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.