How Should a Family Assess the Risk of Borrowers in a Private Lending Deal?

Assess a private lending borrower by tracing the cash expected to repay the loan and examining what happens if it falls short. Start with the business or project, then review its debt and collateral, along with the lender's rights. This shows the expected payment path and the realistic recovery path.

Understand the Repayment Source

Ask where principal and interest will come from. Review operating cash flow, existing obligations, and the planned use of borrowed capital. If repayment depends on a project reaching completion, a property sale, or refinancing, identify the assumptions behind that outcome. Delays, lower revenues, or higher costs could affect the borrower's ability to pay.

Look at the borrower as a whole, including assets beyond those named in the loan materials. Review other debt and guarantees, along with obligations that may compete for cash or assets. If the borrower is a company, understand its business model and who manages it. For a real estate project, review its costs and status, then identify the expected sources of repayment.

Test the Collateral and Legal Position

Identify the collateral, how it is valued, and whether another lender has a claim ahead of yours. Confirm that the security documents cover the relevant assets and that the collateral can be maintained and insured. A stated loan to value figure is useful only if the valuation is credible and the asset can be sold or controlled when needed.

Understand the loan's priority and the steps available after a missed payment or default. Recovery may require negotiation or enforcement, and a sale may take time and incur expense. Review the agreement with your attorney, including guarantees and covenants, as well as available remedies. Talk with your CPA about tax or entity questions tied to the structure. Assess the credit agreement's protections in light of the borrower's circumstances.

Evaluate Monitoring and Downside Scenarios

Determine who will monitor the borrower after funding and what information will be provided. Set expectations for financial reporting and notice of material changes. Agree on how communication will work if a payment or milestone is missed. Consider whether the lender has the staff and experience to respond to a problem or depends on a sponsor or servicer.

Model a delayed repayment and a partial recovery alongside the expected case. Consider how much of the family's capital would be exposed and whether the position fits its liquidity needs. Private lending can carry significant risk despite a high stated return. Assess it separately from public securities and other assets, as described in the family office's portfolio model.

A sound review connects borrower capacity with enforceable loan terms and practical recovery steps. If the family cannot explain how repayment is expected or what it could do after a default, it has not yet assessed the full credit risk.

Read next: What should a family consider before investing in private credit?

A small number of single family offices have waded into this territory by offering mezzanine financing and making other debt- and lending-related investments.

Sources: The Family Office Book, The Single Family Office. Informational only, not financial, legal or tax advice.