Funded But Fragile: The Liquidity Mirage in Private Lending

The private-credit boom has been fueled by record inflows. Global private-credit AUM doubled over the past half-decade – roughly $3 trillion by mid‑2025 sterlingassetgroup.com (U.S. alone ~$1.34T by mid‑2024 federalreserve.gov) – as pension funds, insurers and retail channels clamor for yield. Much of this capital has poured into closed-end, drawdown funds (10‑year private-credit funds) and credit vehicles like BDCs. Closed-end funds raise capital in a fixed window and then “lock in” investors for 5–10 years graviscapital.com. This locked-in capital allows managers to invest in very illiquid loans without worrying about redemptions. In practice, the vast majority of private-credit assets remain in these funds, whose appeal is stable capital (and returns) but no liquidity until fund wind-down graviscapital.com jdsupra.com.

In contrast, open-ended (evergreen) credit funds are a newer and smaller slice of the market. These vehicles have no fixed term and allow ongoing capital subscriptions and redemptions graviscapital.com. They include things like interval funds, perpetual credit trusts, and especially U.S. Business Development Companies (BDCs). Unlike closed funds, open-ended funds can accept new money indefinitely. For example, many large credit managers launched perpetually offered BDCs over the past decade adamsstreetpartners.com. These BDCs accept monthly subscriptions and permit quarterly redemptions (subject to board approval) – essentially operating as closed-end entities that continually reopen to investors adamsstreetpartners.com. Non-traded perpetual BDCs have exploded in size (roughly $128B in assets as of Q1 2025) adamsstreetpartners.com, reflecting retail and adviser demand for a “liquid” private-credit yield. In Europe the trend is similar: new EU rules (AIFMD II) now permit open-ended loan funds that offer periodic redemptions, though only under strict liquidity regimes jdsupra.com jdsupra.com.

Closed-Ended Funds: Stability by Design

Closed-end private-credit funds are blind-pool, drawdown structures: GPs raise a fixed pool of capital (often in 12–18 months), then invest over a few years, harvest returns, and return capital to LPs by liquidating loans toward the end of the fund’s life graviscapital.com. Investors commit capital up front and have no redemption rights until distributions are made. This permanence allows funds to match long-duration loans to long-term capital. Investors gain access to high-yield, opaque credits not available in liquid markets graviscapital.com, and managers need not worry about meeting cash outflows. Indeed, closed-end structures proved resilient during past crises: for example, they navigated the COVID-19 shock with no forced “runs,” since LPs were locked injdsupra.com.

The flip side is obvious: illiquidity. LPs in closed-end funds cannot readily exit before the fund term. They must either hold to the end or sell their interest on the thin secondary market (often at deep discounts). As one industry note explains, the “fixed capital structure” provides stability for the fund but leaves investors unable to liquidate until maturity graviscapital.com graviscapital.com. Most private-credit allocations today are in closed funds graviscapital.com. In fact, industry sources estimate that over 80% of private-credit AUM remains locked up in 7–10 year vehicles. The only “liquidity” for investors is occasional distributions (loan repayments) or structured continuations after fund expiry. For illiquid assets, this model is considered by regulators and economists as manageable (since liquidity is matched to term) jdsupra.com.

Open-Ended Funds: Liquidity with Strings

Open-ended or evergreen credit funds seek to blend private-credit returns with investor liquidity. In these vehicles, investors subscribe at NAV and can request redemptions periodically graviscapital.com. In principle this sounds more flexible, but in practice every open-end credit fund features heavy constraints. Most open-end credit managers impose lock-up periods (typically 2–3 years) so that early-investor capital can be deployed without being immediately pulled privatecapitalsolutions.com. After the lock-up, investors may redeem only in specified windows (usually quarterly or semi-annually) privatecapitalsolutions.com. Critically, funds set redemption gates: a cap on withdrawals per period (often 5–10% of NAV per quarter) to prevent a flood of redemptions that the portfolio cannot support privatecapitalsolutions.com jdsupra.com. If redemption requests exceed the gate, excess amounts are queued and carried into later windows privatecapitalsolutions.com.

