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PAGE 4 | Alternative Income for an Unpredictable World: Understanding Private Debt Funds

Selected Risks of Private Debt Funds

Some of the risks and issues to consider regarding any particular fund include: 

  • “Name brand” funds may not be able to efficiently put enough capital to work, and as a result, may have to refrain from investing in certain asset classes. Or they may have to incur two layers of fees to access these assets, by hiring a loan origination specialist or sub-manager who has deal flow in each specific niche.

  • Fiduciaries tend to avoid less well-known funds, for fear of harming relationships with their clients in case of adverse outcomes.

  • Debt funds can use many levers to generate extra returns and many investors are not well-equipped to understand how some levers affect risk and volatility of returns (for example, structural leverage and other nuances of debt funds discussed in this white paper).

  • Unlike publicly-traded bonds, which are rated by rating agencies, the area of private debt funds has not yet seen any significant third party research function emerge. Such research would help investors assess the risk of a fund or strategy. 

As a result of these factors, fiduciaries such as RIAs willing to do their own research may be able to utilize debt funds to generate attractive yields and total returns.

RIAs may want to consider the recent findings from research firm PERE. In that firm’s Investor Perspectives 2020 report regarding private real estate lending and investing, the authors write:

“Just 10 percent of investors polled report they are overallocated to the asset class going into 2020, with 32 percent saying they are underallocated. Further, 35 percent of respondents are looking to commit more capital this year. Only 9 percent say they will invest less. Investors are also largely content with the performance of their investments with 56 percent saying the asset class either met or exceeded benchmarks in 2019—only 7 percent feel they were short changed. Happily, private real estate is expected to deliver in 2020 too, with 65 percent of investor respondents foreseeing benchmarks being met or exceeded. Just 15 percent anticipate performance will fall short.” 6

warehouse building

There is little question that private debt funds will see ample demand for their capital that they raise. RCLCO Real Estate Advisors notes that “the single-family rental market will likely be undersupplied over the next 10 years…currently, approximately 6% of new single-family homes are purpose-built for-rent, which would result in approximately 700,000 new units over the next 10 years.”7 Given demographic trends, RCLCO forecasts much greater demand than the current pace of production. To help fill the anticipated gap in the supply of housing, private debt funds are expected to see greater opportunities for an expansion in lending volumes.

metal wave design on building structure

Section II How to Conduct Due Diligence on a Private Debt Fund

In this section, we provide some insight into how to analyze and conduct due diligence on a private debt fund manager and his or her fund. We use the insight we have gained from managing such a fund for more than 10 years, across more than 1,600 investments, to highlight the areas that we believe distinguish the best-managed funds from all the others.

We have divided the diligence checklist into qualitative factors and quantitative factors. Qualitative factors include the reputation of the key individuals. Quantitative factors include the measurable parameters such as the amount of leverage used to achieve returns.

Qualitative and Manager-Focused Due Diligence

Key people

The most important initial screen for any business relationship is the people involved. For most alternative investments, including private debt funds, the limited partners are placing their trust with the general partner or fund manager, who acts as primary decision-maker for the fund. For that reason, establishing the integrity of the key people is critical. Items to research should include the following:

Reputation

Are you comfortable working with the key decision-makers for the fund? Funds are typically structured as partnerships or limited liability companies that are very similar to partnerships. Just as you would choose a business partner or life partner very carefully, you should choose the fund general partner diligently. A key step in this process is speaking or meeting with the partner (in-person or via videoconference). Another step is to check references. A great way to find good sources is LinkedIn, which allows you to see connections that you might have in common with the fund manager. These mutual connections may be able to provide very valuable candid input, particularly if they are well-acquainted with both you and the fund manager. 

You should also ask to speak with an existing investor in the fund. Rather than accept a reference that the fund manager chooses, ask whether the manager will accommodate an investor reference chosen at random, for example, based on the last digits of the investor’s account number. The most transparent managers should have nothing to hide and should be willing to accommodate thorough due diligence.

Understanding their life goals & priorities 

What are the life goals of the fund manager? And how does the manager prioritize different goals? You want a manager that considers their reputation to be paramount. You want to avoid managers who are overwhelmingly focused on their image or material possessions, even more than their reputation with investors. Excessive concern with impressing others with material wealth could lead the manager to make decisions at some point that are not good for investors in the fund. For example, it is best to avoid managers that are in the midst of a challenging year and will pursue a “Hail Mary” high-risk investment in order to turn the year around in one fell swoop. Even worse is a manager who doesn’t handle investor money properly. Because many of the best private debt fund managers are not large global alternative investment managers, you will need to learn about the key people yourself, enough to feel comfortable that you understand their core motivations.

