Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / Wealthy Families Use Direct Lending to Beat Private Equity Returns
Transcript
- Lucas: A family office managing, say, two hundred million dollars has a decision to make. They can write a check to a private equity fund, pay two-and-twenty, and hope to net eight or nine percent after a decade. Or they can lend fifty million directly to a mid-market manufacturer, secured against its equipment and receivables, and earn twelve percent current yield — controlling every term themselves. Luna: That's direct lending, and it's the single biggest shift I've seen in family office allocations over the last five years. The Family Office Exchange published a study last year — families putting more than twenty percent into direct lending outperformed their benchmarks by three hundred basis points. Lucas: And that's net of defaults. The data runs through 2025, so it includes the higher-rate environment. What's interesting is that this isn't distressed debt or mezzanine stuff — it's first-lien senior secured loans. These are boring, asset-backed loans with loan to value ratios often below sixty percent. Luna: So the pitch is: skip the fund, skip the fees, keep the spread. But how does a single family office source and underwrite these deals? They don't have a team of thirty analysts. Lucas: They don't need one. A lot of them partner with a small, specialized origination shop — maybe two or three bankers who know a specific industry. Or they co-invest with other family offices in a club deal. There's a network called the Family Office Network that syndicates loan opportunities among vetted members. Lucas: The typical deal I've seen: a forty-million-dollar facility to a niche industrial parts distributor. LIBOR plus 575 basis points, five-year term, amortizing. The family office puts in ten million, the rest comes from three peers. They all share the same legal counsel, same due diligence report. Luna: That due diligence is key. When you're the lender, you're not just evaluating the business — you're structuring covenants, negotiating reporting requirements. A private equity fund would do all of that internally. A family office has to buy that expertise. Lucas: Right, and that's the trade-off. You save the two percent management fee and twenty percent performance fee, but you pay maybe fifty to a hundred basis points for origination and advisory. Net-net, you're still ahead by a couple hundred basis points if you size it right. Luna: And you get control. If the borrower wants to amend a covenant, they call you, not some associate at a fund. You can say yes or no based on your own read of the situation. That's a real advantage in a downturn. Lucas: Absolutely. In 2023 and 2024, when rates spiked, a lot of private equity-backed companies tripped their loan covenants. Funds had to negotiate en masse with dozens of lenders. Family offices with direct loans could act faster, often getting better terms because they were a single decision-maker. Luna: But there's a liquidity problem. A direct loan is illiquid — you're locked in for five to seven years, usually. If the family needs cash unexpectedly, they can't just sell a piece of the loan. Compare that to a private equity fund, where they can sell their LP interest on a secondary market. Lucas: That's fair. But the secondary market for direct loans is actually growing. There are now platforms like LSTA's Trade Data that match buyers and sellers of private credit. It's not as liquid as the high-yield bond market, but it's not a total lock-up either. Lucas: And the yield premium compensates for that illiquidity. A comparable high-yield bond might yield eight percent today. A senior secured direct loan to a similar credit quality is yielding eleven to thirteen percent. That's a three-to-five-point illiquidity premium. Luna: Let's talk about defaults. In the Family Office Exchange study, the default rate on direct loans was two point one percent over the five-year period. That's actually lower than the leveraged loan market, which ran around two point eight percent. Lucas: That's because family offices tend to lend to companies they know well. There's a selection bias — they're not chasing yield in the CLO market. They're lending to a local manufacturer whose owner they've known for a decade, or a real estate developer they've partnered with before. Lucas: It's a relationship business. And that's actually why this trend is accelerating. As baby boomer business owners retire, they're looking for private capital to transition their companies. Family offices can step in as lenders with patient capital, rather than forcing a sale to a private equity firm. Luna: Which brings up the estate planning angle. A direct loan can be structured as a note that pays interest to a trust, bypassing estate taxes in some cases. That's a whole other layer. Lucas: Exactly. You can use a grantor retained annuity trust or a charitable lead trust to hold the loan. The interest payments go to the trust beneficiaries, and the principal eventually passes to heirs with reduced gift tax exposure. It's a favorite strategy among the wealth management firms we talk to. Luna: But not every family office has the stomach for it. Direct lending requires active monitoring — quarterly financial statements, site visits, covenant compliance checks. Some families prefer the passive exposure of a fund. Lucas: That's where the 'direct lending co-investment' model comes in. There are funds that let you co-invest alongside them, picking specific loans while the fund handles administration. You still get the direct deal economics, just with a smaller operational burden. Luna: So it's not an either-or. It's a spectrum. On one end, pure direct lending with full control. On the other, a traditional private debt fund. And in between, co-investment