How to Assess Risk in Private Debt Funds: What Every Accredited Investor Should Know

The fortunes, as far as investment circles are concerned, and which touch on private debt funds, lie in understanding and evaluating the risks. The deeper pocket-usually always meaning accredited investors-would want to look at more depth for risk factors so that their wealth will not only be preserved but positioned well for growth. Indeed, while private debt funds, such as those invested in trust deeds, have an unrivaled opportunity for diversification and return on investment that is much more attractive, there are several risks involved. In this regard, the accredited investor should be thoroughly informed as to how these can be mitigated and what the risks are in their entirety.

So, precisely how are you going to gauge the risk when contemplating an investment in private debt funds? Let’s break it down.

1. The Nature of Private Debt Funds

• Private debt funds gather capital from various investors and extend the combined capital to businesses or individuals. In this regard, in the case of the LBC Capital Income Fund, LLC Income Fund, for example, the fund focuses on trust deeds, which simply implies that the loan is secured by real estate. The yield from such investment is normally quite stable; however, like every other financial instrument, it embodies certain risks.
• Private debt funds are mostly outside of traditional banking, and as such, fall out of most of the regulatory oversight. That brings up an opportunity for higher returns, but it also means you need to do your homework on the fund’s operational model and risk management practices.

2. Underlying Assets Assessment

The underlying assets need to be discovered. Continuing with the example of LBC Capital Income Fund, LLC, which invests in trust deeds, for instance, risk would surround real estate that underpins the loans. Ask yourself questions like:

• What type of real estate is this backing the loans? It could be residential, commercial, or mixed-use. All three have different levels of risk and return.
• Where is the real estate located? Location affects property values significantly. Strong growth markets usually give security.
  What is the loan-to-value ratio? Lower LTVs mean less risk because the real estate collateral supports more of the loan’s value.
  
  These factors are beneficial in showing the likelihood of the property underlying the loan to maintain value or appreciate in value. This, therefore, affects the underlying ability of the fund to repay its investors directly.

3. Credit Risk of Borrowers

Credit risk, which is the chance that borrowers might not pay back their loans, is one of the major private debt fund risks. In analyzing the risk profile of a private debt fund, consider the following :
Borrower quality: Which part of borrowers does the fund specialize in-high-quality ones with experience of timely repayments?

• Underwriting standards: How strict is the underwriting policy of the fund? The more conservative, the less risk there will be.
• Borrower diversification: How many loans are distributed among a huge number of borrowers? Those funds that have a heavy concentration in a few borrowers may be more vulnerable to default risk.
  
  For example, the management team at LBC Capital Income Fund, LLC Income Fund ensures that selection of borrowers and loans is done with great attention to detail. That would mean short-term loans against real estate but competitive LTVs. The painful process actually reduces or minimizes the risk of borrower default which in turn does much to protect investors’ capital.

4. Liquidity Risk: Can You Get Your Money When You Need It?

Liquidity risk refers to the ease with which an investor can realize his or her investment in cash terms. As most of the private debt funds are structured on the basis of a lock-in period or on the premise of advance notice for withdrawals, liquidity can be quite an important aspect for them. So here are liquidity-related questions:

• What is the lock-up period? Many private debt funds will lock in capital for several years; you will not have access to your funds until the period is up.

• What are the withdrawal terms? Some funds allow quarterly or annual redemptions, while others might require longer waiting periods.
  LBC Capital Income Fund, LLC Income Fund: Although the loans themselves are typically short-term – often 6-18 months in duration – the fund itself may have its own liquidity guidelines. Be sure to understand these before investing.
  
  5. Interest Rate Risk

Interest rates are at the very core of private debt fund performance. If interest rates increase, then so does the cost of borrowing; this could result in higher default rates. If rates decline, then the fixed income that a private debt fund generates might not be as attractive relative to other investments.
Interest rate risk:

• In what type of interest rate environment are we currently in? It is important to know that with rising interest rates, the risk of default for borrowers could increase, whereas falling rates lessen the relative attractiveness of fixed returns.
• How does the fund respond to changes in interest rates? Some funds may adjust their loan terms or alter their portfolio strategy based on changes in interest rates.

This risk might be partly sheltered for trust deed debt funds, like those operated by LBC Capital Income Fund, LLC, given the loans are short-term in nature. This means the fund can turn around quickly and refinance loans when rates change.

6. Operational Risk: How well is the fund managed?

Success for any private debt fund rests on the aptitude and experience of the management team. Operational risk, which spans everything from poor decision-making to administrative incompetence, emanates from the day-to-day management of the fund. In assessing operational risk:

• What is the management team’s track record? Once more, experience is crucial. Look for a fund whose management team has a proven history of managing debt funds through multiple market cycles.

• What is the investment process for this fund? Does it have a good underwriting process? How transparent is the management team in terms of the working of the fund?
• What about its historical returns? A history of earning returns consistently could be indicative of good management and a well-established process.
  
  For example, LBC Capital Income Fund, LLC Income Fund has been managed by veterans in the industry, with a vast knowledge of real estate markets and trust deed investments. This tends to temper operational risk and maintain profitability of the fund.
  
  7. Regulatory and Compliance Risks

Because private debt funds are usually outside the traditional banking channels, they are also not under the same level of scrutiny. This makes them always regular risk due to changes in laws and regulations which may regulate the operations or returns of the fund.

Regulatory risk assessment:

• Is the fund in compliance with all relevant regulations? Though there are fewer regulations associated with private debt fund operations, they are forced to operate according to certain guidelines.
• How transparent is the fund with respect to its compliance procedures? A good fund will be the one in which clear processes are laid down for compliance with all applicable laws.
  In this case, for example, LBC Capital Income Fund, LLC follows the strict Regulation D guidelines, so its offerings are pretty transparent and within all the legal boundaries. Indeed, the added layer of oversight protects the offering for the accredited investors.

Indeed, the private debt funds ensure an accredited investor has a great opportunity for portfolio diversification and earning regular passive income. Like any investment, the risks need to be weighed well. Understanding the quality of the underlying assets, creditworthiness of borrowers, liquidity terms, and quality of management leading the fund are all critical steps in making a sound investment decision.
These considerations come, in turn, hand in hand with the design of the LBC Capital Income Fund, LLC Income Fund, which grants investors access to loans that are backed by real estate through trust deeds. Previsions of predictable returns, crystal-clear risk management, and transparency-all very important factors any investor would look for in ensuring that the return on their investment is maximized while minimizing the risk-might become one of the main concerns.