If a fund's whole strategy is private credit, are you an investor or a depositor

Question

Half the fund decks that reach me now are debt funds. Senior bridge, mezz, preferred equity, some mix. The pitch is consistent: current pay in the 9 to 12 range, first position, short duration, no operational risk because you never own the building.

The thing I can't settle is what you're actually buying.

One view is that a debt fund is an investment. The manager's skill is credit selection, and credit selection in a stressed market is where the real spread lives. He's picking sponsors, sizing against real values, negotiating covenants that let him take the asset back cleanly. That's a genuine skill and the returns reflect it.

The other view is that you're a depositor with extra steps. The returns are capped at the coupon no matter how well the manager does. Your upside is fixed, your downside is the whole thing, and in a stressed market you find out that first position on an overleveraged asset means you own a construction project you didn't underwrite. All the skill in the world gets you the coupon you were already promised.

Both of those seem partly true and I don't know which one describes the current wave of new debt funds. There are a lot of them, and a lot of them are first-time debt funds from firms whose track record is on the equity side.

diane_kowalski · Answer

The capped upside framing is the part I'd argue with slightly. You get the coupon in the good case, sure. The distribution of outcomes isn't symmetric though, and manager skill shows up almost entirely in the left tail.

Two funds both promising 10 can end at 10 and at 4. The difference is whether the manager underwrote the collateral at a value that holds when the sponsor stops paying, and whether the loan documents let him move fast when it happens. You never see that skill in a good year. It's the only thing that matters in a bad one.

Which makes it hard to evaluate a first-time debt fund from an equity shop, because they haven't had the bad year yet in this seat. I'd want to know who on the team has actually worked out a loan, and how many.

bmoreno23 · Answer

I'm new to this, so correct me if I have it backwards. If the fund makes a loan and the borrower stops paying, the fund forecloses and now owns the building. At that point isn't the fund doing exactly the job it told me it wasn't doing, running an asset?

@arbor's point about who has worked out a loan makes sense to me if that's right. The skill you need on the bad day is the equity skill, just arriving unexpectedly.

If a fund's whole strategy is private credit, are you an investor or a depositor

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