Insights Article | November 1, 2023
10 Key Questions to Consider When Building Private Credit Investments into Multi-Asset Portfolios
Private credit investments continue to grow in popularity as investors march toward alternatives in search of greater stability and higher yield. Unsettled markets have not only driven investor interest to further diversify, but they’ve created an underlying need to complement portfolios with assets independent from equity and bond markets.
As private credit tips into mainstream investment strategies, evaluating alternative opportunities often requires a specialized due diligence process compared to vetting traditional investments because they generally behave differently.
Consider addressing the following 10 key questions when building private credit investments into multi-asset portfolios.
1. What is the target return of the investment?
It’s important to assess an investment’s historical and target returns to determine whether the potential returns align with the investment expectations and risk tolerance of an investor. Among other things, investors can weigh the risk factors, consider the investment attributes, and compare the potential investment to their other investments to determine whether the new investment meets their risk-adjusted return objectives.
Remember, while private credit often produces higher risk-adjusted returns, chasing the highest yield often correlates with greater actual or perceived risk. Be sure to consider the risk-return tradeoff and investor’s tolerance for risk.
For Comparison: Wilshire’s WFP Income Fund is a short-term, fixed-income alternative investment that seeks to deliver attractive risk-adjusted returns between 5% to 8% to its investors primarily through the fund’s investments in first trust deeds and mortgages with lower loan-to-values secured by seniors housing, healthcare, multifamily, and commercial real estate.
2. What are the potential risk factors associated with the investment?
As you know, every investment carries some sort of risk, but the underlying risk exposures can vary widely within similar investment asset classes, such as price sensitivity due to changes in interest rates or market volatility.
When evaluating risk exposure, consider comparing apples to apples in a multi-asset portfolio. For example, when investing in any form of debt the inherent risk is nonpayment by the borrower. When investing in private debt secured by real estate, risk factors include borrower defaults on loan terms, such as missing a payment, and a decline in the value of the property securing the debt. Evaluating a fund’s loan-to-value (LTV) ratio, how that ratio is calculated, whether an investment is backed by a hard asset as the collateral, the lien position of the loan against the collateral, the type of real estate serving as collateral, diversification in the fund, how borrowers are vetted, the loan cycle, and other factors will all play a part in determining the potential risk associated with the investment and, more importantly, how to choose the right investment.
For Comparison: Wilshire’s WFP Income Fund seeks to reduce the likelihood of default and potential loss exposure should a default occur through the protective equity cushion on each loan in the fund’s portfolio. When loans are made at lower LTVs—often around 65% - the borrower has more at-risk capital in the transaction (or more “skin in the game”). The equity of the borrower in the property and any subordinate debt becomes a buffer against loss for the Fund and helps to reduce the likelihood of default and the potential loss exposure should a default occur.
3. What is the liquidity of the private credit investment?
Private credit involves a more long-term asset allocation strategy than its publicly traded counterparts. Why? As seen in active public markets, securities can be easily traded among many buyers and sellers, offering higher liquidity and the ability to make short-term tactical moves. In private credit, however, oftentimes there’s a lock-up period in order to strategically deploy capital and then once capital is invested, it may take some time to exit the fund.
However, there is a positive trade-off. Unlike tactical allocations in public markets, private credit that is not exchange traded is not correlated to the stock or bond markets. It does not respond quickly to market shifts and stresses impacting the markets like exchange traded investments. Further, often private credit investments can offer a higher return than fixed income securities with comparable durations – a liquidity premium. So, implementing a strategic approach to employ non-exchange traded private credit investments may help to hedge volatility within a portfolio and provide the potential for higher returns.
While investors may have the opportunity to avoid market volatility and potentially generate higher returns through the liquidity premium, they should also consider their cash needs and the more liquid investments in their portfolio before implementing certain alternative investment strategies.
For Comparison: Wilshire’s WFP Income Fund has an initial one-year lock-up period. After that period, investors can withdrawal up to the lessor of 25% of the total investment or $1,000,000 every 3 consecutive months.
4. What are the underlying assets of an investment?
Meaning, what is the make-up of the underlying assets comprising the investment that drives the value of your investment and generates the cash flow to you? For example, private credit includes a tapestry of strategies across the borrower type and capital structure, ranging from subordinate loans against land and new development to senior loans secured by existing structures. Understanding the assets underlying the investment and the investment managers investment approach will help investors determine what risk and returns to anticipate, what opportunities exist, and how well the investment may align with the investor’s desire to diversify in a multi-asset portfolio.
For Comparison: Wilshire’s private debt fund, the WFP Income Fund, generates returns based on the interest produced through investments in first trust deeds and mortgages backed by seniors housing, healthcare real estate, multifamily, and commercial real estate.
