Key Takeaways
- • Morningstar argues that semiliquid private credit funds carry more risk than their smooth reported returns suggest, because most direct-lending vehicles combine investor capital with borrowed money, roughly doubling market exposure in a 1:1 leverage structure.
- • In a hypothetical nontraded BDC example, an unleveraged 8% yield becomes a 16% gross yield with leverage, falling to an estimated 9%-10% net of a 3.5% borrowing cost and a 3% combined fee load.
- • Incentive fee structures with a 5% annualized hurdle (1.25% quarterly) and a catch-up to 5.72% can reward managers for adding income through risk, even when loan defaults rise.
- • Low reported volatility in private credit reflects infrequent loan pricing rather than low risk, and Morningstar warns that volatility-based models can understate exposure.
- • Unfunded commitments at the five largest nontraded BDCs averaged about 27% of net assets at the end of 2025, a contingent leverage risk if borrowers draw on credit lines during stress.
Summary
Morningstar's analysis addresses growing investor skepticism toward semiliquid private credit funds after heavy asset growth and recent shareholder redemptions over several quarters. The article notes that SEC filings and aggregated manager statistics offer far less transparency than the disclosures required of mutual and exchange-traded funds, which makes risk evaluation difficult for investors.
On leverage, Morningstar argues that private credit funds are not comparable to corporate credit mutual funds. Using a nontraded business development company that borrows $1 for every $1 of investor capital, the article notes that exposure roughly doubles. An assumed 8% unleveraged yield would become 16% before costs. After a 3.5% borrowing cost and a conservative 3% combined fee estimate on net assets, the hypothetical net yield falls to roughly 9%-10%, before any credit losses, cash drag or dilution.
The article also challenges fee design. Morningstar states that the largest nontraded BDCs typically use a 1.25% quarterly (5% annualized) yield hurdle, which it calls low relative to the 8%-12% annualized yields on most private loans before leverage. Catch-up provisions carry the fund's income to 5.72%, after which the manager collects incentive fees. The article argues this structure encourages managers to take on more credit and leverage risk.
Morningstar further contends that reported volatility understates risk. Private loans rarely trade, giving managers latitude in valuation, and floating rates shield prices from rate moves. Morningstar argues that such smoothed prices make volatility-based metrics and portfolio construction models unreliable, and that infrequent pricing can transfer value between redeeming and remaining shareholders. It also argues that private credit's lower leverage relative to pre-crisis banks does not eliminate systemic risk, since losses could force large investors to sell liquid holdings elsewhere.
On liquidity, Morningstar notes that managers often cite multiple quarters of coverage for redemption requests, but that their liquidity definitions frequently include syndicated loans, bonds and borrowing capacity, and that using borrowed funds to meet redemptions adds leverage. Finally, the article identifies unfunded commitments as a hidden risk, with the five largest nontraded BDCs averaging roughly 27% of net assets in unfunded commitments at the end of 2025. Morningstar warns that a credit squeeze prompting borrowers to draw these lines could force funds to borrow further when conditions are deteriorating.
On leverage, Morningstar argues that private credit funds are not comparable to corporate credit mutual funds. Using a nontraded business development company that borrows $1 for every $1 of investor capital, the article notes that exposure roughly doubles. An assumed 8% unleveraged yield would become 16% before costs. After a 3.5% borrowing cost and a conservative 3% combined fee estimate on net assets, the hypothetical net yield falls to roughly 9%-10%, before any credit losses, cash drag or dilution.
The article also challenges fee design. Morningstar states that the largest nontraded BDCs typically use a 1.25% quarterly (5% annualized) yield hurdle, which it calls low relative to the 8%-12% annualized yields on most private loans before leverage. Catch-up provisions carry the fund's income to 5.72%, after which the manager collects incentive fees. The article argues this structure encourages managers to take on more credit and leverage risk.
Morningstar further contends that reported volatility understates risk. Private loans rarely trade, giving managers latitude in valuation, and floating rates shield prices from rate moves. Morningstar argues that such smoothed prices make volatility-based metrics and portfolio construction models unreliable, and that infrequent pricing can transfer value between redeeming and remaining shareholders. It also argues that private credit's lower leverage relative to pre-crisis banks does not eliminate systemic risk, since losses could force large investors to sell liquid holdings elsewhere.
On liquidity, Morningstar notes that managers often cite multiple quarters of coverage for redemption requests, but that their liquidity definitions frequently include syndicated loans, bonds and borrowing capacity, and that using borrowed funds to meet redemptions adds leverage. Finally, the article identifies unfunded commitments as a hidden risk, with the five largest nontraded BDCs averaging roughly 27% of net assets in unfunded commitments at the end of 2025. Morningstar warns that a credit squeeze prompting borrowers to draw these lines could force funds to borrow further when conditions are deteriorating.
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