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One direct lending fund returned 12.7% last year;
seen as alternative to measly returns on bonds.

As traditional bond funds scramble to navigate around the threat of rising interest rates, a growing number of investors and financial advisers are tapping into private credit markets, thanks to an expanding network of entry points.

“It's a great concept, but it's definitely a matter doing enough due diligence to make sure you like the company you're doing business with,” said David Reyes, founder of Financial Architecture, a financial advisory firm that has been allocating client assets to the private credit markets for nearly a year.

When stacked against traditional bond funds that carry both inflation and interest rate risks, Mr. Reyes described the private credit markets as a “no-brainer, because it's a natural to take money out of bond funds and replace that allocation with this kind of investment.”

What investors and advisers like Mr. Reyes are tapping into is a growing niche of the so-called peer-to-peer lending market, which is expanding by filling gaps ignored by traditional banking systems.

“We are targeting a market that was underserved by banks and was being overcharged by other alternative lending options,” said Ethan Senturia, chief executive of Dealstruck Inc., one of the growing list of no-balance-sheet lending companies that rely on outside investors to capitalize and hold the loan portfolios.

That's where the investment opportunity comes in.

Companies like Dealstruck are handLing the upfront and operational lending issues for loans of between $50,000 and $250,000 — taken mostly by small businesses — which are capitalized by outside investors for minimums starting at $5,000.

Even though the minimums are sometimes low, this is still considered a private investment arena, and investors must meet the same net-worth standards required of hedge fund investors.

Mr. Senturia, whose firm recently made its 100th loan after less than a year of actively lending, said firms like his are taking market share from the $10 billion cash advance industry, and from the $125 billion factoring market, in which companies finance the sale of their own products.

The loans, which typically have durations of less than two years, come with interest rates of between 15% and 36%.

“Our rates are higher than those charged by banks, but they are much, much lower than the alternatives, which can sometimes mean rates in the triple digits,” Mr. Senturia said.

Brendan Ross, president and portfolio manager at Direct Lending Investments, launched a hedge fund in November 2012 for the specific purpose of investing in this category of small private loans.

The $55 million Direct Lending Income Fund, which has a $100,000 investment minimum and currently holds 1,700 loans, generated a 12.7% return after fees and expenses last year. And the fund is currently up 6.7% through July.

That compares to a 2% decline by the Barclays U.S. Aggregate Bond Index last year, and a 3.7% gain this year through July.

“All I do is buy and hold loans of between six and 18 months in duration that are amortizing daily,” Mr. Ross said. “The whole idea is to focus on the part of the credit market where borrowers are paying the most interest.”

While the loan rates, which represent income to investors, sound high, the reality is less sensational because the loans are often paid off early, and they are structured like a home mortgage where the interest is constantly being applied to a shrinking principal.

For example, a $100,000 one-year loan at a 20% interest rate will cost the borrower $10,000, or 10%, if all payments are made on schedule.

Eric Thurber, one of the founders of Three Bridge Wealth Advisors, uses Mr. Ross' hedge fund for his clientele, which is made up of wealthy families.

“It's a relatively new investment for us,” he said. “But we are allocating to less traditional fixed income than we have in the past, and about half of our client portfolios are allocated to alternative and illiquid investments.”

While liquidity is usually an issue with private investments, the short duration of the loans and the fact the portfolio is turning over at a 20% monthly rate makes liquidity less of an issue, according to Mr. Ross, who provides his 85 investors with liquidity on 35 days' notice.

The default risks are similar to those faced by any lending institution. But because the loans are set to fixed rates and are held to maturity, the portfolio is uniquely shielded from interest rate and inflation-related risks.

Mr. Ross said the category has a 7% annualized default rate, and that his portfolio's break-even point would kick in if the default rate got above 22%.

“Our average borrower has been in business for 12 years, at an average age of 51, and has an average credit score of 680, with business revenues of between half a million and $55 million,” he said. “That's the sweet spot we're dealing with — the same group of businesses that was once being served by community banks.”

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