Earlier this month, I had occasion to congratulate an old friend-a multifamily office executive-on the addition of a new family trust relationship to his firm.
Even though he was excited about it, he shared a cautious sentiment on the minds of many family office managers today: He said that we need to think of alternative ways to generate income in the current capital market environment if we are to fulfill the needs of our clients' trusts and their beneficiaries.
The reality is that today's unprecedented low interest rates have changed most operating and investment assumptions for all investors, but especially those who manage money at family offices. The Federal Reserve's continued policy of keeping rates low has reduced already anemic returns in U.S. public market debt. This strikes at the heart of the family office's traditional twin investment goals-to preserve capital for future generations and distribute regular income.
Indeed, there are a fairly limited number of suitable proxies for the traditional fixed-income component of such portfolios. The yields in U.S. public market debt are so low that clients will likely have to draw on principal. One approach to that problem is to extend the maturities of a U.S. fixed-income portfolio, but that increases the risk of principal erosion when interest rates inevitably rise.
Another option is to invest in traditional public market high-yield funds and distressed debt. While that idea is appealing for managers seeking overall yield, a debt portfolio comprising only these investments would be exposed to ongoing price swings and be vulnerable if the dramatic market conditions we saw in 2008 repeated. We continue to weather these conditions today, if to a lesser degree.
A third choice is to seek higher yields by purchasing foreign public debt, including that of emerging markets. The challenges with this approach have been very clear over the past year, as investors faced overseas currency fluctuations and as chronic volatility gripped the global public markets.
However, there is a fourth fixed-income strategy beginning to gain traction: investing in private-debt funds for U.S. middle-market companies. In essence, an investment made by a family office in this type of fund becomes lending capital for a portfolio of businesses. These loans are often secured by the assets or enterprise value of the entities they invest in. By putting money into a direct-lending portfolio, investors receive returns from private market loans that typically offer higher returns than U.S. public debt does. Benefits of investing in a direct-lending portfolio can include stable income (derived from the loan note). They also tend to be less volatile than public market debt and loan terms are transparent.
Not surprisingly, this kind of private market debt has become much more available as traditional bank loans to middle-market businesses have dwindled. Middle- to smaller-tier banks have been disappearing (after a wave of consolidations and failures) and new regulations have constrained more traditional bank lending. New firms are filling this lending gap (and taking advantage of the return potential), including private equity firms, hedge funds, finance companies and smaller investment management firms.
The question for family offices is: What are the top due diligence considerations when exploring U.S. private-market debt fund investments?
Top Five Due Diligence Considerations
1.) Consider the reputation of the debt fund firm as both a qualified and creative lender as well as a seasoned investment manager. The ideal firm has a demonstrated and rigorous underwriting process coupled with the skill to manage risk at the portfolio level. You need to be confident that you are working with an experienced lender that has a team of proven investment professionals who can construct and monitor a well-diversified portfolio of loans.