November 22, 2023

12 Specific Questions for Evaluating Private Credit Funds

The $1.5 trillion private credit market is expected to grow nearly another trillion over the next five years, bringing it top of ­­­­mind for investors.¹ As private credit carves out more space within well-managed portfolios, it’s important for investors to understand the different strategies subsumed under private credit – direct lending, senior secured, mezzanine and other forms of lending – and how to navigate their respective nuances and typical loan terms.

Underwriting and loan structuring provide significant lines of defense against potential losses, and investors should not be shy about asking the hard questions. Here are several specific points to raise with managers before making a private credit fund investment.

Topic 1: Fund Leverage

1. How much fund leverage does the fund use?

Why: Most funds use leverage to increase returns. The fund’s loans act as collateral and create a net interest margin between the rate paid and the amount charged to borrowers. Some of the most popular private credit firms employ 1 – 2X leverage in terms of debt to equity. This introduces a level of risk that needs to be addressed. The last 12 years of economic expansion and abundant liquidity do not provide a good representation of risk associated with taking on fund leverage. Utilizing fund leverage enhances returns, but excessive leverage amplifies the amount of risk taken by the strategy. As fund leverage increases, the margin for error erodes, increasing the reliance on underwriting, loan structuring and monitoring.

2. What is the cost of that leverage?

Why: Depending on the average life of a fund’s loans, some fixed rate loans may have lower interest rates than the current rate of borrowing. Consequently, the fund’s net interest margin may have shrunk. It is vital to determine if the spread is worth the risk or simply a way for the manager to charge more fees. Ask the manager what their cost of debt capital is and evaluate granular details like structure, maturity, covenants and whether the fund’s leverage is floating or fixed.

Topic 2: Fund Structure and Vintage of Fund Assets

3. Is the fund open-ended or a fixed term?
4. If it is a fixed term, what is the duration?
5. Does the fund pay a yield, or recycle the returns until the harvest period?

Why: Fund structure should align with your goals. If you value liquidity in private credit, you are generally better off with an evergreen or an interval fund. There is some downside risk, like valuation risk, but values generally carry significantly less volatility in credit than equity. If you value yield, make sure the fund pays out the bulk of investment income instead of recycling it. Some funds recycle returns during the investment period to increase returns, but this creates more risk than having capital returned to investors.

Finally, evaluate the investment period of the fund. While longer-term fund structures are often necessary in private equity and venture capital, they may be exploited by private credit fund managers to trap capital and impede portfolio re-balancing.

6. What is the average age of the portfolio or is this a new vintage fund?

Why: The last 20 months have shown unprecedented fast-paced interest increases. Loans issued prior to 2022 have conditions significantly more favorable to the borrower. If you are buying into a pool of existing loans, it is vital to understand when they were issued. In general, an investor is better off allocating to a new vintage fund where all the loans will be originated in the new, higher interest rate and stronger covenant environment. A tradeoff for investing in a newer vintage fund is that in the early stage, there may temporarily be less diversification as the fund builds out its loan portfolio.

Topic 3: Loan Characteristics

7. Ask for the typical breakdown of key loan characteristics:
   • What is the typical term?
   • Are the loans floating or fixed rate? If they are floating, do you have floors on the index rate, and are they set at the prevailing rate at close or lower than the current index?
   • What is typical call protection?

   Why: The term is important from a risk perspective. Longer-term loans generally bear more risk to the lender. For example, if you originated long term fixed rate loans in 2021 when the Secured Overnight Financing Rate (SOFR) was around 50 bps, the value of your loan or bond will have dropped considerably. Real estate is another good example. Any fixed income stream loses value when interest rates go up.

   If the loans are floating, having floors and setting them high is also important. Given forward yield curve expectations, the market is implying rates will come down over the next 12-36 months and having floors will preserve the income from those loans. While this might prove to be incorrect, the best structure from the lender’s perspective is to have floors set at the prevailing index rate at close, so you receive the upside of any future rate increases and are protected from the downside if the Federal Reserve begins cutting rates. Additionally, understanding the typical call protection is vital as it entitles the lender to receive additional fees if the borrower looks to refinance. The better the call protection, the more leverage the lender has to retain their best borrowers.

   • What is the typical term?

   What percentage of loans have required amortization? Are they interest-only or only paid down through an excess cash flow sweep?

   Why: Mandatory amortization is another key attribute for downside protection. Meaningful amortization reduces your exposure throughout the term of the loan, achieving lower leverage and increased collateral coverage. When coupled with a strong covenant package, like a fixed charge coverage ratio, it provides stronger guardrails for the borrower. Prior to 2022, amortization regimes have continued to become extended, inuring very much to the borrower and its equity holders.

   • Ask the manager to provide a breakdown of the sources of return and disclose whether the investor is entitled to all fees paid to the lender:
     • What percentage is cash interest?
     • What percentage is Paid-In-Kind (PIK), Original Issue Discount (OID) and other non-cash income only monetized at maturity?
     • Is there additional upside with equity kickers or other forms of consideration?

   Why: Many lenders use OID and PIK interest as a tool to increase their returns and entice the borrower with preserved cash flow for additional reinvestment into growth. In general, the more PIK the loan carries, the more risk on the lender, as you are deferring your returns. PIK interest also generates phantom income, which requires you to pay tax immediately even if the realization of the interest is years away. With all other forms of consideration, it is good to get a breakdown of cash returns, non-cash returns and see if any considerations, like equity kickers, achieve long-term capital gains treatment that can improve after-tax returns.

   • What is the target size of the loans the fund is investing in?

   Why: There is direct evidence to support that bigger loans are more competitive than small and medium-sized loans.² The bigger the loans, the more players typically involved. In large deals, an overlap of the established leveraged loan market and competition creates a ‘race to the bottom’ as far as losing protections are concerned.

    

   Topic 4: Originations

   8. What percentage of the portfolio is directly originated where the manager is a lead or co-lead, and what percentage of the portfolio is invested through participations with other lenders being the lead?
   9. What percentage of loans are originated through an investment banker or broker vs. direct?
   10. Can you break down where the manager’s deal flow comes from?

   Why: If the manager is routinely working with other agents or leads and not originating their own deal flow, there is a high likelihood you are paying two sets of fees. In most cases, the originator of the loan will syndicate pieces of the loans to other managers and charges other participating lenders a fee for doing most of the work. If the manager gets most of their deal flow through investment bankers or brokers, there are additional fees related to sourcing from those entities.

    

   Topic 5: Fee Structures

   11. Does the fund charge management fees on contributed capital or commitments, and on assets or equity?
   12. Does the fund charge performance fees on unrealized returns?

   Why: Unlike private equity funds, private credit funds often charge management fees only on committed capital. If the fund charges management fees on assets and is using 2X leverage, the investor is paying exorbitant fees. For example, if the fund charges a 1.25% fee on assets, you are paying a 3.75% management fee on equity! If a manager heavily relies on PIK, OID and other non-cash features to generate returns, charging performance fees on unrealized income increases risk for investors and mis-aligns incentives.

   We hope these questions are a useful starting point for investors seeking to understand key aspects of direct lending within the broad category of private credit. There is much more to cover in the areas of overall strategy, origination process, underwriting, loan structuring, monitoring and workout experience and process. We would be happy to have a deeper discussion to shed light on all aspects of a strategy before making your decision to invest.

    

   ^{1 Bloomberg, as of September 2023.}

   ^{2 Moody’s Investor Service Report, as of October 2023.}