Private credit liquidity crisis: why retail fund redemptions are exposing a structural flaw

The mismatch is built in from day one. A private credit fund is a book of corporate loans with multi-year maturities and almost no secondary market. Turning that into cash quickly means selling loans at a discount, calling capital, or waiting for repayments, and none of those is fast. Put the book inside a vehicle that strikes a monthly NAV and opens a quarterly redemption window, sold on access, and you have a fund whose liabilities are far more liquid than its assets. The mismatch is there every day. Inflows hide it.

The hiding is what makes it dangerous. As long as new subscriptions run ahead of redemptions, the manager pays every redemption out of incoming cash and the mismatch never surfaces. When flows reverse, with subscriptions slowing while redemptions rise at once, which is exactly what happens when sentiment turns, the manager can no longer net the two, and the only way to meet redemptions is to sell the most saleable loans first. Investors who redeem early get out at a NAV struck before the trouble is fully in the marks; the investors who stay are left with a residual that is more concentrated, less liquid and lower quality. That is the first-mover advantage, and it makes a redemption wave in an illiquid open-ended fund self-reinforcing.

Gating advertises the problem rather than containing it. When a fund restricts or halts redemptions, every investor in every similar structure recalculates their exit, distressed buyers circle the gated fund at a discount, and the board is left choosing between crystallising losses, trapping investors behind the gate, or finding capital to bridge the gap. That capital is available only to a manager with a big enough balance sheet. What often separates a mega-manager’s credit fund from a mid-market one is the balance sheet behind the redemption queue. A structure that depends on the manager writing a large cheque in a crisis is an illiquid structure with a sponsor backstop, and most sponsors can’t provide one.

A second channel turns a fund-level problem into a systemic one, and a board should follow it even where its own funds aren’t retail. A large share of private credit’s permanent capital now sits with insurers, on the theory that long-dated insurance liabilities are a natural match for illiquid credit. That holds only while credit quality is stable and the regulatory treatment of the concentration stays put. If credit quality deteriorates and insurers have to mark their private credit holdings toward market, the effect runs well past the funds: insurer capital ratios tighten, supervisory scrutiny picks up, and the “permanent” capital that was meant to be immune to redemption pressure turns out to be contingent after all. The links between private credit, the banks that finance it and the insurers that hold it are what the Bank of England’s financial-stability work is meant to probe, and it is why the regulators read a retail liquidity event as a possible transmission channel rather than one fund’s isolated problem.

None of this is new to them. A UK manager should treat the recent stress as a preview of the supervisory conversation to come, a risk the regulators have anticipated for years rather than one they have only just discovered.

The Financial Policy Committee has named liquidity mismatch in open-ended funds as a structural vulnerability more than once, and has backed international work to deal with it. The Bank of England went further, putting private credit funds inside a system-wide exploratory scenario (SWES) built to test how the private markets behave under a severe but plausible stress, precisely because the sector has grown to its present size without being tested through a real downturn. And the FCA’s concern, expressed through its supervision of UK retail platforms offering private market access, is the one the episode exposed: clients unfamiliar with gating, holding products whose liquidity promise the underlying assets can’t support.

The direction that follows has been consistent. A fund’s redemption terms must match the genuine liquidity of its assets. That principle sits in the AIFMD liquidity-management requirement at FUND 3.6, which requires a manager to run a liquidity management system, to keep the liquidity profile of the fund’s investments consistent with its redemption policy, and to stress test under both normal and exceptional conditions. The ESMA liquidity stress-testing guidelines put detail on it, requiring both the assets and the liabilities of the fund to be stressed. The FCA’s wider liquidity reforms push managers toward anti-dilution tools that make redeeming investors carry the cost of their own exit. And when the FCA designed a vehicle to bring illiquid assets to a broader investor base, the Long-Term Asset Fund, it did not pretend the assets were liquid. It built in the opposite. Under COLL 15.8 an LTAF deals no more than monthly, requires a notice period of at least 90 days, and makes redemption requests irrevocable. That is the regulator’s answer to the whole problem in a single structure: don’t promise more liquidity than the assets can support, match the redemption terms to the real liquidity of the book, and make both plain in the disclosure.

A second structural weakness surfaced in the same stress, and it compounds the first. A redemption is struck at a NAV, and a private credit NAV is a model output, not a market price. When listed proxies trade at a material discount to stated NAV, it raises the question whether the marks are right, and that doubt is itself a redemption trigger: an investor who suspects the NAV is stale has every reason to redeem at it before it falls.

The two flaws feed each other. Optimistic or slow marks make the fund look more liquid than it is, because they understate the discount at which the loans would actually have to sell, and they hand early redeemers a better exit than the book can support at the expense of those who stay. Liquidity and valuation can’t be fixed separately: the redemption price is the mark. This is why the FCA’s private market valuations work and its liquidity work sit inside one supervisory concern, and why a credit manager’s answer on liquidity has to carry an answer on valuation: independent, prompt marks that move with the borrowers, so the NAV investors redeem at is real.

For a UK manager, the episode forces a choice better made on purpose than discovered in a redemption wave. There are two workable models for offering private credit to non-institutional investors.

The first matches the redemption promise to the assets: low dealing frequency, real notice periods, calibrated anti-dilution so redeemers carry their own liquidity cost, and gates and side pockets defined and disclosed in advance rather than improvised. This is the LTAF philosophy, and it’s where the regulators are steering the market. It sells less well, because “you can have your money back in 90 days, and the cost of your exit falls on you” is a harder pitch than “convenient access”. It is also a promise the manager can keep.

The second is not to offer flexible-access private credit to investors who can’t bear illiquidity at all, and to say so plainly in the design and the disclosure. The option that doesn’t work is the one the market has just tested to destruction: a flexible-access wrapper around illiquid assets, sold on convenience, running on continuous inflows and, in a crisis, on a sponsor balance sheet to honour the queue. A board still running that third model should read the recent stress as a warning delivered to others on its behalf, and move to one of the two workable models before its own flows turn.

A manager offering private credit to a broad investor base needs the liquidity framework set out in detail elsewhere in this series, applied with the retail stakes in view. The framework has six elements.

Start with the redemption terms. Dealing frequency, notice periods and any lock-up should reflect how fast the loan book can genuinely raise cash, on the LTAF principle, not mimic a mutual fund’s liquidity that the assets can’t support. Sit anti-dilution tools on top of that: swing pricing or an anti-dilution levy, calibrated to the real cost of liquidating loans under stress, so the redeeming investor bears that cost and the investors who stay aren’t diluted by someone else’s exit. That is the direct antidote to the first-mover advantage.

Gates and side pockets need to be specified, calibrated and disclosed before the crisis rather than sprung on surprised investors, so that using them is the operation of an understood term rather than a distress signal. Behind them sits the stress-testing file: both sides stressed, a realistic liquidation profile for the assets and severe, correlated redemption scenarios for the liabilities, pulled together in a redemption coverage ratio, with reverse stress testing to find the breaking point and a contingency funding plan that doesn’t assume a sponsor cheque.

Then valuation. The NAV investors redeem at has to be real, marked independently and re-marked promptly as borrowers deteriorate, so early redeemers can’t leave at a stale price at the expense of the rest. Last, suitability and disclosure for the channel. Where the product reaches retail or wealth investors, the disclosure has to make the illiquidity, the notice periods and the gating tools genuinely understood, and the distribution has to reach investors who can bear the liquidity profile, because the Consumer Duty (PRIN 2A) and the financial-promotion rules will judge whether the promise made to the investor matched the product they actually got.

This insight is provided for general informational purposes only and doesn’t constitute legal, investment, or regulatory advice.