5. What is the Net Asset Value of the fund?
Inquiring about the Net Asset Value, or NAV, is an important metric when evaluating private credit funds to determine the level of safety of the investment. A stable NAV helps to protect investors from losing their principal investment.
For Comparison: Since its inception in 2013, the WFP Income Fund has maintained a stable NAV of $1,000 per unit.
6. Does the private credit investment fund provide regular cash distributions, and how often?
Investing for cash flow is a conservative investment strategy used to help build a more diversified portfolio. Further, many investors position cash-flow investments as a retirement strategy to generate sustainable income from a predictable source rather than tapping into retirement accounts or worrying about how economic impacts may affect their income. Preferred stock of corporations, corporate bonds, municipal bonds treasury securities, money market accounts, certificates of deposit and similar investments have historically been used to generate cash flow in an investment portfolio. However, increasingly private credit investments are being used as part of an allocation strategy to deliver potentially higher levels of cash-flow.
For Comparison: The WFP Income Fund provides monthly cash flow to its investors and paid investors a 5.93% net annualized non-compounded return for full year 2022. Since its inception in 2013, the fund has delivered between 4.16% (during COVID in 2020) and 8.19% net annualized non-compounded returns to its investors. At December 31, 2022, the net annualized compounded return for the fund since inception was 8.84%.
7. What types of diversification do the underlying assets offer?
The definition of a truly diversified portfolio has changed overtime, but the underlying motivation behind it has not. A healthy mix of debt to complement equity investments and cash has always been a dependable source of balance in times of public market fluctuation.
The 60/40 portfolio of stocks and bonds was historically the go-to investment strategy; however, modern portfolio allocations depend on alternative investments to offer more portfolio diversification and investment attributes, which traditional stock and bond investments may not be able to deliver. With no correlation to the stock or bond markets and little to no sensitivity to interest rates, non-exchange traded, real-estate based private credit is a growing subset of alternative investment strategies.
For Comparison: The WFP Income Fund diversifies across property types, geographies, and borrower types, so that investors can feel confident that greater safeguards are helping to protect their investments.
8. Where do the underlying loans in the fund sit in the capital stack?
Not all private credit is created equal. To weigh risk, it’s important to understand how an investment will be repaid by the borrower. The capital stack is the layers of financing sources in order of repayment priority— with senior positions holding the greatest priority and subordinate positions take less priority. Senior loans in the capital stack have a lower risk of repayment and therefore a lower return. Subordinate loans carry more risk but may also earn higher returns to compensate for the riskier position.
For Comparison: Wilshire’s WFP Income Fund is designed to be a balanced and conservative fund. The fund invests in first trust deeds and mortgages, a senior debt position, with a weighted average LTV of approximately 65%. In addition to the protective equity cushion described above, the Fund also sets aside a Loan Loss Reserve as an additional cushion to help protect the investor’s principal investment.
9. How will economic changes affect the private credit investment?
Between rising interest rates and a year-long run of market whiplash, selective and conservative underwriting techniques will help minimize any potential ripple effects correlated with the fluctuations of the public markets, such as investing in defensive sectors like healthcare or utilities and embedding lower LTVs in loan investments.
Luckily, private credit is generally slower to respond to market conditions and more resilient at weathering tough times. However, it’s important to invest in a private credit fund that strives to provide cash-flow in through different economic cycles.
For Comparison: In anticipation of potential market changes, the WFP Income Fund’s current underwriting philosophy employed by the Manager results in the use of third-party valuations (e.g., appraisals), market analysis, stress testing of cash flows, capitalization rates and other factors, lower Loan-to-Value (LTV) ratios, shorter maturities, and other loan terms to help mitigate downside risk. When combined with the Loan Loss Reserve in the Fund, the result is a protective equity cushion for the loans within the Fund to help buffer the impact of changing real estate values and related market conditions.
10. What is the lifetime of the underlying loan in the investment?
When it comes to private debt investing, there are opportunities to invest in long, medium, and short-term loan strategies. Often investing in a strategy that has shorter-term loans (typically maturities under three years) means that loans mature more quickly, giving the fund the opportunity to assess current market conditions and adjust interest rates on new and renewed loans. By having loans with different maturities in a fund helps to ensure the natural generation of liquidity as loans repay – similar to a laddered bond portfolio.
For Comparison: The WFP Income Fund holds short-term bridge loans in its portfolio ranging from six months to three years. By keeping the terms of the loans short, the Fund has the ability to generate internal liquidity to meet investor redemption requests and make new loans at current market values, reducing the risk of having a large legacy portfolio of loans with longer maturities made under different market conditions.
As you evaluate a private credit offering, including on Wilshire’s platform, consider asking a few strategic questions to get a detailed picture of what’s under the hood running the investment vehicle. It will help you select the right investment for your goals.
Contact us with any questions or for more information about our investment opportunities at (866) 575-5070.
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