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PAGE 8 | Alternative Income for an Unpredictable World: Understanding Private Debt Funds

Overview of Private Debt Funds for Individual Investors

Most investors have typically built and protected their wealth by investing in stocks, bonds, mutual funds, and more recently, index funds that invested in public market securities. Some investors owned real estate such as rental properties, while more sophisticated and very wealthy investors participated in more esoteric investments such as private equity, venture capital and hedge funds, collectively known as “alternative investments”. 

Given reduced expected returns and high volatility of traditional public market investments, alternative investments are now garnering greater interest from wealth advisers and their clients. Among alternative investments, private debt funds are capable of generating attractive income while maintaining a margin of safety. These funds are especially well-suited for investors willing to spend the time to ramp up their understanding of debt funds. 

This two-page summary is meant as background for a white paper entitled, Alternative Income for a Low Interest Rate World: Understanding Private Debt Funds. The white paper suggests that profitable opportunities exist for alternative investments—noting that comprehensive studies have not yet been generated to prove conclusively that private debt funds in particular make a portfolio perform better than a traditional portfolio of only stocks and bonds. However, many investors in such strategies know from experience that these investments can be an attractive complement to volatile, low-yielding public stocks and bonds.

There’s more to investing than stocks and bonds

The chart below shows a traditional recommended portfolio for individual investors, split between stocks and bonds.

traditional portfolio graph

The Federal Reserve has indicated that ultra-low benchmark interest rates are expected to remain in place for at least the next several years. Furthermore, public market investments remain volatile: The S&P 500, for example, fell 33% between February 19, 2020 and March 23, 2020. Over the longer-term, equities have fared well since the Great Recession of 2008/2009, which has led to a reduction in expected future returns for stocks. Meanwhile, bonds deliver paltry yields. In response, some investors are now adding alternative investments to their portfolios, as shown in the chart below. The largest pension funds and endowments have endorsed this approach strongly and have tended to increase their allocation to alternative investments over time.

alternative Investments graph

Potential benefits of well-run private debt funds

Certain niches may offer very attractive returns relative to their risk—for example, making senior secured loans to real estate investors who renovate properties—as long as the loan-to-value ratios remain conservative. Benefits of private debt funds may include:

  • Returns in many such funds have been relatively steady over the past 10 years, in contrast to the volatility of public market investments.

  • Many such funds generate significantly more income than either stocks or bonds. 

  • Some investors are prone to panicking and selling their investments precisely when markets are most depressed. By reducing volatility, and taking some time to liquidate, private debt funds may reduce this temptation.

Issues to consider before investing in a private debt fund

At the same time, investing in private debt funds requires time, energy and the ability to apply your own common sense and trust your instincts. Like any investment, they come with risks. Some issues to consider before investing include:

  • Ensure you or your financial adviser are able to conduct real due diligence on the fund, the manager, and their strategy, before you invest.

  • Understand the underlying investments that the fund makes, and all the key risks that the fund may be taking on to generate its returns.

  • Study the fees charged by the fund manager and ask whether the likely returns justify these fees.

  • Private debt funds are not liquid like stocks and bonds. Understand how long it will take to get your money back when you need it.

In summary, private debt funds may reward investors willing to conduct due diligence on their investments. Most major pension funds and endowments have embraced alternative investments in recent decades. Now may be a good time for individuals to explore private debt funds as a relatively simple way to complement a portfolio that is otherwise tied to the volatile public markets.

Types of Real Estate Loans

Real estate loans come in many shapes and sizes, and they perform very differently from one another in each economic cycle. Real estate loans can be categorized according to three different dimensions—property type, loan size, and maturity. 

Property type 

Consider loans on single family homes being renovated; apartment buildings; retail buildings; hotels; and industrial buildings. During COVID-19, single family homes have been selling briskly at robust prices, and industrial buildings and apartments have been bright spots, but many retail tenants have stopped paying rent, while many hotels remain completely shut down. In contrast, in the Great Financial Crisis, single family homes dropped in value—particularly in the distant suburbs of major cities.

Loan size 

In some cases, the loan size makes a big difference in terms of the interest rate that a borrower pays. For example, a loan on a large apartment building that is going to be renovated may feature a lower interest rate than a loan on a small apartment building. The lender on the large loan has economies of scale in originating and servicing the loan, and is more likely to have capital from institutional investors who are eager to invest in these types of loans. Also, the buyer of a large building is more likely to be an institutional investor and more systematic about creating competition among lenders, thereby commanding better terms than the buyer of a small building.

Loan maturity 

Bridge loans are short term loans that borrowers typically use for one to three years, while repositioning a property. Bridge loans used to purchase property are sometimes known as acquisition loans or purchase money loans. Loans with construction draws are called renovation loans or construction loans. Permanent loans, by contrast, typically have maturities of 5-10 years. Borrowers are more sensitive about the interest rate for permanent loans because they intend to pay the interest for a longer period of time. Many private debt funds focus on shorter-maturity loans because these loans offer the prospect of higher returns, all other things being equal.

 
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