The media in recent weeks has rightly paid a lot of attention to signs of stress within private credit and heightened redemption requests from semiliquid funds devoted to the asset class. But all this attention runs the risk of obscuring the underlying dynamics and inherent trade-offs of these vehicles, which are more likely to surface in turbulent markets, like the present.Advisors and investors trying to navigate the headlines should keep the following points in mind.Morningstar Calls Them ‘Semiliquid Funds’ for a ReasonSince these funds intentionally limit how much money investors can redeem in an effort to harvest an illiquidity premium, the amount each individual investor receives back is a function of how much other investors asked for in aggregate during a given redemption window. In periods of stress and negative headlines, it won’t be unusual to see redemption requests exceed the limit, which will result in each investor only getting back a portion of what they asked for. Redemption Amounts Aren’t FlexibleOnce a board-approved redemption percentage has been set and the tender offer is sent to investors, that percentage cannot be changed, regardless of investor demand or the fund’s available liquidity. The industry standard redemption amount and cadence is 5% every quarter, and firms can also buy back an additional 2 percentage points, no matter the tender offer window’s preset amount. Thus, a 10% tender offer could flex upward to 12%. But even if a fund with the 5% standard has enough liquidity to redeem, say, 14%, it is technically not allowed to go beyond 7% because that would violate the previously authorized limit. Criticizing a manager for delivering the promised liquidity may say more about the critic than the manager. Whether investors want to redeem 2% or 20%, the best Cliffwater Corporate Lending could legally do this quarter, for instance, is 7%. The amount a fund offers to buy back can only be changed by the board between redemption windows, and these changes are infrequent for good reasons. Proration Has a PurposeWhen investors ask for more money back than a semiliquid fund is offering, the redemptions will be prorated. Assume investors tried to redeem 14% from Cliffwater Corporate Lending, but the fund only bought back 7%. Every investor who asked for their money back would only receive half of what they asked for (7 divided by 14). Capping redemptions through proration allows the manager to own assets with limited or no liquidity. There should be strong alignment between fund liquidity (its redemption amount and frequency) and the liquidity of the fund’s underlying assets. The industry doesn’t have a perfect track record here, though, as the experience of Bluerock Total Income + Real Estate Fund can illustrate. Proration also protects investors from other investors. In daily liquid vehicles like mutual funds and exchange-traded funds, investors who stay the course can be punished by those who pull their money at the first change in market weather. When this happens, managers can be forced to return cash to investors exactly when they should instead be using it to buy attractively priced assets. It may also force managers to sell their better assets—the ones that can be sold in a downturn—to pay back those redeeming investors, leaving the committed investors with a portfolio of worse ideas. Limiting redemptions eases both problems, albeit only to a degree.The Agreement Between Manager and InvestorSemiliquid funds come with an implicit agreement: The investor gives up some liquidity, and in return, the asset manager attempts to offer returns above what’s available in mutual funds or ETFs. The investors are limiting themselves to 5% quarterly liquidity, expecting some benefit in exchange. The onus is on the manager to deliver returns above what an investor can get elsewhere in more liquid products, while providing the promised liquidity, however limited. A manager who promises 5% and delivers 5%, even when investors want more, is delivering on the second half of that promise. But a manager who promises 5% and can’t deliver it has failed. Consider the following: The manager, with the consultation and approval of the fund’s board, sets the level of liquidity available to investors. The manager, not the investor, chose 5% per quarter, and so the manager knows every quarter that the fund must come up with cash at most equal to 5% of net assets. The manager has perfect visibility into potential outflows, a luxury that no mutual fund or ETF manager can claim. The manager also understands, hopefully better than any other party, the assets purchased for the portfolio—whether good or bad, the amount of cash those assets should generate, if they’re tradable or not, whether they can be used as collateral, and so on. School of Hard KnocksPublic markets experience redemption cycles often. For example, according to forthcoming Morningstar research, roughly 80% of mutual funds and ETFs that have existed for at least five years have experienced a 20% redemption within a 12-month period. In other words, what might be the worst-case scenario for semiliquid funds—maximum redemptions for a year or more—is normal in liquid public markets. The risk to semiliquid 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. Until the advent of semiliquid funds, private credit was mostly held in drawdown funds and listed business development companies, neither of which must meet periodic redemptions, and so this is the first true outflow cycle for these products. 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. Assuming semiliquid funds experience the same 80% number cited above, then prorating is a likely outcome, not an outlier, and investors need to prepare for that. Is 5% Too Low?Investors in mutual funds and ETFs can withdraw all their money in a single day. While this can pressure the asset manager, it also means the fund quickly sheds investors who are no longer happy. Semiliquid funds don’t benefit from a similar dynamic; when proration kicks in, investors must wait until the next redemption window to try again.Forcing investors to wait may cool the desire to redeem, and there’s copious evidence (at least for public markets) that time in the market leads to better outcomes than timing the market. On the other hand, investors might remain disgruntled and continue asking for their money back, turning what in public markets is a short-term shakeout into a slow but inexorable push for the exits. The current outflow cycle may reveal that investors prefer funds that don’t prorate or have higher redemption amounts. Of course, the trade-off is that those funds are less likely to offer the higher returns driven by illiquid assets. That might be a trade some investors discover they are willing to make, though. Wrapping UpAdvisors and investors should buy semiliquid funds with the understanding that, at some point, proration is an expected outcome, not an unexpected one. Proration serves a purpose, but not every investor is willing to bear that restriction. Managers should be held accountable for the level of liquidity they offer to investors. Finally, there is an onus on asset managers, advisors, and firms such as Morningstar to educate their clients, offer fair and transparent opinions and data, and encourage behavior that leads to better investor outcomes. This article aims to do just that.