Investing in debt? Here’s why private debt funds are booming

Debt is often made the villain of personal finances. Hearing ‘Get out of debt quickly,’ ‘Dig your way out of debt,’ or ‘9 reasons debt is bad for you’ makes the D-word seem like something we should all keep barge-pole distance from. But us property players know that debt is part of the beauty of property investment. Most of us couldn’t afford the big ticketed real estate investments without a helping hand from the bank. But what about investing in debt? Ever considered it? Enter private debt funds.

Investing in debt is not a new phenomenon. Investors have been doing it for years using a range of vehicles, including Collateralised Debt Obligations (CDOs) – perhaps one of the best known financial products in this realm. Private debt funds are far easier to understand and are becoming far more popular than the alternatives.

What is a private debt fund?

Say loan, think bank. It’s a link we all naturally make. But the bank isn’t the only source of finance that investors can use to fund their investments.

Savvy investors can put their money together in a debt syndicate – much like a property syndicate or unlisted property trust – and instead of aiming the capital at a property which they will have an equity stake in, they put it towards funding another investor’s property investment. This is called a private debt fund, and it’s booming in popularity in Australia.

The private debt market has grown tenfold in the last decade, and is labelled as the ‘diamond in the rough’ for yield-hungry investors. According to Australian financial adviser Lonsec Group, in December 2020, “The private debt market was estimated to be US$848 billion [approx AU$1.17 trillion] in size. Within Australia, the largest segment is residential mortgages (62.5 per cent) followed by commercial loans (32.7 per cent).”

The private debt market is expected to follow the same strength as Australia’s piping hot real estate market. Experts also say there is a fundamental need for more debt alternatives in Australia, which is why there’s a push toward privately sourced debt.

What’s the benefit of investing in a debt fund?

Yield. That’s the primary pro of investing in a debt fund, because your debtor is responsible for paying an agreed interest rate on the debt you are providing them.

If your money is, for example, tied up in residential property investments, your yield is likely to be small to insignificant. Capital growth is the major windfall for most residential property investors, so something like a debt fund, where you’ll receive a regular passive income, could be a way to diversify your investment.

The flexibility of a private debt contract is another beauty of this type of investment. You can negotiate a suitable arrangement with the debtor, without the red tape that the banks will put you (and them) through.

And for debtors, the guarantee of funds with the ability to negotiate contract clauses which perhaps better suit their situation is a winner. The banks rarely alter their lending policies and their loan contracts, whereas a private debt contract puts the ball in both courts to establish covenants you can both agree on.

Things to consider before investing

Before turning your capital into someone else’s debt, you might want to consider a few things.

Who is the borrower?

Firstly, ensure you know who the debt is being provided to?

Banks undergo lengthy credit checks and loan assessments before determining a prospect is a suitable borrower. So, if you’re investing in a fund, ask the fund manager about the investor’s:

• Income source to repay the debt (this is likely from the investment itself)
• Track record of investment
• Existing debts
• And so on…

Of course, you should be given a Product Disclosure Statement (PDS) or Information Memorandum (IM), and this will likely be one of the first pieces of info detailed. The next will be…

What am I financing?

You should also find out what it is you are actually financing. If it’s a commercial property, you’ll be wise to understand the leasing terms, the relevance of the asset, and the prospective future of the market – basically all the things a commercial property investor should know before they invest.

What interest rate should I charge?

Ensure the interest on your funding amount is relevant to the future market. If interest rates are set to skyrocket in the next 12 months but you’ve locked in a rate that’s touching the floor, you’ll be missing out on significant yield in the future. Inflation will begin eating up your regular returns and you’ll be jealous of the investors whose purchase you funded.

And speaking of ‘locked in’, you’ll want to consider whether your interest rate on the debt is fixed, variable, or a combination of both. Much like your own home loan, you should have the ability to negotiate whether the rate is going to fluctuate alongside the official cash rate or perhaps even the

The contract

You might also want to bring in a legal specialist to build you an ironclad contract. Even if you’re funding your best friend’s purchase, there’s no substitute for precise wording in a legally binding contract. Once it’s done, it won’t be wasted time if you pour over the wording several times before either you or your debtor signs.

Talk to your legal and financial advisers

This is a must, and hopefully a given for anyone reading this post. Never make a large financial or investment decision without discussing it with your trusted financial and legal advisers first.

Investing is tough at the best of times. With so many options and alternatives out there to grow your wealth, it’s hard to know what will work best for you. So, if you’re looking to partner with an investment expert – whether in residential real estate, commercial property, or private debt – perhaps start by finding an investment company who you can trust. As we know from years of investing, trust can play as big a part in your success than the investment itself.

Want to get to know us? Book a meeting today

Our Director (Investor Relations) Guy Doggett is ready to answer your queries about investing in Australia’s real estate and debt markets. Book a meeting today.