If a fund's whole strategy is private credit, is the investor buying skill or buying a coupon

Question

A large share of fund decks in circulation 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 the fund never owns the building. The question worth sitting with is what an investor is actually buying. One view is that a debt fund is a genuine investment. The manager's skill is credit selection, and credit selection in a stressed market is where the real spread lives. Picking sponsors, sizing against real values, negotiating covenants that allow a clean recovery of the asset, that is a real skill and the returns reflect it. The other view is that an investor is a depositor with extra steps. Returns are capped at the coupon no matter how well the manager performs. Upside is fixed, downside is the whole position, and in a stressed market, first position on an overleveraged asset can mean owning a construction project nobody underwrote. All the skill in the world only delivers the coupon that was already promised. Both views hold some truth, and which one describes the current wave of new debt funds depends heavily on the manager. A large share of them are first-time debt funds from firms whose track record sits on the equity side, which is worth weighing carefully before assuming the credit discipline is proven.

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?

@diane_kowalski'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, is the investor buying skill or buying a coupon

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