Team culture & cohesiveness

What is the culture of the company that manages that fund? What types of people have the founders brought on to build the company, and what amount of turnover has there been? Some turnover is acceptable and inevitable, particularly if it involves bringing on the right senior people to manage the company's growth. However, a firm that has a history of excessive turnover may be driving away top talent, which may be a sign that the business is totally dependent on one or two key people. Such a culture inhibits a firm’s ability to grow and respond nimbly to market conditions. One of the author’s mentors has conducted due diligence on fund managers for some of the largest public pension funds. He finds that some of the best information he receives happens during on-site due diligence. For example, the receptionist or office manager frequently knows how things really work at the company and may be able to provide candid input on the subject.

Track record

Like anyone’s reputation, a fund manager’s track record follows the manager throughout his or her career. The best fund managers likely bring an almost obsessive focus to how they have performed for investors. This does not mean they will avoid any losses, but rather that the track record is objectively superior to that of most other fund managers in the same category. 

How long is the track record? Does it include at least one period of market turmoil, so that investors can ascertain how the fund manager performed relative to others during this period? As we will explore later, it can be easy to outperform most managers in good times by taking on extra risk, but it is the challenging times that expose the cost of a risky approach. 

In addition, when evaluating a firm’s track record, completeness and transparency are both critical. Be sure that you are seeing all investments, not only the attractive part of the track record. And you should be able to receive answers and detailed documentation addressing any questions you have about the track record. It may be useful to ask the fund manager or their staff about which other funds they see as direct comparables. Try to talk to these other funds as well, in order to assess their track records on an apples-to-apples basis. Of course this topic is very nuanced and would require specialized training to perform in great detail. Any extra work you can do assessing the track record is better than simply accepting whatever the manager offers on this subject in the standard fund marketing materials.

Elevator test—”explainability” to clients

Whether acting as a fiduciary for clients, or investing on your own behalf, it is important to be able to explain a debt fund’s strategy quickly and easily to a lay person in a clear and concise manner. The simpler the strategy, the better. For example, a strategy based on making loans on real estate that you can see and visit for yourself may be safer than an esoteric strategy that involves a degree in finance to understand. The more complex the strategy, the greater the chance that your results will be harmed at some point by an investment variable you did not grasp or could not anticipate. As the name implies, it is ideal if you can explain the strategy to someone in the time it takes to ride in an elevator.

Secular vs. cyclical underlying opportunity

Some strategies target a cyclical opportunity. An example might be auto loans which are closely tied to consumer purchases of new cars. In a cyclical strategy, demand for loans exists when the economy is doing well. Other strategies target a secular opportunity which plays on a larger trend that will continue whether the economy is expanding or contracting at the moment. For investors seeking to invest in a fund and enable the funds to keep working for many years, a secular strategy is preferable, as the investor will not need to make portfolio changes as frequently in order to ensure that conditions for favorable returns remain in place. Many debt funds that have emerged after the Great Financial Crisis (GFC) are able to target niches that were previously served by banks, where banks retreated because of new regulation that came into effect after the GFC. An example of a secular strategy is one that provides loans to real estate investors, where the declining number of banks has created a long term opportunity for non-bank lenders.

Moat test

When explaining his investment approach, Warren Bufffett has espoused the benefits of businesses that have a “wide and long-lasting moat” around them.8 The same is true of debt investment funds. Some have a proprietary approach which enables them to deliver superior returns to their rivals over time. Usually this takes the form of a strong reputation and brand, resulting in a steady stream of good loans earning attractive yields for investors. A good indicator of this “moat” effect is the degree to which loans are made to repeat borrowers. If borrowers find there is a high switching cost, and they prefer to stay with their existing lenders, they will likely pay a slightly higher interest rate. In contrast, a lending business that has no moat and no loyal borrowers will need to compete in other ways to attract loans. They may need to offer higher leverage than other lenders, which will result in higher risk and more volatile results. Or they may need to compete on price, resulting in lower interest rates and returns for investors.

 
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