Redemption gates in private credit: stress signal or protective feature?

TO INVESTORS, particularly in Asia, investments that offer three things are compelling: a strong sponsor, high returns and liquidity.

Until recently, private credit appeared to possess those attributes in spades, with a historical return of 8 to 10 per cent, and managed by blue-chip firms. Evergreen funds which typically allow quarterly redemptions are a solution to a traditionally illiquid asset class.

But now the surge in redemptions from private credit funds, downward revaluations of portfolio assets, and gating appear to threaten the viability of the asset class, especially for the private wealth market.

Private credit will survive this. It is, after all, offering a financing lifeline for companies that are unable to tap bank financing. For high-net-worth (HNW) individuals and families, the proposition is unchanged: It helps to diversify portfolios and offers a risk premium well above government bonds.

The evergreen structure will also continue to thrive – but its trajectory going forward may slow, and that’s not a bad thing.

Going forward, fund managers who are intent on a slice of the private wealth market should raise their game in terms of transparency not just on underlying assets but also on liquidity management strategies.

Managing expectations

On their part, intermediaries, mostly wealth managers and private bankers, will need to tread carefully in terms of how they market such funds and manage client expectations.

Redemption limits on evergreen funds – typically capped at 5 per cent quarterly and prorated should requests exceed the cap – are usually well disclosed. But clients who agree to this when times are smooth may suddenly find their backs against the wall in a bear market, especially if they tap margin financing for the investment itself or elsewhere in their portfolios.

The Monetary Authority of Singapore (MAS) is surely watching events closely. It sought feedback last year on opening up access to private-market funds for retail (non-accredited) investors. In the context of the current developments in private credit, two aspects are worth noting in MAS’ consultation paper.

One is the proposal that private credit funds’ underlying assets should be “senior, backed by collateral such as income-generating real assets, subject to protective covenants or issued to profitable companies of a certain size and gearing limit”. This suggests an effort to nudge offerors towards higher-quality debt.

Second is that for direct unlisted funds, redemptions should be allowed at least annually. Today, the most common liquidity window is quarterly, leaving funds to manage the inherent mismatch between the tenors of the underlying debt, which can be three years or longer, and how much in cash equivalents to set aside for redemptions.

All that sounds straightforward, but as market crises unfold, the drip-feed of bad news can dent investor confidence. As of today, large-bracket firms have imposed gates in specific funds, including Blackstone and BlackRock.

The latest is Apollo Global Management, whose Apollo Debt Solutions business development company was hit with 11.2 per cent in redemption requests. It is capping withdrawals at 5 per cent.

Gating sounds alarming to investors. But as Lighthouse Canton wrote in its newsletter, gating is a structural feature, “not a malfunction or sign of underling stress, but the structure operating exactly as documented”.

“Once gates became public, further redemption requests followed from investors seeking to exit before queues lengthened, a classic run dynamic. The situation is ... a product-design constraint meeting investor expectations misalignment, not an asset-quality crisis.

“Notably 80 per cent of private credit committed capital globally is held in closed ended rather than semi-liquid structures. The gating events are concentrated in a specific minority segment of the market, though the headline risk they generate is disproportionate to their structural significance.”

Gates protect investors’ interests

The truth is gating is poorly understood. To understand why gates are needed, we need to step back to appreciate the trade-off investors implicitly agree to when they invest in a private-market evergreen fund.

Private-market investments dangle the allure of higher potential returns with relatively lower correlations to public markets. Closed-ended funds lock investors in for long periods. For this, they seek to be compensated with higher returns or a so-called illiquidity premium.

Evergreen or semi-liquid funds are a compromise. By limiting redemptions to a specified window – quarterly or longer – returns are expected to be lower than a closed-ended fund.

This is a trade-off that investors are apparently happy to make. Pitchbook expects growth of the evergreen market to be robust, from US$2.7 trillion at end-2024 to US$4.4 trillion by 2029.

Gating isn’t a denial of investors’ rights, but a mechanism to protect the interests of the fund itself and other investors who wish to remain invested. Without a gate, managers would be forced to sell underlying assets.

In a downturn, it may mean selling at a loss, which penalises everyone in a fund. This predicament is worse in illiquid private assets where bespoke debt arrangements may be hard to price.

Prorating the redemptions when requests exceed a cap ensures no investor is favoured over another. Unmet requests are rolled over to the next redemption window.

Brian Moriarty, a principal (fixed-income strategies) for Morningstar, explains it well in a column. Redemption surges in open-ended mutual funds are not uncommon, he wrote.

According to Morningstar research, roughly 80 per cent of mutual funds and exchange-traded funds that have existed for at least five years have experienced 20 per cent in redemptions within a 12-month period.

“The risk to semi-liquid funds is not if they can meet elevated redemptions for one or two quarters, but if they can meet them for a year or more.”

Private credit funds, Moriarty wrote, are seeing the “first true outflow cycle”. “It’s up to asset managers to prove they can handle that pressure… The experience also puts investors to the test, especially those who bought these funds expecting all the upside and none of the downside.”

So how do investors get a handle on the risks lurking in a private credit fund? Sanket Sinha, managing director and chief executive officer for global asset management, Lighthouse Canton, said limited partners need to look beyond country or geographic risk.

“The real assessment has to be done at the borrower level. That is where quality, security and the path to repayment are either present or not.”

In the absence of data on a fund’s underlying borrowers, investors may scrutinise how the asset manager fund screens and chooses investments.

Sinha said: “When you invest in a particular fund, you have to see the kind of deals and borrowers the manager has historically accepted in their funds. That gives you colour on the manager’s underwriting philosophy and the metrics he focuses on – leverage, profitability, vintage and growth, among others.

“Historical information on underwriting tells you what kind of borrowers the manager is likely to pick in the future.”