A private debt fund specializes in the kind of lending activity that’s handled by a variety of entities aside from banks. These funds raise money from investors before lending that money to a wide range of companies. While a private debt fund is mainly used as an alternative to traditional bank lending, it also can provide investors with access to steady returns that occur from having private debt as a separate asset class. This particular form of investment has become increasingly popular since the 2008 financial crisis. In fact, the overall value of these debt funds has almost tripled globally between 2010-2019.

After the Great Recession of 2008, private debt funds grew in popularity because U.S. banks stopped taking on investments that they deemed to be risky. Since smaller companies oftentimes have difficulty obtaining funding for their business, they turned to private investments, which allowed private debt funds to increase significantly in popularity. Private debt currently accounts for a substantial portion of the private investment markets. If you have been searching for new investment opportunities and are interested in private debt funds, this article provides a detailed guide on what private debt funds are and when they can be used with commercial real estate projects.

Who Invests in Private Debt Funds?

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There are many individuals who find it beneficial to put their money towards a private debt fund. For instance, this form of investment is particularly common among peer-to-peer lenders. Peer-to-peer lending allows individuals who are looking for a loan to borrow money from other individuals. When you start to engage in peer-to-peer lending, this means that you are cutting out the middle man, which is usually a financial institution. While peer-to-peer lending has a high amount of risk to it, the loans are usually able to provide higher returns because of steep interest rates imposed on the borrower.

Since banks aren’t involved in the process, borrowers have a higher chance of obtaining one of these loans when they have poor credit. Because of this, providing one of these loans to borrowers with poor credit increases the risk that peer-to-peer lenders take on. For the borrower, this lending option provides them with the opportunity to obtain money from several different individuals as opposed to a single financial institution.

Specialized Entities also Invest in Private Debt Funds

Along with peer-to-peer lenders, specialized entities and companies that focus mainly on certain segments of the economy can also invest in a private debt fund. For instance, an investment firm that specializes in real estate investments may handle private debt funds. A private debt fund will usually employ lending teams that have strong and reliable backgrounds in investment banking as well as expert knowledge of the market that they operate in. When an individual investor decides to partner with an investment firm that focuses on real estate, they can be confident that the firm will manage their investments properly.

Private Debt Funds are Different than Investing in Private Debt

Private debt funds are designed to provide and manage portfolio loans rather than invest in private debt. These debt funds don’t invest in any kind of public market, which avoids the unpredictable element of investing in stocks. Instead, these funds can provide and manage an entire portfolio of loans that are made by individual investors. A loan that’s obtained from a private debt fund can be of many different sizes and may be worth millions of dollars. Some firms that manage private debt funds will require individual investors to provide a minimum amount of money before they are able to invest, which could be anything from $1,000 to $1 million.

Strategies for Private Debt Fund Investments

There are many different ways to invest in private debt funding if you’re interested in doing so. The strategy that works for one investor may not match well with the portfolio of another investor. Before you begin investing in private debt, it’s recommended that you study each strategy available to you.

Venture Debt and Private Debt Funds

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Venture debt financing is provided to companies that already have venture capital backing. The majority of businesses that are able to obtain venture debt financing will have already successfully gone through at least two rounds of equity fundraising with venture capital firms. Instead of being provided with capital, investors are given warrants for common equity because of the high-risk element of this investment. These warrants allow investors to obtain a stake in the company at a later date.

Companies take out these types of loans when they want to reach certain milestones or to acquire sizable assets that are necessary to reach such milestones. When a company gets to this point, it will almost certainly have garnered a certain level of success. In fact, most startups and businesses won’t be provided with venture capital or venture debt unless they have already proven themselves in some way. The main benefit provided to entrepreneurs who decide to take out this type of loan is that it allows them to avoid diluting ownership. Since warrants provide investors with a promise that they can purchase stocks at some point in the future, the company that obtains this loan is able to retain the equity stake of existing investors for the time being.

If you want to take part in venture debt financing, you will likely need to be a part of a venture capital firm, which is easier once you’ve invested as an angel investor. Along with a relatively high-interest rate, the warrants that you obtain from your investment may allow you to eventually obtain a high return on your investment if the stock is worth more when you’re able to purchase it.

Special Situations for Private Debt Fund Investing

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There are also special situations where someone may be able to invest in a private debt fund. These special situations occur when debt or structured equity investments are made with the goal of obtaining control of a company. This usually occurs when the company is in financial distress. While you might find it to be counterintuitive to invest in a failing company, there are ways to make money with this kind of investment. Investing in a company that’s in financial distress can include trading within the secondary market via distressed debt or direct origination. The secondary market involves making an investment into the stock of a business through a secondary source, which means that the investment isn’t made with the company in question.

Direct origination occurs when loans are made to companies without the involvement of an intermediary. These loans will oftentimes include second liens and credit lines. As for distressed debt, this form of investing involves purchasing securities through a secondary market when the company in question is on the verge of going bankrupt or is performing poorly in general. The investor will purchase bonds that allow them to take control of the company.

If you want to invest your money into a distressed company, your main goal should be to determine if the company can get back on track once you take control. While some investors choose to purchase shares in the troubled company, it may be wiser to invest in the company’s debt. Since you will become a creditor for the company, this gives you the opportunity to direct what happens to the company during liquidation or reorganization.

Investing in Private Debt Funds via Real Estate Debt

White, grey, and red house for sale

Among the more common strategies of investing in private debt is to invest in real estate debt, which typically occurs by direct lending for real estate acquisitions. This money can be lent to existing owners of real estate property as well as prospective buyers who are currently in the market. When you invest in real estate debt, your returns will mainly consist of monthly interest payments that are made against the principal of the loan, which usually allows for steady returns. You will also receive security with this investment via a mortgage, which means that you can take control of the property if the borrower happens to default.

This type of investing is highly popular because it provides borrowers with fast turnarounds where they can purchase the property quickly without needing to go through a lengthy approval process. Banks aren’t involved in this process, which makes it much more straightforward. While it’s possible to invest in residential homes through real estate debt, you can obtain solid returns by investing in commercial real estate. There are also many different types of commercial real estate investments, which should make it easier for you to diversify your portfolio.

Private Debt Funds in Commercial Real Estate

commercial real estate with blue sky in background

Private debt funds are commonly used in commercial real estate to quicken the process of obtaining a loan. When it comes to commercial real estate, the investors who borrow will typically use the loans for bridge loans, rehabilitation loans, redevelopment costs, as well as commercial construction loans. While many borrowers will choose to obtain a loan from a bank, it’s usually faster to apply for a loan directly from a private debt fund because borrowers won’t have to deal with the bureaucracy and lengthy approval process of banks.

*Disclaimer: The statements and opinions expressed in this article are solely those of AB Capital. AB Capital makes no representations, warranties or guaranties as to the accuracy or completeness of any information contained in this article. AB Capital is licensed by the Financial Division of the California Department of Business Oversight as a California finance lender and broker (DBO Lic. No. 60DBO-69427). AB Capital makes money from providing bridge loans. Nothing stated in this article should be interpreted, construed or used as legal, financial, investment or tax planning advice, or a substitute for thorough due diligence and the exercise of sound independent judgment. If you are considering obtaining a bridge loan, it is recommended that you consult with persons that you trust including but not limited to real estate brokers, attorneys, accountants or financial advisors.