Private debt investing can be an excellent way to generate passive income, offering higher yields than traditional bonds or dividend stocks. However, higher returns come with more risk, and investors who don’t fully understand those risks can end up losing capital instead of generating income.
In this guide, we’ll break down:
- What private debt is and how it works
- Why investors are turning to private debt in today’s market
- The major risks of private debt investing
- How to mitigate those risks with a disciplined strategy
If you’re looking to diversify into private lending, this is your guide to doing it safely and successfully.
What Is Private Debt?
Private debt refers to loans made outside traditional banking systems. Instead of borrowing from banks, businesses and real estate operators turn to private investors, funds, or alternative lenders for financing.
These loans are typically backed by assets—like real estate—or structured with repayment terms that provide higher yields than traditional fixed-income investments such as corporate bonds or Treasuries.
Common types of private debt investments
- Real estate-backed loans: Lending to developers or property owners
- Bridge loans: Short-term loans used for property acquisitions or renovations
- Mezzanine debt: A hybrid of debt and equity financing
- Business loans: Private funding for growing companies
Unlike public debt (bonds, corporate loans), private debt is negotiated directly between investors and borrowers, offering higher returns but requiring careful due diligence.
Mark and Sarah: Two Private Debt Investors, Two Very Different Outcomes
Before we dive into how to protect yourself when investing in private debt, let’s take a look at two accredited investors who approached private debt very differently.
Both Mark and Sarah have the same goal
Mark and Sarah are both accredited investors, each with $250,000 to invest in private debt. They’re looking to generate passive income, compound their returns, and retire comfortably in 15 years. But their choices lead to very different financial futures.
Mark: The Disciplined Investor Who Focused on Risk-Adjusted Returns
Mark knew that private debt can be a powerful passive income tool—but only when managed correctly. Here’s how he did it:
- He invested his $250K into a senior secured debt fund with a historical return of 8% annually.
- He reviewed the fund’s underwriting process, ensuring low default rates, zero leverage, and strong collateral protection.
- He spread his investments across different maturities, managing his liquidity risk effectively.
The result?
Over 15 years, Mark’s investment compounded at 8% annually, growing to $794,000—a solid nest egg for his retirement.
Sarah: The Investor Who Chased Higher Returns Without Understanding Risk
Sarah, on the other hand, wanted higher returns as quickly as possible. She found a private debt fund promising 12% annual returns and jumped in—without reviewing the fund’s structure, operator track record, or risk management strategies.
For the first three years, Sarah’s investment compounded at 12%, growing to $351,000. She felt confident she had made the right choice.
But then the fund went off the rails. The operator was lending to their own projects without investor knowledge, and the fund was over-leveraged with no clear risk protections. Several borrowers defaulted, and because the loans were backed by speculative real estate, there was nothing to recover. The fund collapsed, and Sarah lost 75% of her capital before she could pull out.
The result?
Sarah was left with $87,750, a devastating loss that set her retirement plan back by a decade.
How to Manage Private Debt Risks Like a Pro
Now that we’ve seen how Mark protected himself and how Sarah took unnecessary risks, let’s break down exactly what went right and wrong, and how you can structure your private debt investments for success.
Here are some steps to vet private debt risks:
Step 1: Understand your legal and structural protections
Private debt investments aren’t all structured the same way, and that structure determines how protected your capital is if things go wrong.
Before investing, ask:
- Where do I sit in the capital stack? Senior debt holders get paid first. Junior debt investors take on more risk.
- Who has control over the funds? A well-structured fund has either a strong collections team or third-party custodians who manage loan payments.
- What legal protections do investors have? Review investor agreements for clear repayment terms.
Smart move: Mark only invested in senior secured debt funds with clear investor protections that prioritized capital preservation before profits. Sarah, on the other hand, didn’t check the fund’s structure, and when things went south, she was stuck.
Step 2: Dig into the loan portfolio risk
A private debt fund is only as strong as the borrowers it lends to.
Before investing, ask:
- What types of borrowers are in this portfolio? Look for seasoned operators with a track record of paying back loans, not first-time borrowers.
- What’s the default rate of this fund? A strong fund should have a low historical default rate (typically under 2%).
Smart move: Mark only invested in funds that lent to established businesses and real estate projects with hard asset collateral. Sarah didn’t check what backed the loans, and lost nearly everything when borrowers defaulted.
Step 3: Make sure the fund manager has skin in the game
Before investing, ask:
- Does the fund manager personally invest in the fund?
- Is the fund lending to its own projects?
- How does the fund manager make money?
Smart move: Mark only invested in funds where the manager had significant personal capital invested, and they were not lending on their own projects, ensuring their interests were aligned with investors. Sarah didn’t check and ended up funding the manager’s risky personal projects.
Step 4: Consider market stress tests—how does this fund perform in a downturn?
Before investing, ask:
- How did this fund perform in past market downturns?
- What’s the average loan-to-value (LTV) ratio?
- What’s the backup plan for defaults?
Smart move: Mark chose a fund that stress-tested its loans against different market conditions and had clear contingency processes to take possession of the property and reposition it in the case of default. Sarah didn’t—and when the downturn hit, her fund had no plan.
Step 5: Have a clear exit strategy—can you get your money out?
Before investing, ask:
- What are the withdrawal options?
- Is there a secondary market?
- What happens if I need my money early?
Smart move: Mark only invested in funds with clear liquidity terms and structured exit options. Sarah didn’t check and was stuck when the fund collapsed.
Final Takeaway: Be Like Mark, Not Like Sarah
Private debt can be a powerful tool for building long-term wealth—but only if managed with rigorous due diligence and risk mitigation. Mark turned $250K into $794K by focusing on risk management, due diligence, and long-term investing principles. Sarah turned $250K into just $87K because she chased high returns without vetting the investment.
The key to success isn’t just picking a fund with high returns—it’s ensuring your investment is protected with strong legal structures, experienced fund managers, diversified borrower pools, and clear exit strategies.
Want to Invest Like Mark? Get My Private Debt Risk Assessment Tool
Navigating private debt doesn’t have to be overwhelming. If you want to evaluate deals like a pro and avoid the mistakes Sarah made, I’ve put together a Private Debt Risk Assessment Tool to help you vet opportunities quickly and confidently.
DM me the codeword “DEBTSTRATEGY” and I’ll send you my Private Debt Risk Assessment Tool—the same system I use to evaluate real opportunities in today’s market.
With the right strategy, private debt can be a reliable, wealth-building asset in your portfolio. Invest wisely.
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