Why wealthier investors are delving into private debt now

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Ultra-high-net-worth investors through family offices are venturing rapidly into private debt investment, recent studies show.

Interest in offering loans negotiated between a lender (the investor) and a borrower (often a company) – is growing at a stronger rate than ever before in an effort to diversify in the current economic environment.

According to the 2022 Global Family Office Report by UBS, which surveys 221 single family offices around the world, 27 per cent of these investors are turning to private debt. On top of that, allocation for the average family office portfolio consisted of 2 per cent private debt investment.

There is a definite appetite in family offices to make this kind of investment, even more so than with other investors. A recent report from privately-held London-based investment data company Preqin stated that as of Q4 2021, public pension and endowments were at 2-per-cent allocations in private credit versus a 5-per-cent target. Meanwhile, family offices were at 10-per-cent allocation – far higher than the pension space, and which was actually slightly overweight to their 7-per-cent target.

And this increase in interest shows no signs of slowing, as 40 per cent of institutional investors planned to add private credit to their portfolios in the first half of 2022, according to a recent poll from Alternative Credit Council, a subsidiary of the Alternative Investment Management Association (AIMA), and London, England-based investing data firm With Intelligence.

“The reasons for that being equity valuations at the time, concerns for inflation at the time, the strong return expectations of the private credit asset class, the need for yield and new opportunity access as part of their reasons for doing so,” explains Claire Van Wyk-Allan, managing director and head of Canada at AIMA.

Specifically, 50 per cent of the family offices polled were planning to allocate to private credit,” she continues, “To say this is an area of interest for families can’t be understated.”

There are certainly economic reasons for this uptick, but there could also be more philosophical reasons as well, as this could be a “natural alignment” with private credit for many family offices, says Van Wyk-Allan.

“Families often generate wealth from being family-owned businesses, creating their own wealth,” she explains, “and so they understand the need to seek financing, perhaps from non-bank sources, and they understand, then, the importance of investing in other businesses through that private credit lens.”

Due diligence needed

But as more family offices and HNWI may be venturing into this asset class, it is important to take certain steps before acquiring private credit, including assessing the people involved, looking into who’s in charge, their track record in the space, governance structures and how they manage conflicts.

The next layer of this due diligence is to assess the fund’s strategy, meaning the fund’s objective, according to Van Wyk-Allan.

“Has it deviated from that objective over the past years? Who’s making the decisions and how are they made? Of course, [you need to look at] the risk-return profile and history. How has it performed during its tenure? How are they doing valuations of the portfolio and is there an independent valuation source rather than in-house? How are they sourcing potential borrowers? For example, do they have direct relationships that are ongoing?”

She also suggests looking at how the loans are structured, what are the typical range of maturities they seek, the repayment terms and what collateral might be required.

Proceed with caution

When it comes to direct investing in private debt there’s an extra level of caution that needs to come into play, particularly if a family office is dealing with someone they don’t know, advises Dan Riverso, chief investment officer and chief compliance officer at Jesselton Capital Management.

“If you are lending while we’re in an environment where [interest] rates are rising and things could go a bit pear shaped, the type of approach you would want to take is one of caution and do your due diligence on that person, their character and look at the type of loan, as well. … You need to cover yourself,” says Riverso.

It is also a time to look at in-house capabilities and whether this is a deal that can be structured by the family office or whether it needs outside counsel.

The type of collateral is also something to consider when looking at these deals, to understand what actions would be needed if the deal fell through. For instance, if inventory is offered up as collateral, the lender must think about what happens if that collateral is in their possession: How are they going to offload that inventory?

“You have to think through the worst-case scenario,” says Riverso, “because that’s what debt investing is. Stock investing is all about the upside, debt investing is all about the downside.”

Transparency around these points are paramount in a deal like this, but Van Wyk-Allan says that, in her experience, just because companies are ‘private’ doesn’t mean they don’t share information. In fact, if they don’t give up this information upon request then it might be a red flag about them or the deal.

“I would say that that’s a great way to evaluate a manager,” she says. “If you’re asking questions and not receiving the information that you’re requesting to your satisfaction versus you are seeing that information come from other managers you’re evaluating, then that’s a great way for a family to evaluate who they might prefer to do business with.”

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