining us.
(This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording and are subject to change without notice. The views and opinions of guests on this program are not necessarily those of Morningstar Inc and its affiliates, which together we refer to as Morningstar. Morningstar is not affiliated with guests or their business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy or the completeness of the data presented herein. This recording is for informational purposes only, and the information, data, analysis, or opinion it includes, or their use should not be considered investment or tax advice, and therefore is not an offer to buy or sell a security. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from or related to the information, data, analysis, or opinions or their use. Past performance is not a guarantee of future results.
All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives, and risk profile before making any investment decision. Please consult a tax and/or financial professional for advice specific to your individual circumstances. Morningstar Investment Management, LLC is a registered investment advisor and subsidiary of Morningstar, Inc. The Morningstar name and logo are registered marks of Morningstar Inc.)