By Jon Barlow & Caroline Hayes

NEW YORK, Aug. 26, 2020. Because direct lending transactions require detailed due diligence, are difficult to source, are legally intensive and complex to model, private credit continues to be a highly inefficient asset class, with the potential for risk-adjusted returns that are superior to traditional fixed-income investments.

As with any alternative investment, due diligence and deal structure play a critical role in protecting investor capital. With a number of high-profile due diligence failures recently making the news, what are the pitfalls for investors to watch for with due diligence?

As a private credit platform with experience in sourcing, providing due diligence on and structuring direct lending deals, Finitive believes better vetting and structuring are the start point for risk mitigation and avoiding investor losses from fraud.

For Starters: Always Focus on Underlying Investments

Feeder funds are a common way for individuals to invest in alternative investments. While feeder funds have benefits – notably, that they bring together multiple investors, syndicate-style, reducing the minimum investment per investor – they can sometimes shroud and distract investors from looking at the quality of their underlying investments.

As we saw in the spectacular failure of Bernie Madoff’s fund in 2008, investors in feeder funds often assume that the asset manager, its operations and underlying investments have undergone thorough due diligence, when in fact, they may not have.

Structure Protections Can Be Guardrails Against Fraud

In addition to standard qualitative and quantitative due diligence measures, investors in direct lending transactions should look closely at the structural protections in the loan agreement.

Here are some key structural protections for investors to consider:

Protect against bankruptcy by forming a special purpose vehicle (SPV). In private credit transactions, the debtor forms an SPV and “sponsors” an affiliated trust or limited liability company. The sponsor sells assets, such as loans, to the SPV in a true sale. This ensures the assets will be isolated from the sponsor’s liabilities in the event it files for bankruptcy.

Ensure the SPV has an independent trustee to represent creditors. The trustee for the debt, who should be independent from the other parties to the transaction, is a guardian against fraud. The trustee is responsible for making distributions of cash received by the SPV to creditors, key service providers and others in accordance with a priority of payments.

Place original loan documents with custodian or verification agent. To prevent sponsors or their borrowers from creating fraudulent documents, a reputable custodian or verification agent should hold an authoritative copy of original loan documentation. That way, a lender can’t modify or double-pledge that same loan to multiple parties.

Segregate cash proceeds with a lockbox. To protect cash for the benefit of creditors and reduce opportunities for fraud by the sponsor, deal structure can mandate that proceeds from loans or other cash-generating assets be directed to a lockbox account, or a protected third-party collection account. The lockbox segregates cash from the sponsor to ensure proper payment to third parties.

When appropriate, ensure a backup loan servicer is part of the deal. In many direct lending transactions, the sponsor is a loan originator who lends the capital to consumers. If a loan originator experiences financial deterioration or bankruptcy, and its loan servicing company cannot perform its duties, the loan agreements should ensure that the SPV has a back-up servicer in place to quickly take over collections to minimize losses.

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It shouldn’t take high-profile investment scandals to show private credit investors that they need to be diligent about where they allocate their capital. Ensuring your investment targets have been fully vetted with the most sophisticated due diligence methodologies available will separate the best opportunities for capital appreciation from transactions best avoided.

Jon Barlow: CEO, Finitive

Caroline Hayes: President, Finitive

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