vehicles, club deals, and separately managed accounts. Lucas: Right. And the smartest families I've seen allocate across that spectrum. Maybe ten percent in pure direct deals where they have expertise, another ten percent in co-investments, and five percent in a private debt fund for diversification. Luna: That's a pretty big shift from five years ago, when most families just wrote a check to a private equity fund and called it alternative assets. The democratization of private credit is real. Lucas: It is. And I think it's worth mentioning that this isn't just a family office phenomenon. We're seeing high-net-worth individuals with, say, twenty-five million or more starting to do the same thing. They form a small group, pool capital, and lend directly. Lucas: One example: a group of ten doctors in Texas — each with maybe five million in investable assets — formed an LLC and lent fifteen million to a medical office building project. They're earning a net return of nine and a half percent, secured by the property. Their alternative was a REIT yielding four percent. Luna: And the doctors understood the asset class. They knew what a medical office building was worth. That's the key — direct lending works best when you're lending into an industry you understand. Lucas: Which brings us to the risk: concentration. If you lend to one company in one industry, you're taking on idiosyncratic risk. A single default can wipe out years of yield. That's why the club deal model is so effective — you spread the risk across borrowers. Luna: And across time. A good direct lending program has a laddered maturity structure — loans coming due every year so you have regular liquidity and can reinvest at prevailing rates. Lucas: Exactly. Look, there's a reason private equity is raising less capital this year. LPs are saying, 'Why pay fees when I can do this myself?' The data backs it up. Direct lending returns have exceeded private debt fund returns for five consecutive years. Luna: I want to dig into the fee math a bit more. A typical private debt fund charges one point five percent management fee and a fifteen percent carry. On a fifty-million-dollar commitment over ten years, that's about seven point five million in management fees alone. Plus carry on top. Lucas: And if you do it direct, you pay maybe half a percent for origination and legal. That's two point five million over ten years. You save five million dollars. And that's before the performance advantage from picking better loans. Luna: That's real money. And it's not just about the fees — it's about alignment. When you're the direct lender, you have no incentive to take unnecessary risk to juice returns. You just want to get paid back with interest. Lucas: That's the core insight. Direct lending aligns incentives perfectly. The borrower wants to grow, the lender wants to be repaid. No fund manager trying to hit a hurdle rate. No risk of 'style drift' into riskier assets. Just a clean, contractual relationship. Luna: Let's talk about the tax implications. Interest income from a direct loan is ordinary income, not capital gains. For a family office in a low-tax jurisdiction, that might be fine. But for a us based family, it could push them into a higher bracket. Lucas: That's a consideration. But you can structure the loan through a corporation or a trust to manage the tax impact. Or you can use a loan participation note, which may offer some tax deferral. It's worth consulting a tax advisor. Luna: And there's the issue of documentation. A direct loan agreement is simpler than a fund's limited partnership agreement, but it's still a legal document. You need a good lawyer to negotiate terms like prepayment penalties, financial covenants, and events of default. Lucas: Absolutely. But the cost of that legal work is a one-time expense per deal, not an ongoing fee. And once you've done a few, you have a template. The incremental cost drops significantly. Lucas: I think the bottom line is this: direct lending is not for everyone. It requires expertise, time, and a tolerance for illiquidity. But for families who have those things, it's a powerful way to earn a premium return without the fee drag of a fund. Luna: And it's a trend that's only going to grow. As more families get comfortable with the model, we'll see more capital flowing into direct loans. Private equity funds will have to adapt. Lucas: They already are. Some funds are offering 'direct lending sleeves' — basically a separately managed account within the fund structure. They'll handle the operations, but you get the direct deal economics. It's a hybrid approach. Luna: Interesting. So the fund managers are essentially admitting that the direct model has advantages. They're trying to keep the assets in-house by offering a middle ground. Lucas: Exactly. And the winners in this space will be the families who can execute direct loans effectively — either on their own or through smart partnerships. The fee-only model is losing its appeal. Luna: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. Lucas: Yeah, and we're grateful for every one of them. It keeps us ad-free, which means we can dig into topics like this without any sponsor constraints. Luna: So if our money conversations have helped you think about a decision differently, that's the place. No pressure, just the reality of how this gets made. Lucas: And back to the larger picture — I think we'll see more families using direct lending as a core part of their fixed-income allocation, replacing bonds and even some private equity. The risk-adjusted returns are compelling. Luna: As long as they do their homework. Because when a loan goes bad, there's no fund manager to blame. You own it. Lucas: That's the discipline. But the families that get it right are building wealth that lasts generations. It's patient capital, deployed intelligently.