Image Credit: Christophe Vorlet
By Jason Zweig | 12:56 pm ET Sept. 11, 2015
The tougher it gets to squeeze any income out of a bond portfolio, the more tempting it becomes to invest in things that aren’t even bonds.
Investment advisers around the country say clients are asking about increasingly unusual and exotic ways to raise the yield on their portfolios. Among the most common: various “direct lending” opportunities, including private pools of real-estate debt and hedge funds that hold loans to small businesses.
Such funds often offer annual income of 8% or more in a yield-starved world — dazzling many investors into forgetting to be skeptical. But, in fact, as is always the case: The higher a fund’s yield, the greater the scrutiny you should give it.
With many banks spooked out of aggressively making new loans, private funds that act as go-betweens for borrowers and lenders are spreading fast. So far in 2015, according to Preqin, a research firm, 26 direct-lending private debt funds have raised $21 billion; another 115 are seeking to raise $48 billion more. For all of last year, 54 such funds pulled in $32 billion.
Such funds can hold assets ranging from residential or commercial real-estate loans to consumer debt or borrowings by small businesses. While many of these offerings are registered with state and federal securities regulators, others — no one knows how many — are hyper-local deals settled with a handshake and a signature.
Consider PriLend Funding Group, an unregistered fund run by an affiliate of Rizzo, DiGiacco, Hern & Baniewicz, an accounting firm based near Rochester, N.Y. Offered only to “accredited investors who have at least $1 million in net worth and $200,000 in income, the fund seeks to pay “interest based on a fixed rate of 8%,” its marketing material says.
PriLend makes loans at 12%, plus a 3% origination fee, to buyers of “investment real estate that is either rented or sold (flipped),” according to its marketing material. The fund’s manager takes a 5% annual fee. The loans are due in a lump-sum payment after one year, at which point the borrowers should either have flipped the properties or refinanced with a conventional mortgage; if not, they could default.
There is no market for the fund, and investors can’t make withdrawals for two years. To get their money out after that, they need to wait either for loans to be paid off or for money from new investors to cover their withdrawals.
John Rizzo, the senior partner of the accounting firm who also manages the fund, didn’t respond to requests for comment.
Other private loan funds are more liquid and much more broadly diversified.
Direct Lending Income Fund, a $290 million partnership based in Los Angeles, buys small-business loans from such online lenders as Biz2Credit, QuarterSpot and IOU Financial. Since its launch in late 2012, the fund has averaged annual returns of about 12%, according to an investor who has seen performance data.
The Direct Lending fund holds about 3,000 loans at a time from businesses around the U.S., says president Brendan Ross. The loans range between $5,000 and $500,000 and mature, on average, in about one year. The borrowers — small retail businesses such as dentists and gas stations — pay rates averaging 25.5% annually.
The fund holds loans only from borrowers that rely on a wide range of customers, and an average of only about 5% of the loans default, says Mr. Ross.
Because of the high income and short maturities, he says, “this fund could withstand an absolute hammerblow of defaults and still deliver far more income than what you can get elsewhere today.” Investors can cash out monthly.
Still, argues Todd Petzel, chief investment officer at Offit Capital, an investment firm in New York that manages $9.2 billion for wealthy clients, “as we saw in 2008 and 2009, when credit markets go awry they don’t necessarily go according to the script.”
Mr. Petzel worries that investors in such a fund could be left unable to cash out promptly without incurring steep losses. He says that, to be adequately compensated for the extra risk, investors should be earning more than 12% on loans that the borrowers paid more than 25% to get.
These borrowers are good credit risks, says Mr. Ross, but pay up largely because small-business loans are expensive for lenders to service.
Direct Lending is unleveraged — it doesn’t invest with borrowed money — and about 15% of the portfolio’s loans mature or are prepaid each month, he says.
In a credit crunch or market panic, the fund would limit redemptions and let the loans mature without selling them, says Mr. Ross, so “investors that stay in the fund should not experience the sale of assets at a discount.”
With interest rates so low, he contends, “you’re going to have to replace your traditional fixed income with some direct-lending funds if you want to have any return.”
But you could also simply wait; once rates begin to rise, the income on conventional bonds will go up too. And high-quality bonds offer safety and stability that can be even more valuable than income in a crisis. For most investors, the risks of direct lending probably outweigh the rewards.
Source: The Wall Street Journal
http://blogs.wsj.com/moneybeat/2015/09/11/what-to-ask-before-you-reach-for-yield/