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PAGE 6 | Alternative Income for an Unpredictable World: Understanding Private Debt Funds

Discussion of Fees

The following questions should be considered:

  • What is the difference between the gross returns and the net returns of a fund? 

  • What is reasonable compensation for the fund manager? 

  • How much of that compensation should come from fund investors vs. fees paid by borrowers to the fund manager or their lending affiliate? 

  • What is the right balance of incentive fees vs. other fees for a private debt fund? 

A detailed discussion of fees is beyond the scope of this white paper.

Use of Structural Leverage

This topic is part of the quantitative due diligence but it has its own separate section because it is a topic unto itself that requires attention when structural leverage is used. Some fund managers use structural leverage to boost returns. In this section we will introduce a number of terms used in structured finance. These terms are defined in the glossary at the end of the white paper. 

A third-party lender such as a bank may provide some of the capital to fund one or more loans, charging a relatively low rate because their position is more secure than the fund manager’s position. The bank loan is known as a warehouse line of credit or it may also be called a repo line of credit. To use a warehouse line, the fund must pledge loans that it holds on its balance sheet into a borrowing base. Every warehouse line of credit has a prescribed advance rate. Suppose the advance rate is 65%. This means that if the fund manager pledges a loan of $1 million into the borrowing base, the fund can borrow $650,000 against that loan. When the $1 million loan is paid off, the fund must repay $650,000 of the warehouse line of credit, unless there is sufficient other collateral (loans) in the borrowing base to keep the overall warehouse line of credit in balance within the maximum 65% advance rate.

Structural leverage can provide for higher returns for the lender. However, leverage works both ways. If there are losses on a loan, the impact of those losses becomes magnified, compared to a fund that does not use structural leverage.

As an example, consider a loan of $10 million that has an 8% interest rate. Suppose that a private lending fund puts $5 million of investor capital into the loan, and borrows the other $5 million from a bank at a 5% interest rate (using the $10 million loan as collateral). This is known as "one turn of leverage", because for every $1 of capital invested, there is $1 of bank financing. We can calculate the effect of the structural leverage on returns as follows:

Even though the underlying loan generates an 8% return, in this example the fund generates an 11% return (before management fees). However, note that if the whole loan generates a loss of $500,000 (that is 5% of the $10 MM loan amount), it is actually a 10% loss relative to the fund’s investment in the loan of $5 MM. In other words, structural leverage enhances returns on good investments, but also magnifies losses on bad loans. In this respect, using some bank financing on loan investments is just like using some leverage when buying and holding real estate. Moderate use of leverage can make sense for some investors, but excessive leverage creates the risk of much more volatile results—particularly when structural leverage is combined with one or more of the other risk factors discussed in this white paper.

When Structural Leverage Takes the Form of a Rated Bond

When a private debt fund uses structural leverage, in many cases the fund borrows money from a bank. When the size of that line of credit gets big enough—say, more than $200 million—then the private debt fund may find more advantageous terms by using the public markets to borrow the money. The process of issuing a bond backed by interest income from a pool of loans is called securitization. It pays to understand securitization because in the U.S. alone there is over $10 trillion of mortgage backed securities outstanding, making this asset class one of the largest parts of the fixed income investment universe, as shown in the chart below. As a result, understanding private debt funds and structural leverage is a good way to understand what you or your clients really have in your portfolio when you own bonds.

Frequently, the intermediate step to securitization is to use a repo line provided by a Wall Street investment bank. The repo line allows the investment bank to get a feel for the underlying loans produced by that lender, and to monitor their performance, as a kind of test prior to issuing a bond backed by these loans.

Once a portfolio of loans is held on a repo line of credit, the next step is to get a rating from a rating agency for a potential bond that will be backed by these loans. Because many private debt funds are comprised of short-term loans, sometimes securities backed by these loans allow for a substitution of loans backing the security. When one loan pays off, another loan with similar characteristics may be placed into the vehicle to replace it. 

With the bond rating in hand, the investment bank then approaches bond investors to sell the security. Typically the yields on these bonds are quite low, because they often have investment-grade ratings. From the issuer’s perspective, they also often provide a higher attachment point than what banks will allow. In other words, they allow the issuer to use structural leverage fairly aggressively, with many turns of leverage, relative to what a bank will allow, which increases the issuer’s returns on their remaining capital invested in the pool of loans.

Fixed Income Securities Outstanding in the U.S.

When the real estate loans are backed by income property such as commercial real estate or apartments, the securities created in the way described here are called commercial mortgage backed securities, or CMBS. When backed by single family home loans, they are called residential mortgage backed securities, or RMBS. Another type of security used in a similar way is the collateralized loan obligation or CLO. For a more detailed discussion, please reference “Commercial Real Estate Lending: The CLO Factor” by Franklin Templeton.12

Section III Case Studies

How Morton Capital Utilizes Private Debt Funds to Deliver Robust and Consistent Returns

While not all RIAs have adopted alternative investments in their client portfolios, some firms consider them to be an important driver of investment income and total returns. Calabasas, CA-based Morton Capital makes it clear to clients that alternatives are a core focus for their advisors and research team. And private debt funds have proven to be a strong area of focus for Morton over the years.

