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WHITE PAPER

Alternative Income for an Unpredictable World: Understanding Private Debt Funds

A Guide for Fiduciaries and Individual Investors

By Jan B. Brzeski with David A. Sterman, Contributor & Editor
Last updated: September 2022

Executive Summary 

In an era of unpredictable rates, Registered Investment Advisors (RIAs) are increasingly seeking out fixed income alternatives that provide robust yields with strong track records of minimal volatility and risk. Private debt funds are garnering greater interest, and increasing fund flows. These funds are offered by specialized financial institutions, often replacing a role played by traditional banks, that exited various lines of business after the Great Financial Crisis (GFC).

While private debt funds don’t have the volatility of publicly-traded investments, they usually come with liquidity restrictions, which makes them more suitable as an anchor of a long-term portfolio.

Various studies point to a relatively strong level of expected returns for private debt funds in the next decade, on both an absolute and risk-adjusted basis.

RIAs must ensure they conduct proper and thorough due diligence on private debt funds, the firms that manage them, and their long-term track record. Communicating their relative merits to clients is also essential.

While near-term economic challenges remain paramount for many advisors, conservative lending standards, with loan-to-value ratios rarely exceeding 65%, have enabled the most prudent private debt funds to largely avoid losses of principal.

Industry operators tend to deploy their expertise within specific segments of the real estate market and focus on various sizes and durations of loans issued. In some cases, structural leverage can be deployed to enhance returns.

What’s in a Name?

There are many names for the industry at the center of this white paper. We will use the term private debt funds but credit funds or private credit strategies would be equally valid. Each of these names focus on this industry from the perspective of investors who want to take advantage of the opportunity to earn returns through lending strategies. 

Another approach is to focus on the service provided to borrowers, which is the other side of the same coin. Private lending and non-bank lending are two descriptions favored by the authors. Other descriptions have included shadow banking and hard money lending (mostly referring to real estate). However both of these labels have negative connotations. These labels do not reflect how the best operators have professionalized this area of finance and brought down borrowing costs for their clients to the greatest extent possible, consistent with meeting investor return expectations.

The Financial Stability Board refers to this industry as non-bank financial intermediation — which may be the most impartial description of all.

Introduction 

This white paper aims to explain private debt funds, with a focus on readers who are professional investment advisers who act as fiduciaries for their clients. This growing asset class has been garnering a greater level of fund flows in recent years. Over 1,000 institutional investors currently allocate to private real estate debt, according to research firm Preqin. As of December 2019, the industry had $190 billion in aggregate assets under management – doubling in size since 2014. 

bar graph Private Real Estate Debt Assets under Management, 2006 - 2019

Private debt funds, like other alternative investments, may appear to be challenging to understand. Yet investors can benefit from taking the time to understand them, and the key goal of this white paper is to “demystify” this asset class. We hope to help investment advisers understand the key strategies used by private debt fund managers to generate positive and robust absolute returns across economic cycles; how to approach the task of performing due diligence on private funds and non-bank lenders; and how to compare and contrast different debt fund strategies.

Among private debt funds, there are many types of underlying assets that can be used to generate returns, including: real estate; equipment; unsecured business loans; and consumer loans. This white paper uses examples from real estate lending, which is the author’s area of expertise, to explain various aspects of debt funds in general. At the end of this white paper is a glossary defining many terms used in the white paper. Terms covered in the glossary are underlined when they are used for the first time.

Readers wanting a short, non-technical summary of the contents of the white paper should turn to page 24. This overview is designed for individual investors.

Finally, readers of this white paper will gain meaningful insight into one of the largest asset classes in existence, namely bonds. More than $10 trillion of the $45 trillion of U.S. bonds outstanding are mortgage-backed securities. By understanding the contents of this white paper, readers will better understand how such securities are created and how they work, from the ground up.

Section I What are Private Debt Funds?

Private debt funds are pools of loans which provide attractive monthly or quarterly distributions. The fund manager typically originates or purchases new loans when the fund has liquidity, either because an existing loan has been paid off, or when new investor capital is placed into the fund. Private debt funds are usually designed to generate income while preserving investor capital. In this regard, they are similar to the fixed income allocation of most portfolios. Equity allocations, in contrast, are focused on total return, with typically only a smaller portion of the return coming from current income. 

During the Great Financial Crisis (GFC) of 2008-2012, there was substantial popular resentment toward banks, many of which required a bailout from taxpayers. Banks were perceived as having profited from making risky loans using government-insured deposits from ordinary Americans. Consumers, in contrast, did not receive any bailout from the government. 

In response, Congress passed the Dodd-Frank Act, among other laws and new regulations, which forced banks to maintain more capital. These laws also established regular, robust regulatory audits of bank lending activity to ensure that banks were not taking on excessive risk. Compliance with these laws was a clear challenge for smaller banks, which helped fuel further banking industry consolidation. The remaining banks became ever larger and less nimble. The trend is shown in the chart below.

Graph-Number of Commercial Banks in the U.S.-Debt Funds Whitepaper

Businesses faced greater challenges in gaining access to credit with the reduction in the number of smaller, local banks due to the stringent lending regulations. For example, real estate investors and developers found it difficult to get loans from banks, unless the borrower profile and project type fit within a very restricted “box” provided by banks. To fill the void left by banks, hundreds of small private lenders—many set up as private debt funds—have emerged to provide loans to small and medium-sized companies. In this way, the GFC created an ongoing, large demand for loans by various borrowers left behind as banks gravitated toward more restrictive lending practices.

 
 
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