Other liquidity-management tools abound. Many funds charge early redemption fees or “penalties” during a soft lock-up to deter flippers privatecapitalsolutions.com. They may use swing pricing or dual pricing, shifting costs of redemptions to exiting investors. Some adopt “slow-pay” or runoff share classes: redemptions convert to a liquidating class that only receives cash as loans pay off, effectively side-pocketing the assets privatecapitalsolutions.com privatecapitalsolutions.com. Industry guidelines (including EU AIFMD II) explicitly require loan-originating open-end funds to implement multiple such tools jdsupra.com. For example, EU law mandates at least two of nine permitted tools (gates, notice extensions, suspension, side pockets, etc.) to align fund liquidity with the illiquid portfolio jdsupra.com. In the U.S., regulated funds have some limits too (e.g. mutual funds must hold ≥15% liquid assets, though many private credit funds rely on contractual gates instead of asset holdings).

In short, open-end credit funds offer “liquidity” on paper, but it’s bounded. As one analysis notes, such funds are only “semi-liquid”: capital is theoretically available for redemption, but only at fixed rates and subject to heavy restrictions privatecapitalsolutions.com jdsupra.com. If large redemption waves hit, managers can simply defer or gate them. In fact, industry surveys warn that with rising interest rates, many open-ended credit vehicles could hit their redemption limits and then face actual liquidity crunches gfmag.com.

Liquidity Risk: Assumptions vs. Reality

Many investors assume a modest redemption right means easy cashout – a dangerous illusion. Private-credit investors often focus on returns and yield, overlooking the fact that most of the fund’s loans have no public market. AllianceBernstein emphasizes that in private credit “liquidity remains limited – and for good reason” alliancebernstein.com. Borrowers prize the confidentiality and certainty of private loans (often insisting on covenants that forbid transfer). Converting these bespoke loans into sellable instruments would require “standardized documents” and frequent mark-to-market pricing, which could undermine the very returns they seek alliancebernstein.com. In reality, a manager facing mass redemptions must sell loans in a distressed environment (likely at steep discounts) or simply suspend redemptions until market conditions improve alliancebernstein.com privatecapitalsolutions.com.

Regulators have taken note. The IMF has warned that even a modest market sell-off could “pressure open-ended funds” by forcing price mark-downs across illiquid assets sterlingassetgroup.com. The Bank of England and other authorities caution that liquidity mismatches are baked into many credit funds gfmag.com. Fitch Ratings similarly flags the risk: while U.S. open-ended credit vehicles are still few, if they proliferate amid higher rates, investors could trigger runs that impair even well-capitalized funds gfmag.com. In short, the “liquidity premium” of private loans exists because these assets are not easily sold. Investors expecting a quick exit in stressed markets face gates, delays or steep losses.

When It All Hits the Fan: Stress Scenarios

What happens if borrowers default, sponsors wobble or LPs stampede for the exits? In such stress scenarios, the structural illiquidity of private credit comes home to roost. Consider borrower distress: recent niche lenders financed by private credit have imploded, causing large losses. For example, in 2025 two subprime auto-finance companies (First Brands and Tricolor) collapsed under bad loans, imposing combined losses of hundreds of millions on their creditors sterlingassetgroup.com. Tricolor’s lender JPMorgan reported a $170M loss from fraud at one portfolio company sterlingassetgroup.com. These cases show how quickly defaults in a sector can erode a private-credit portfolio’s value. Unlike public bonds, these loans have no ready markets, so loan write-downs would directly hit fund NAV. If many such losses occurred simultaneously, open-ended funds could swiftly exhaust their liquidity buffers.

