Private Debt Funds are Attractive Right Now—But You Must Ask These Questions First

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Considering investing in a private debt fund? 

Right now, against the backdrop of market volatility and increased interest rates, private debt funds are attractive to passive investors who want to diversify their real estate investments while achieving steady returns. 

Unlike syndications, which are inherently riskier because of speculative pro forma, private debt funds can provide more stable and predictable returns, albeit with less upside potential than syndications may offer. For those seeking more consistency in their return profile, private debt funds are an excellent choice that often have shorter lock-up periods and provide cash flow almost immediately, as compared to syndications, which have longer, less predictable return expectations. 

There are several key performance indicators (KPIs) you can use to compare private debt fund offerings, including:

• Preferred return
• Targeted return
• Waterfall profit splits—if any
• Lock-up period
• Redemption options
• Total assets under management (AUM)
• Composition of the other limited partners (LPs)

These are just a few questions that allow a prospective investor to evaluate multiple fund offerings with information that can typically be found on a lender and/or fund manager’s website. 

However, most public information, as well as specific fund documents such as private placement memorandums (PPMs) or limited partnership agreements (LPAs), only provide broad-stroke commentary on mandate and execution to avoid clauses that can be too confining and subject the manager of the fund to potential risk and litigation. Fund mandate and subscription agreements are often based on boilerplate legal documents from security attorneys, giving the fund manager a fair amount of discretion.

Basic Questions to Ask

So, how do you get to the real meat and potatoes of what a fund provides in terms of historical performance, risk, and cultural fit? Here are essential topics you should address with a prospective fund manager or management team before deciding.

Track record

How long has the fund been in service, and how has the fund performed historically? Request details on past investments, returns, and any challenging periods they navigated successfully. This includes past funds and investments made by the management team in the same asset class (real estate). 

Portfolio strategy

What is the fund’s approach to loan underwriting and due diligence? Understand the risk appetite and loan-to-value guidelines, historical principal loss and default rates, diversification strategy, and alignment with your investment goals.

Risk management

How does the fund manager assess and manage risk? Inquire about their risk assessment process and how they protect investors’ capital during turbulent market conditions. How do they model for future adverse scenarios?

Fund duration

Is the fund open-ended or close-ended? Does the investment horizon of the underlying investments (assets) match the fund’s cash flow and investor flows (liabilities)?

Fees and expenses

 Is the fund manager transparent about all costs involved, including management fees, performance fees, and any other charges? Consider asking them what their expense ratio is historically. 

Fund size

How much capital is currently under management? This gives insight into the fund’s scalability and the manager’s ability to deploy capital effectively. Moreover, what is the composition of the other investors in the fund—are they individuals or institutions? Does one investor account for over 25% of the assets under management?

Lock-up periods and redemption rules

What rules exist around requesting a redemption or a return of your capital? Are there investor-level gates or throttles to safeguard the fund and its investors from liquidity risk?

Co-investment

Inquire if the fund manager invests their own capital alongside the investors. This indicates their confidence in their own strategies, and they have “skin in the game.” Never trust a chef who doesn’t eat their own cooking.

Distribution and communication frequency

Are distributions monthly, quarterly, or some other time frame? How often will they provide updates on the fund’s performance and risk analytics, and what kind of information will be included?

References

Request references from other investors to get a sense of their experiences and satisfaction with the fund manager.

Going Beyond the Basic Questions

All these questions are fairly basic to ask when interviewing a fund manager. But to really distinguish between managers with proven success and those who don’t meet your expectations, you should ask these questions as well:

Is your historical performance verifiable through an external audit or another method? 

How often are those conducted? While not all funds have mandatory audits, prospective participants should still be requesting how performance can be proven and validated. Also, be sure to ask about the fund manager’s former experience and successes—is that verifiable?

Do you use a third-party fund administrator who performs trust accounting and financial reporting, or is this done in-house? 

While it’s fine to have accounting facilitated in-house, it’s better to have these services provided by an objective third party who can verify and defend fund performance while applying appropriate generally accepted accounting principles (GAAP) that non-CPAs may not be well versed on, particularly as it relates to private debt funds. 

Does your fund have a catch-up clause in case you are unable to meet the preferred return? 

Funds do not always meet their targeted return, meaning that a shortfall is created between the targeted return and the realized return in a given accounting period (monthly, quarterly, and/or annually). When this occurs, do the investors roll over the shortfall into the next account period and receive a future preferred catch-up return before management gets their next set of fees, or do the managers forget about past shortfalls and participate in all the future upside?

What strategies do you employ to handle non-performing loans (NPLs) to avoid diminished returns and cash drag? 

Understand how loans in default affect the performance of the fund—both positively and negatively. For instance, if a loan is in default but has a large equity buffer, the fund would benefit from high default interest rates while the loan is being worked out or foreclosed on. The downside to this situation is that it can take months or years to achieve these rates of return, depending on the state’s foreclosure process and timelines. 

Does your fund employ leverage? 

Particularly in an uncertain economy like the one we’re in today, the use of leverage amplifies risk much more than it amplifies returns. Leverage, which is the use of debt, or typically bank debt collateralized by fund assets to make additional investments greater than the actual assets under management invested into the fund, has slowed down or shuttered lenders unable to pay down increasingly expensive costs of capital in adverse market conditions.

This last question is arguably the most important question to ask because if a fund is leveraged, participants unknowingly assume a junior position to the credit facility that provides the leverage, as there is a creditor (bank debt) ahead of the equity (investors). Borrowers seeking conventional loans are scrutinized by their debt-to-income ratio, and rightfully so—why shouldn’t private debt funds?

The Bottom Line

Remember, due diligence is key when considering any investment opportunity. Make sure you feel confident and informed before committing your capital to anyone or any investment vehicle.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.