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PAGE 2 | Alternative Income for an Unpredictable World: Understanding Private Debt Funds

SIDEBAR ARTICLE

Open-End or Closed-End Funds?

Investors in private debt funds can utilize either an open-end or closed-end approach. Those structures determine when investors can put money into the fund and when they can redeem their capital. Most private equity funds and real estate funds are closed-end. 

In a typical closed-end fund, the fund manager brings in capital over the course of weeks, months, or even quarters and then has a fixed period of time to earmark the funds for a package of loans (the “investment period”). This closed-approach is especially well-suited when private debt fund managers want to provide multi-year loans, enabling them to keep funds fully-invested while loans remain outstanding. 

Los Angeles-based Calmwater Capital has identified closed-end funds as the ideal structure for its approach to the private debt fund market as it provides for more efficient portfolio management. The firm provides senior secured commercial real estate bridge loans on different property types, ranging in size from $7.5 to $100 million, and typically for a period of 18 to 36 months. To build up a capital base to provide for a few years’ worth of loans, funds are raised prior to the investment period until a target amount has been reached, a process that can take between 6 to 18 months. 

During the investment period, which can range between 2-3 years, Calmwater proceeds with deploying the capital raised by issuing bridge loans to various borrowers across the United States. In those 2-3 years, the fund is permitted to reinvest capital received from loan payoffs and the fund also provides current yield through quarterly distribution to investors. Upon the termination of the investment period, as portfolio loans start to pay off (“harvest period”), the proceeds are distributed to investors until they receive 100% of their initial investment plus a preferred return. 

This isn’t necessarily an approach well-suited to typical individual investors, many of whom prefer not to tie up their capital for extended periods. Instead, Calmwater works with institutional investors such as endowments, public and private pension funds, family offices and some high net worth investors. These kinds of investors typically require a longer period of time to become acclimated with the business model. 

Calmwater’s decision to focus on making loans in the $7.5 million to $100 million range allows the firm to slot into the “lower-middle market”, flying below the radar of mega-funds while also being able to dial up loan sizes to have economies of scale. These deal sizes also enable Calmwater to avoid competing on the lower end of the institutional real estate lending market, which tends to see a great deal of competition. As Laura Frega, Head of Investor Relation at Calmwater notes, “Small loans require the same amount of operational support and due diligence as larger loans, and would require us to work with many more borrowers for the same level of capital deployment.”

In contrast to closed-end funds, open-end funds, which are also sometimes called evergreen funds, enable investors to subscribe to a fund at any time. Redemptions from open-end funds are easier to obtain, although the fund manager usually has the ability to slow down or “gate” redemptions under certain circumstances. The key to an open-end fund is that investors need not tie up their capital for many years to access the fund’s investments. Open-end funds are only practical for investments that can be valued at regular intervals, including publicly-traded securities or certain debt investment strategies such as real estate lending.

Selected Characteristics of Private Debt Funds

Key characteristics of private debt funds from the investor perspective include:

Less liquid than public securities; no public market.

Publicly-traded stocks, bonds and ETFs can be bought and sold at any time. This feature of maximum liquidity explains why the great majority of investor assets are held in public securities. In contrast, most debt funds require capital to be invested for a minimum number of months or years. 

Some funds are structured to offer redemption rights, requiring a notice period, which varies in duration from weeks to months, in order to receive redemptions. The authors of this white paper believe that investors unwittingly pay a premium for the real-time liquidity of public markets. Put another way, many RIAs may be missing out on attractive risk-adjusted returns because of their over-attachment to this level of liquidity, while their clients don’t really require such instant liquidity for every part of their portfolio.

Private debt funds vary widely in the types of loans they make. Some funds invest in loans secured by heavy equipment while other funds focus on loans secured by works of art, and there are funds devoted to all types of secured and unsecured loans in between.

Less volatile than public market investments.

Private debt funds are typically required to mark their underlying loan investments at “fair value”. This means adjusting the value of the investment if the underlying investment is likely to be impaired or if the value has increased. The value of an investment in a debt fund typically does not move unless any individual holding is re-classified as being at risk of non-compliance or default. As will be discussed later in this white paper, the number of such defaults resulting in impairments has been extremely low for many of the industry’s leading operators, due to relatively safe loan-to-value ratios, among other factors. 

In contrast, the price of a public company stock may move sharply higher or lower due to market sentiment, psychology and/or panic, regardless of the health of the business or soundness of the underlying investments. This volatility can be seen with mortgage REITs, which can be similarly structured to private debt funds but are publicly traded. Private debt fund investments only change in value when the actual value of the underlying investments change—not simply as a result of psychology in the markets.

To illustrate the volatility of public mortgage REITs, consider the case of Broadmark Realty Capital (BRMK). This company operated a private lending fund for many years before merging with a special purpose acquisition company (“SPAC”) or “blank check company” in November 2019, at which time its shares began trading on the New York Stock Exchange.  

As shown in the price chart nearby, the stock subsequently rose to nearly $13 a share, then slid below $6 in the spring of 2020, before a partial recovery. Even as its shares were volatile, the value and status of the loans owned by Broadmark remained fairly constant. This example shows how the liquidity of public market investments can create unwelcome volatility, despite the underlying soundness of the investment.

Minimum investments and investor qualifications.

Many private debt funds have a minimum investment amount, frequently between $50,000 and $500,000. The larger the fund, the larger the minimum investment that is typically required. Some funds have far lower investment minimums. Also, many private debt funds can only be accessed by Accredited Investors, defined by the SEC as having $1 million of net worth, not including primary residence or annual income that exceeds $200,000. Some funds are limited to Qualified Purchasers, which is an even higher threshold. Recently, the definition of an Accredited Investor was extended to include anyone that is a financial professional with a Series 7, Series 82 or Series 65 license.

Selected Tax Considerations

Income and distributions from debt funds are typically taxed as ordinary income. Real estate debt funds can be structured as a real estate investment trust (REIT) which provides better tax treatment. Specifically, only 80% of income from a REIT is subject to taxes, with the other 20% being tax-free. The result is that REIT income enjoys a higher-after tax return.

 
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