Another risk is a redemption shock. Suppose negative news (e.g. rapid rate hikes or a downturn) prompts LPs to demand redemptions en masse. Managers would face a classic run. In open-ended funds, gates would soon bind. In a severe case, funds may suspend redemptions entirely to halt the outflow. This happened in August 2025 when Canadian real-estate credit firm Trez Capital “temporarily suspended” redemptions across five of its open-end mortgage funds trezcapital.com. Trez cited “elevated redemption requests, ongoing funding obligations and active loan workouts,” and chose to block withdrawals while continuing distributions from existing cash flows trezcapital.com. Any redemptions in queue were cancelled. The firm explicitly stated this move was to “protect the interests of all unitholders” and prevent fire-sale liquidations trezcapital.com. In effect, Trez turned on the brakes: investors cannot simply pull out, no matter the redemption language in the prospectus.

Closed-end funds are somewhat sheltered from sudden runs, but they are not immune to stress. For instance, if a fund’s sponsor faltered (or chose to liquidate early), LPs might be forced into continuation funds or face potentially discounted buyouts of their interests. And since most closed funds invest with leverage (through credit lines or CLO issuance), a sharp market move could trigger margin calls. A broad scenario can be imagined: if a macro shock led all banks to tighten lending, many private-credit funds (both open and closed) would face liquidity strains simultaneously, with no central backstop. This is the “shadow banking” worry regulators cite: the web of banks, funds and securitizations could transmit pressure rapidly across the system sterlingassetgroup.com sterlingassetgroup.com. In the worst case (a market crash or funding freeze), official stress-testing projections see open-ended credit funds halting redemptions, and fund managers delaying or suspending distributions to shore up capital.

In short, the private-credit sector is well-funded but fragile. Healthy markets and rising rates can mask the risks, but a sudden reversal would expose the illiquid core. Investors might expect their money to be available “at NAV,” but in a storm, they may find it effectively locked up.

Global Context and Outlook

While our focus has been on U.S. private credit, similar dynamics apply globally. The U.S. dominates the space (~87% of global private-credit AUM) gfmag.com, but Europe and Asia are catching up. Notably, the eurozone now has a large share of open-ended funds: roughly 42% of European credit funds are non–closed-end, reflecting many insurers and pensions with longer horizons gfmag.com. These funds typically invest in shorter-duration loans and often benefit from conservative investors who are less likely to redeem en masse. In Asia, private credit remains smaller (~$93B AUM) gfmag.com, but Chinese trust products and Indian NBFCs play analogous roles in “shadow lending.” Regulatory initiatives like the UK’s Long-Term Asset Fund (LTAF) are creating more open-ended private-capital vehicles, but with stringent redemption rules (e.g. quarterly or monthly windows and 90‑day notices) to protect liquidity graviscapital.com.

In all regions, the basic mismatch endures: managers use long-term capital to fund illiquid loans, then promise investors gradual liquidity. As global regulators warn, the key is whether these systems can handle a simultaneous rush for cash. History (e.g. 2023 bank runs) teaches that even well-run institutions can crack if funding dries up. In private credit, the pressure points are gating triggers, mark-to-market losses, and funding lines from banks – a combination that could make a buoyant market turn quickly at the first shock sterlingassetgroup.com sterlingassetgroup.com.

The bottom line: investors in private credit should not assume any level of liquidity is guaranteed. Closed-end funds are illiquid by design; open-end funds have conditional liquidity (via gates, locks, etc.). The recent fundraising boom has swollen private-credit fund assets to record highs, but beneath the surface most of these funds can’t be quickly unwound. If borrowers, sponsors, or LPs were to rush for the exits at once, the sector would be forced into orderly slowdowns: redemptions would be queued or halted, asset sales would be limited, and true liquidity would only return when loans mature or markets normalize. In essence, the industry’s “liquidity” is largely a mirage — valid when funds are growing, but problematic when they need to shrink.

Disclaimer: This analysis is provided for informational purposes only. It does not constitute investment advice or an offer to buy or sell any financial instruments. The views expressed herein are those of the author(s) and reflect available information at the time of writing. Sterling Asset Group, LLC, accepts no liability for decisions made based on this content; readers should conduct their own due diligence and consult professional advisors before making investment decisions.