Investors have been lured towards the promising prospects of private-credit interval funds (PCIFs)⁽¹⁾ and nontraded business-development companies (BDCs)⁽²⁾, amongst other exotic investment vehicles, which predominantly focus on private debt. Investors also have the option of investing in merchant cash advance (MCAs)⁽³⁾ or factoring companies⁽⁴⁾. These companies provide financing to businesses by advancing funds against their future credit card sales or accounts receivable, respectively. The rates charged by these companies can be very high, often in the range of 20-50% or more, and are typically considered to be alternative or non-traditional sources of financing.

The distinct characteristics of private debt – high-yielding income, portfolio diversification, and flexible lending options to entities in dire need of capital – have been major drivers of this attraction. However, it is crucial to recognize that funds investing in private assets must be evaluated distinctly from public investments, as private debt instruments are not traded in public markets. Thus, customary risk measures that hinge on market prices variations and price discovery mechanisms are deemed inadequate in evaluating such assets.

I. Introduction

Investors have always been avid in their pursuit of opportunities to diversify their portfolios and achieve lucrative returns. Over the past few years, PCIFs, BCDs and MCAs have emerged as popular alternatives for those seeking a high-income generating investment that offers diversification beyond the conventional investment avenues such as stocks and bonds. However, the reality of investing in these alternative assets is far more multifaceted than what is typically advertised. It is not uncommon for some funds to exaggerate their ability to deliver high returns with minimal risk. In this blog, we’ll explore the nuanced risks and rewards of investing in PCIFs, BDCs and MCA’s providing alternative strategies for achieving similar benefits without the accompanying drawbacks.

II. Private debt investments and their appeal

The allure of private debt investments, such as PCIFs and nontraded BDCs and MCAs has been steadily increasing among investors in recent years. These investment vehicles are becoming increasingly popular due to the high returns they can offer, coupled with the diversification benefits they provide. Private debt investments involve lending money to corporations and other borrowers who may have limited options, resulting in interest rates that can soar as high as 11% or more in PCIFs, BCDs due to their hunger for capital and 20% to 50% or more in MCAs due to factors requiring immediate access to capital. Such loans are typically short-term and offer floating interest rates, making them less vulnerable to severe losses when rates increase. The author of this article has had extensive experience working with many MCA’s and these experiences have led to the conclusion that the investment in this alternative asset class takes an inordinate amount of due diligence to find the “right” company in which to invest and nerves of steel once the investment is made and the returns are received.

According to Robert A. Stanger & Co., PCIFs and nontraded BDCs took in over $104 billion in new money in 2022, up 23% from 2021 ( https://thediwire.com/non-traded-alternative-investments-raised-record-104-billion-in-2022). This impressive surge in popularity is hardly surprising, given the current market conditions where investors are eager for yield and diversification. Private debt investments are an attractive option for many investors as they can provide both of these benefits, which makes them an appealing option for those seeking alternatives beyond traditional stocks and bonds.

III. Investor profiles

Private debt investments may be more suitable for certain types of investors, such as institutional investors, high net-worth individuals, or accredited investors. For those into the more risqué investment opportunities, MCAs offer a high risk, abnormally high return to investors with a greater risk appetite. These investors have tolerance for a higher risk level and can afford to allocate a portion of their portfolios to alternative investments like private debt. They are also more likely to have access to specialized investment advice and resources, enabling them to better navigate the complex world of private debt investments. Retail investors with limited experience or lower risk tolerance should be very cautious when considering private debt investments and seek professional advice before making any decisions. As an old Russian proverb aptly states, “doveryai no proveryai” Trust but Verify!

IV. Misleading claims of low risk

Despite the increasing popularity of private debt investments, there are many concerns regarding the claims made by certain funds regarding the level of risk involved. Some funds make grandiose claims about their risk and return, suggesting that investors can achieve high returns with barely any risk.

It is important to note that funds investing in private assets must not be judged by the same standards of risk as public investments. Private debt does not trade in public markets, and their reported prices are “smoothed”, meaning they don’t fluctuate nearly as often or as sharply as conventional stocks and bonds. This means that customary measures of risk, which are based on how much prices vary, do not apply.

Therefore, investors should exercise the utmost caution when considering private debt investments, and not solely rely on claims made by funds or companies regarding their level of risk and return. It is crucial to conduct proper due diligence and consider the actual risks involved before investing in such assets.

V. The challenge of measuring risk in private investments

It is important for investors to use appropriate measures of risk when considering private investments. Without accurate assessments of risk, investors may be exposed to unexpected losses and other negative outcomes. As with any investment, it is crucial to carefully evaluate the risks and benefits before making a decision. Retail investors with limited experience or lower risk tolerance should be cautious when considering private debt investments and seek professional advice before making any decisions. Some of the widely used models to assess risk in finance are the Sharpe ratio⁽⁵⁾, along with CAPM⁽⁶⁾, VaRV⁽⁷⁾, Black-Scholes⁽⁸⁾ and Monte Carlo simulation.⁽⁹⁾ (For more information on financial risk modeling see Wikipedia.)

VI. Hidden risks of private debt investments

Private debt investments come with hidden risks such as illiquidity, limited withdrawal options, high management and incentive fees, and limited due diligence by some funds. Many US private-credit funds outsource their due diligence, relying on third-party assessments that may not be as rigorous as those conducted by fund managers. Investors should evaluate these factors when considering private debt investments to ensure they are aware of the potential risks.

VIII. Impact of economic cycles

Private debt investments can be influenced by different stages of economic cycles, such as periods of economic expansion or recession. During periods of economic growth, private debt investments may perform well as borrowers are more likely to repay their loans and default rates remain low. However, during economic downturns, private debt investments may face challenges as borrowers struggle to meet their obligations, leading to higher default rates and potential losses for investors. Understanding the potential risks and opportunities associated with investing in private debt in different market conditions can help investors make more informed decisions and better manage their portfolios.

