C&B Notes

‘Direct’-ly Down the Drain

Investor interest in “direct lending” funds, and inevitably the willingness of providers to offer a product in demand, has grown in the yield-starved world.  This type of fund is just another example of the current income-reaching speculations promoted by central banks’ ongoing zero-interest-rate policies. Many strategies risk permanent impairment of capital for a tad bit more income — colloquially known as “picking up nickels in front of a steamroller.”

Investment advisers around the country say clients are asking about increasingly unusual and exotic ways to raise the yield on their portfolios.  Among the most common: various “direct lending” opportunities, including private pools of real-estate debt and hedge funds that hold loans to small businesses.  Such funds often offer annual income of 8% or more in a yield-starved world — dazzling many investors into forgetting to be skeptical. But, in fact, as is always the case: The higher a fund’s yield, the greater the scrutiny you should give it.

With many banks spooked out of aggressively making new loans, private funds that act as go-betweens for borrowers and lenders are spreading fast.  So far in 2015, according to Preqin, a research firm, 26 direct-lending private debt funds have raised $21 billion; another 115 are seeking to raise $48 billion more.  For all of last year, 54 such funds pulled in $32 billion.  Such funds can hold assets ranging from residential or commercial real-estate loans to consumer debt or borrowings by small businesses.  While many of these offerings are registered with state and federal securities regulators, others — no one knows how many — are hyper-local deals settled with a handshake and a signature.

Consider PriLend Funding Group, an unregistered fund run by an affiliate of Rizzo, DiGiacco, Hern & Baniewicz, an accounting firm based near Rochester, N.Y. Offered only to “accredited investors who have at least $1 million in net worth and $200,000 in income, the fund seeks to pay “interest based on a fixed rate of 8%,” its marketing material says.  PriLend makes loans at 12%, plus a 3% origination fee, to buyers of “investment real estate that is either rented or sold (flipped),” according to its marketing material.  The fund’s manager takes a 5% annual fee.  The loans are due in a lump-sum payment after one year, at which point the borrowers should either have flipped the properties or refinanced with a conventional mortgage; if not, they could default.  There is no market for the fund, and investors can’t make withdrawals for two years.  To get their money out after that, they need to wait either for loans to be paid off or for money from new investors to cover their withdrawals.