When investing in private credit, investors need to examine the specific details of every potential loan opportunity to make sure the potential returns and term of the loan match with their investment goals. Investors need to look at the type of loan itself to understand whether it is asset-backed and why exactly the borrower is choosing a non-traditional loan. When working with house-flippers, for example, it’s important to see their track record of success with prior projects.

In many cases, though, rather than evaluating the individual credit score or financial situation of a borrower, investors need to focus on diligencing the platform they choose to lend through. Investors should seek platforms with transparent data showing a good lending record with low rates of bad debt, as well as attractive yields which are approximately in line with the borrower rates on offer. The fee structure of the platforms is also very important, as even fees that seem like small percentages can eat up a large chunk of potential returns. Investors should not hesitate to reach out to platforms with questions before committing any capital.

Capital Stack

When looking at private debt investments, particularly in larger real estate deals or small business loans, an important factor to review is the “capital stack”. The capital stack is the order and priority of the different types of capital - both debt & equity - which contributed to the financing of a deal. An investor’s position in the stack will determine when they are entitled to payouts and what type of payouts they will receive.

At the bottom of the stack are the debt holders, which are loans that need to be paid off before equity holders can see a return. In commercial real estate, the order of the stacks is generally:

Common Equity

Preferred Equity

Mezzanine Debt

Senior Debt

Senior debt, like a first position mortgage, typically takes up the most significant portion of the stack. Because it is first in line to get paid back in the event of a default or bankruptcy, it is the least risky type of debt. Because it’s the lowest risk it also offers lower returns. Mezzanine debt, sometimes called junior debt, is next in line to get paid out. Because this debt is only paid back after all the senior debt has been paid back, it holds more risk than the senior debt. To compensate for this risk, it offers a higher interest rate than senior debt. Mezzanine debt is often called "bridge financing" because it bridges that gap between the senior debt and equity.

Understanding where in the capital stack a debt investment falls is essential toward recognizing the full risk and reward potential of that investment.

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