XI. Alternative ways to invest in private credit

Private debt investments, while offering attractive returns and diversification benefits, can pose significant risks due to the limited regulatory oversight and lack of transparency inherent in these investments. Investors must remain vigilant in order to safeguard against potential fraud and misconduct, as private debt investments are not subject to the same level of disclosure requirements as public investments. Due diligence is essential, and investors should research fund managers’ historical performance, fees, and track records. Seeking advice from financial experts can also aid in making informed investment choices.

An alternative approach to investing in private-credit funds (https://www.mackenzieinvestments.com/content/dam/mackenzie/en/brochures/mi-your-guide-to-investing-in-private-credit-en.pdf) is to purchase stock in firms that offer such funds, such as Apollo Global Management Inc.(APO-NYSE), Blackstone Inc.(BX-NYSE), Carlyle Group Inc.(CG- NASDAQ), and KKR & Co(KKR-NYSE). This provides investors with exposure to the private credit market without the high fees typically associated with private credit funds. Purchasing stock in such firms allows investors to share in the fee income generated by these funds, as well as potential upside from the firm’s overall portfolio performance. Moreover, stock investments can offer greater liquidity compared to investing in private-credit funds. By diversifying their portfolios, investors can spread their risk and optimize their investment returns while mitigating potential losses.

X. Conclusion

Investing in private debt can indeed be a risky and complex endeavor for investors, as it entails a variety of hidden risks and challenges, ranging from high management and incentive fees to limited liquidity and due diligence. However, the Financial Policy Council (FPC) acknowledges the significance of private credit in promoting economic growth and wealth creation, particularly within the Investment silo sector. The FPC is committed to fostering an environment that nurtures innovation and prosperity, in line with the country’s founding principles of free enterprise and wealth creation. By advocating for initiatives that contribute to a thriving environment for silo companies and investors, the FPC plays a vital role in upholding the American spirit of progress and opportunity. As investors, we can also participate in advocating for public policy solutions that support our investments and contribute to economic growth and prosperity.

In conclusion, it is crucial to be cautious when investing in private debt and to exercise skepticism regarding claims of low risk and high returns. Misleading claims, coupled with the difficulties of measuring risk in private investments, can make it challenging for investors to make informed decisions. Investors should also explore alternative ways of investing in private credit, such as buying stock in firms offering these funds, which can provide a share of fee income and the upside of their portfolios if they deliver returns like they have in the past. Ultimately, due diligence is key to making successful investments in private debt.

If you find this blog post informative, I encourage you to share it with your friends and colleagues. Additionally, I invite you to leave a comment below with your thoughts on the topic or any questions you may have. Furthermore, we suggest that you explore the resources shared, including the SEC’s investor bulletin on private funds, to gain a deeper understanding of the risks and benefits associated with private debt investments. Lastly, if you’re considering investing in private credit, I urge you to seek professional advice from a financial expert before making any investment decisions. By taking these steps, you can help protect yourself from the risks associated with private debt investments and make informed decisions that align with your investment goals.

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Footnotes:

1. Private-credit interval funds (PCIFs) are a type of investment vehicle that allow investors to gain exposure to the private debt market. These funds typically invest in high-yielding, non-traditional loans to businesses that aren’t publicly traded. Unlike traditional mutual funds, they offer shares to investors on a periodic (interval) basis, rather than continuously. These funds are generally less liquid than traditional mutual funds, meaning investors may only be able to buy or sell shares at specific intervals, such as quarterly or monthly.
2. Business Development Companies (BDCs) are publicly traded, closed-end investment funds that invest primarily in small and mid-sized private businesses, often providing capital for growth, mergers, acquisitions, and restructuring. BDCs are designed to facilitate the flow of capital to businesses that might not otherwise have access to funding and, in return, they offer investors the potential for high yields. They are regulated by the U.S. Securities and Exchange Commission.
3. Merchant Cash Advances (MCAs) are a type of financing where a business sells a portion of its future credit card sales in exchange for immediate funding. This is typically a short-term solution with a high cost of capital.
4. Factoring Companies, on the other hand, purchase a business’s unpaid invoices (accounts receivable) at a discount. The factoring company then collects the full amount from the customer, essentially providing the business with immediate cash flow. This is often used as a financial solution for businesses with long invoice payment terms.
5. The Sharpe ratio is a measure of risk-adjusted return on an investment, which compares the excess return above the risk-free rate to the volatility of the investment’s returns. It was developed by Nobel laureate William Sharpe and is calculated as the difference between the expected return of an investment and the risk-free rate of return, divided by the standard deviation of the investment’s return. The Sharpe ratio is used to help investors understand how much excess return they are getting for the amount of risk they are taking on. Higher Sharpe ratios are generally considered more desirable, as they indicate higher returns relative to the amount of risk taken on.
6. Capital Asset Pricing Model (CAPM): This model is used to determine the expected return on an asset based on its systematic risk or beta. It assumes that investors are risk-averse and require a risk premium for taking on additional risk.
7. Value at Risk (VaR): VaR is a statistical technique used to measure the maximum potential loss that an investor could incur on an investment over a given time period and confidence level.
8. Black-Scholes Model: This model is used to determine the fair price or theoretical value for a European call or put option, assuming that the underlying asset follows a lognormal distribution.
9. Monte Carlo Simulation: Monte Carlo simulation is a statistical method that uses random variables and probability distributions to model possible outcomes of an investment. It is often used to evaluate the risk of complex investments with uncertain outcomes.