THE DEBRIEF: Be the Bank
Private debt may not be the happily-ever-after story it appears to be.
This is The Debrief - a post-game analysis for LPs. Breaking down actual real estate syndication investments to better understand risk and invest accordingly.
LPs burned by common equity are moving up to private debt.
Because being the bank is safe, right?
But an LP investing in the bank is not the same as being the bank. So is private debt really “safer”?
To respect the confidentiality of private investment vehicles, all names, locations, and proprietary figures have been anonymized or rounded. Alignment with actual investment metrics is purely coincidental.
The analysis provided is for educational purposes to illustrate market mechanics and risk management.
In 2020 I invested in two income funds: one performed to plan; the other veered wildly off course.
Can you guess which is which?
#1: A fund of funds that invested in cash-flowing mobile home and self-storage facilities across the US. Two-year capitalization period with a ten-year term. Relatively new GP, complex structure, low to moderate underlying debt.
#2: A debt fund with a portfolio of short-term bridge loans to developers in its local market. All loans were first position with a maximum 70% LTV on current valuation (not capitalization), and an average 65% LTV for the portfolio. Evergreen fund with a steady 15+ year track record. Boutique-sized GP with decades of success.
Did you guess #2?
The income fund I perceived as a high-yield, “safe” place to park cash was anything but safe.
Defining Private Debt
The term “income fund” is not synonymous with private debt. Income-producing investments include things like real estate, an oil rig, a business, or debt.
Private debt investments are just as varied. This discussion is limited to debt backed by real estate that is commonly available to retail LPs.
Debt Funds
A debt fund is a portfolio of loans held by a GP. There are two common structures: evergreen and term/closed-end.
Evergreen funds pool capital to fund a revolving portfolio of loans. These funds typically permit an investor to choose between collecting or reinvesting earnings, and their semi-liquid state permits investors to withdraw all or part of their invested capital. However, redemption is not guaranteed and could land you in a marriage to the GP with no options for divorce.
Term funds have a pre-determined life-span that follows three phases: 1) a capitalization period; 2) a hold period; and 3) a wind-down period. Upon term expiration, the fund is obligated to close and divest all members of their interest. Unlike an evergreen fund, a term fund is illiquid.
Single Notes
A single loan is originated by the GP and funded by investor capital. This structure permits the investor to scrutinize the loan, and select individual deals that best align with their interests, although this level of investor selectivity can come at the expense of the built-in diversification provided by a fund.
Potential Risk Factors
The GP
The GP is the critical link between your investment and your investment returns.
Skill
The GP’s value to LPs is the ability to make prudent decisions under highly-variable market conditions for many years, and - in the case of an evergreen fund - indefinitely.
Character
Humans are unpredictable; their priorities and motivations can change dramatically over time. Track records are indicative, but are no guarantee.
Management Structure
Who and how loan approval and overall fund management is performed, such as:
Who are the decision-maker(s)?
What happens if key staff are lost?
How will the fund respond to market or regulatory changes?
Where things went wrong
The managing partners split up, and the remaining principal dramatically changed the management of the firm and its various funds.
Lessons learned
There was no way I could have anticipated the principals’ break-up, but I could have better understood the terms of the GP’s partnership agreement and contingency plans for loss of key staff.
Debt Terms
Lending terms are not always “conservative” or “safe”. The loan standards used by the GP may include:
Borrower profile (credit score, experience, net worth, etc).
Types of loans (business, bridge, long-term, etc).
LTV (and what is the V based on?).
Debt service coverage (i.e., the ability to pay back the loan).
Collateral (what is guaranteeing the loan?).
Loan terms (max loan size, interest rate, payment schedule, maturity, extension options, recourse terms).
Geography (what area(s) does the fund service?).
Exceptions (when will the GP ignore their own underwriting?).
Where things went wrong
The fund’s current portfolio bears little resemblance to the portfolio or stated intention of the fund when I invested five years ago. This is all permissible under the subscription agreement.
Lessons learned
If I had read and understood the latitude the GP could operate under, I may have more accurately perceived the fund as carrying significant rather than negligible risk.
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Fund Terms
The management of a fund’s portfolio requires the GP to: decide how and where to deploy capital, manage existing loans, balance prudent lending with cash drag, consider investor redemption requests, and respond to the lending market cycle.
Lending has a market cycle - and it matters more than most debt fund marketing will tell you. We’ll talk about that shortly.
The waterfall structure defines when and how GPs and LPs are paid, but certain structures can have unintended consequences. For example: a cumulative preferred return may sound good, but this could incent a GP who is not able to fulfill preferred returns in one period to make riskier loans (with higher returns) the next period in an effort to pay off the arrears due to LPs.
The PPM and OA/OM are the rules that define what the GP can and cannot do, regardless of what the business plan or pitch deck tell you. In reviewing a number of debt funds, I have found many surprising details in the fine print that weren’t in the slide deck:
Underlying debt (the fund itself is using debt to fund its lending).
Use of crypto.
