Can You Invest in Private Debt Funds with a Self-Directed IRA?

Some investors are fine being limited to how they can save for retirement. For these people, traditional investments—such as stocks, bonds, and exchange traded funds—are sufficient.

But many individuals prefer to have more freedom and choice when it comes to their retirement investments. If you’re one of these individuals, a self-directed IRA (SDIRA) may be the way to go. SDIRAs allow DIY-minded investors to hold alternative assets in addition to traditional investments. With the potential for greater returns and portfolio diversification, alternative assets have become a significant part of the investing landscape. However, there is no guarantee that returns from alternative assets will be greater than those provided by traditional assets, such as stocks, bonds, ETFs, and mutual funds, or provide portfolio diversification.

• In the universe of alternative investing, private debt has become a popular choice. And for good reason: Since its debut around the year 2000, this asset class has, overall, demonstrated the ability to deliver compelling returns to investors (although in specific situations, returns are often worse). According to the Federal Reserve, total private debt assets reached $1.7 trillion as of June 2023—higher than both leveraged loans and high-yield debt.
• However, private debt investments can entail significant risks, and past performance may not be indicative of future returns. Key risks involving private debt include a lack of liquidity, as well as the possibility of elevated default rates that result in investor’s missing out on income and losing part of their capital. A prolonged recession, which has not happened since this asset class experienced exponential growth, could see private debt investments suffer significant losses. In this kind of environment, private debt may significantly underperform assets such as publicly traded bonds.

What is Private Debt?

When we think of debt, we typically think of two things: a bank extending a loan, or a company or government issuing bonds to investors. Increasingly, however, there’s a third kind of debt, and that’s private debt. Private debt usually refers to loans that are made by investment funds to companies or individuals. As of June 2023, total private debt reached nearly $1.7 trillion, making it one of the fastest-growing asset classes.

The Potential Benefits of Private Debt

There are numerous potential benefits to investing in private debt. Some of the notable advantages include:

• Potentially higher interest rates and returns than traditional fixed income securities
• Predictable payments
• Less risk than some forms of private equity, given that debt takes preference in the capital structure

How Private Debt Works

A private debt fund raises capital from outside investors. Once the fund has raised the money, the fund’s managers can go about making loans. Typically, a borrower is a medium-size business ($10 million to $1 billion in annual revenue), although the Federal Reserve notes that larger companies (revenues greater than $1 billion) have also been seeking this type of funding in recent years.

Private debt funds are often diversified (to varying degrees)—loaning money to different borrowers at the same time. According to central bank data, the average private debt loan matures in just under 4.5 years—and the average size of loan is $80 million.

Most private debt is considered “senior secured.” In other words, the private debt fund is first in line to be repaid. A riskier kind of private debt, known as “subordinated debt,” is behind the secured lender in terms of priority. Subordinated debt holders are paid higher interest rates but stand a greater chance of losing their investment if a company cannot meet its obligations.

The Democratization of Private Debt

Historically, only institutional investors (such as pension funds) or the super wealthy could invest in private debt funds. That meant that the asset class was something of a gated community, accessible only to a select few. Today, however, more and more people can invest in private debt funds, so long as they are considered by the Securities and Exchange Commission (SEC) to be an Accredited Investor.

Risks and Other Considerations

Prospective investors should be aware of some important risks and other considerations before committing money to a private debt fund:

• Potential loss of capital: There is no guarantee that an investment in a private debt fund will result in a profit. If one or more of the fund’s borrowers were to default, for example, the fund’s investors may suffer a complete loss.
• Private debt funds are illiquid: Unlike stocks or mutual funds, you can’t quickly redeem your money from a private debt fund. Because these funds often loan money for several years, they usually do not allow investors to cash out in short order.
• Correlation risk: There’s always the chance that private debt may decline alongside traditional assets. In other words, no one can be certain that private debt will always diversify a portfolio.

How Investing in Private Debt with a Self-Directed IRA Works

To invest in private debt with a self-directed IRA (SDIRA), you first need to have a custodian (such as Forge Trust) that provides custody for private debt within a SDIRA account. Once you have funded your SDIRA and have identified the private debt fund you would like to invest in that is currently accepting new investors, you can go about making your investment. Any payments made by the fund (interest or capital) will be sent directly to your SDIRA custodian.

Who Can Invest in Private Debt Funds with Their Self-Directed IRA?

However, to invest in a private debt fund, you must be an accredited investor. The SEC defines an accredited investor as someone with assets exceeding $1 million (excluding their primary residence), and an annual income of $200,000 ($300,000 if their spouse or partner is included).

Conclusion

From near-obscurity, private debt has established itself as a significant asset class. If these investments appeal to you (and you understand the risks), you may wish to consider including them in a self-directed IRA

For investors interested in learning more, go to forgetrust.com.