Meghan Pinchuk, Chief Investment Officer at Morton, notes that some clients may have up to 16-18% of portfolio assets placed with private debt funds. That’s a higher percentage than some advisory firms tend to pursue, yet Pinchuk and her team have found that private debt funds provide an ideal combination of solid returns (which often exceed the rates found on high yield, or “junk” bonds), along with lower volatility and risk.

Morton Capital is very selective in the types of debt funds it will invest in. For example, the firm avoids cash-flow based (unsecured) lending vehicles, which bring with them too many variables to ensure consistent payouts. “Asset-based lending is a lot more predictable, especially when loan-to-value ratios are kept at healthy levels,” says Pinchuk. “We have a lot more comfort with this approach.”

Pinchuk notes that there is a wide range of private debt funds to choose from, from aggressively-focused lending strategies that hold the promise of exceptional returns to conservatively managed funds that ensure that risks are kept to a minimum.

When discussing real estate lending, default risk (also known as “foreclosure risk”) comes to mind. Yet conservatively-run private debt funds can virtually eliminate losses due to foreclosures, according to Pinchuk. For starters, loan-to-value ratios rarely exceed 65%. If for any reason a borrower that taps funds from a private debt fund runs into trouble with a real estate development, the significant amount of equity in the property pledged to the private debt fund serves as a strong guarantee of salvaged value. While private debt fund managers have little appetite to press their legal rights in a default and assume control of a distressed asset, their ability to unload that asset and be made whole is an important risk mitigation feature of this strategy.

Notably, a tiny fraction of private debt fund loans ever reach the point of default. That’s testament to the intense scrutiny that potential borrowers of private debt funds must overcome to qualify for loans. 

It’s fair to ask how private debt funds can generate yields above those offered by junk bonds. And the answer comes down to liquidity. Unlike publicly-traded investments that can be monetized with a click of the mouse, investors in private debt funds understand that the timing of distributions must be discretionary. Forced liquidations of a fund, at an inopportune time, can be damaging to all interested parties.

“We understand, and explain to our clients, that it is in our interest to accept liquidity restrictions,” says Pinchuk. “Such restrictions are actually preferred, because without them, other investors might liquidate their interest, leading performance to suffer for those investors that remain in the fund. You want the funds to be able to have complete control of liquidity timing.”

And private debt funds bring another “cost” to the equation—complexity. These funds generate K-1s, which creates some extra paperwork at tax time, because they require an enhanced level of scrunity. Morton Capital is large enough to conduct a substantial amount of due diligence to fully understand the dynamics of the investment vehicle, the philosophy and track record of the management team, and the ongoing status of the fund in terms of the health of the loans in the portfolio.

Pinchuk raises a few more topics that should be part of every advisor’s due diligence: “This can include analyses such as how will the lender be able to handle challenging economic periods? Do they have safeguards and proper risk controls in place?” Pinchuck says that her firm spends many hours with the management teams of private lenders, ensuring a high degree of comfort with their approach and experience.

The SEC requirements in terms of due diligence are a bit of a gray area. Firms like Morton Capital extensively document their due diligence process and retain extensive notes. “That’s just in the upfront process,” says Pinchuk. “We also do an extensive amount of ongoing due diligence from quarter to quarter so we can stay abreast of trends, liquidity events, and other key matters.” 

While there is no such thing as guaranteed returns, Pinchuk has found that asset-based private debt returns have been very predictable throughout the 10 years her firm has been investing in them. Of course, the current era of falling interest rates has put somewhat of a damper on returns. “While we were able to get double-digit returns a decade ago when interest rates were higher, we are still able to garner upper single-digit returns these days, which is an extremely competitive return,” adds Pinchuk. 

So what distinguishes one private debt fund lender from another? “The quality of the valuation process by the lender is the most critical aspect for success,” says Pinchuk. “Done properly, you are likely to see very low default risks,” she says, adding that “defaults don’t mean losses for us, but they can alter the timing of liquidity and lead to a temporary drop in returns.”

Morton Capital has a preference for funds that make many short-term loans rather than fewer long-term loans. That helps to eliminate duration (interest-rate) risk. 

Make no mistake, a core challenge for firms like Morton Capital is to ensure that their clients understand these non-traditional investment vehicles. Pinchuk says her firm lays out a robust education process about the merits of this and other alternative investment approaches. “We are known for focusing on alternative investments, so we attract the kinds of clients that would be amenable to alternative investments like private debt funds,” she says.

Pinchuk concedes that most RIAs have yet to embrace private debt funds, usually because they avoid alternative investments in general. Alternatives have a reputation for exoticism and opacity. Pinchuk argues, however, that private debt funds are far less complex and far more transparent than many other “hedge-fund style” alternative investments.

 
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