Self-dealing (the GP can/does use the debt fund to lend to its own projects).
Liberal permissible loan terms (up to 90% LTV, no collateral, etc).
Gating and distribution provisions (the all-inclusive “at the GP’s discretion”).
Secret loan tapes (i.e., the GP is not required to divulge the details of the loans held by the fund).
None of these factors make a fund good or bad, but they do influence investor returns, the amount of risk, and overall viability of the fund.
Where things went wrong
The portfolio shifted from bridge loans to funding the GP’s projects. This was in accordance with the subscription documents. But not in accordance with my expectations or preferences.
Lessons learned
Reading (and understanding) the subscription documents reveals the latitude available to the GP, and prevents surprises. And keeping watch on the fund’s performance as stated in the quarterly reports can be an early indicator of changing lending terms.
Read how AI can help.
Liquidity
Term funds are typically illiquid, but most evergreen funds are semi-liquid, which means that an LP’s interest (i.e., invested capital) is intended to be held long-term with redemption provisions. This is also referred to as gating.
A common belief is that debt is safer than equity due to its semi-liquid nature. If the investor wants their funds returned they request a redemption and exit. In theory, yes. In reality, maybe not.
There can be very good reasons for a fund to restrict redemptions; a “run on the bank” by investors can collapse the fund. Sometimes investor redemptions are fueled by macro market conditions - such as moving to better risk-adjusted investment opportunities. Sometimes they are fueled by investor fear: loss of faith in the health of the fund, or investor concerns over the viability of debt at large. Whatever the reason, a fund can only accommodate a certain amount of redemptions and still remain viable. This is where the discretion of the GP comes into play: just because an investor made a redemption request doesn’t mean it will be granted. It could be months, years, or maybe never.
Where things went wrong
By the time investors got suspicious, it was too late. The fund was gated, and all distributions and redemption requests were indefinitely stopped. It’s been two years, and there is still no sign of either distributions or redemptions resuming.
Lessons learned
Monitoring the health and performance of the fund can help to see loan management changes, but don’t assume you can run for the exit before everyone else. It’s unlikely you’ll be the first one out.
The Market Cycle
Fluctuations in home and stock prices are well-known symptoms of market cycles. But lending is also cyclical.
Like all markets, the lending industry responds to supply and demand, and is dictated by regulation. Both impact how conservative or liberal lending may be at any given time, with terms fluctuating widely.
When capital is rare and conditions are favorable to lenders, a GP’s lending may be very conservative and the loan terms relatively safe. Under inverse conditions when lending capital is profuse and conditions are favorable to borrowers, a GP under pressure to put cash to work may start making much riskier loans.
Where things went wrong
As lenders retreated from all private equity in 2023, the GP faced increasing challenges to financing the portfolio of deals already made. The debt fund offered an easily-accessible solution. Within a short time, the bridge loans were gone and replaced with a variety of very different assets.
Lessons learned
Cycles have a strong influence on behavior. Be aware of the current position of the market, and how market changes may affect the GP’s decision-making.
Marketing Messages
As the current belle of the ball, private debt is the object of investor desire. But investors take note: today’s marketing campaigns are echoing the virtues of investing in private real estate promoted by crowdfunding and other GPs during the frenzy of 2020-2022. This includes:
Risk Mitigation
Hopefully, the previous section has convinced you that private debt is not necessarily “safe”. As with all investment vehicles, it’s critical to understand the terms of the investment and if it aligns with your own risk tolerance and investment objectives.
Capital Preservation
Isn’t the point of all investments to preserve capital? This is a baseline assumption for any investment - that the investment manager (be it a public or private offering) will not only protect but grow your capital.
Superior Long-term Returns
When compared to similar income-producing investment options, private debt does (generally) out-perform public market options. However, this is due to the risk premium; a direct comparison to public offerings is not entirely accurate.
Bottom Line
The bank does NOT always win. Consider:
The liberal, reckless lending practices and resulting bank losses that were partially responsible for the GFC, the collapse of crowdfunding, and the current widespread commercial loan distress. You can read more about that in last week’s Debrief.
Or this example, of a deal that was returned to the lender at less than the loan amount. Although the bank didn’t lose everything, the full amount borrowed was not returned, interest and other payments were not made, and the bank must incur additional costs to liquidate the asset.
The fallout of liberal lending is not over. CoStar’s Q1 2026 reports indicate that 6% of all commercial trades were 5% to 15% short of paying off the senior debt in full. And approximately 15% to 20% of loans maturing in 2026 are underwater. As an investor in a portfolio of loans, an average loss of this size may not be consequential. However, if the GP was providing very liberal lending terms, the losses across the portfolio could be substantial.
Investors currently considering private debt should not be fooled into thinking debt = safe. The same conditions that led to the loss of common equity in syndicated real estate deals - unreliable GPs, aggressive lending practices, and market and regulatory changes - apply to debt. The difference between a bad outcome and a good one is not the asset class; it's the work you did before you signed.