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.

2.) Calculate the unlevered returns of the debt fund you are considering. An interesting test of a debt fund's track record is whether its unlevered returns stand up to scrutiny. Frequently, debt funds will borrow money with the objective of enhancing returns, and many funds are leveraged one to two times-or sometimes more-on the total amount of actual capital available. While leverage can magnify returns, it can also magnify losses, which the 2008-2009 financial crisis made apparent. Spend time with the fund's managers to get an understanding of their use of leverage. The yields and total returns for well-underwritten loans should be attractive enough without leverage.

3.) Understand the debt fund team's ability to consistently originate high-quality and diverse loan opportunities. You should be investing in a portfolio of loans that are diverse and in continuous motion. This means that at any given time, some loans are being paid off while others are being paid down and new loans are entering the portfolio. Beware of debt funds that are overly "lumpy" in terms of quality and the volume of deal flow; this could indicate inadequate loan due diligence, insufficient diversification across industries or insufficient fund sources for new loan opportunities. All could hurt the yield and ultimately the total return of the portfolio.

4.) Ascertain the debt fund's experience with covenant protection. When all is said and done, the fundamentals associated with underwriting and structuring a loan to ensure repayment have not changed. Debt teams should be highly experienced in structuring loan covenants in the lending documents to protect the loan from losses should the borrowing company come under financial stress. Each borrower's financial profile is unique. Have the managers discuss specific examples of how they structure these clauses in the documents and give some current examples.

5.) Beware of debt funds that are too large. The larger the debt fund, the greater the likelihood that the fund managers will build a portfolio of diverse holdings that can sometimes dilute simple unlevered private-market debt returns. The more diverse the holdings, the greater the chances that portfolio returns will become less distinctive and imitate the broader markets. This causes the same problems that private-market debt investing is supposed to cure.
At the same time, larger debt funds will also generally need to move further upstream and work with debt from larger companies, where there are more investment competitors and therefore lower yields. The challenge is to identify stable debt fund firms that can easily raise capital for these private loans and find new investors to fund them.

Today, thinking outside the traditional fixed-income box to achieve intergenerational capital preservation and regular income distribution is a challenge. But when armed with the right due diligence, family offices may find private-market debt to be an increasingly critical part of their portfolios.

Michael McNabb is the director of investor relations for the Debt Investment Group of GB Merchant Partners.