Takeaways
- Private lending is a largely unregulated way to make fund companies, particularly in real estate or alternative lending platforms.
- It’s assumed that anyone going into business as a private lender already has a great deal of liquid wealth.
- It is a high-risk business, so lenders need to have an appetite for that risk and commit to due diligence.
- While potential return on investment is high, there are several reasons not to enter into a private lending business, especially the lack of tax favorability.
Money begets money
With all the discussion of how entrepreneurs can raise capital without registering their securities with regulators, we can sometimes forget they don’t necessarily need securities. If you go the debt route, which is just as viable as the equity route, there’s no need to issue bonds if a bank is willing to lend the money. And increasingly, founders don’t even need the bank. More and more, individuals are lending their own capital, and they’re always searching for the right companies to put their money into.
How to sort through them is a story for another day. For now, we’re going to focus on how someone can become a private lender.
There’s all manner of noise online about how to start out as a private lender, and they are all predicated on the same advice: Start by already being rich. FortuneBuilders, which focuses on real estate investing but its advice can be taken more broadly, offers this list – abridged here – of qualifications:
The following often apply to those who decide to become money lenders:
- You are a doctor, lawyer, CEO, or professional of another kind who has a high income or cash surplus.
- You have a sizable retirement savings account.
- You are the owner of an estate or other trust fund.
- You are a tech entrepreneur who owns a successful startup.
- You are a lottery winner.
We're not detecting any degree of irony, so let's assume that you, Dear Reader, have got the zeroes and commas to throw at this pursuit. What are the next steps?
Business is business
So you’ve accumulated substantial wealth. What next?
Establishing a private lending practice is much like starting up any other professional office. You start by retaining a lawyer to craft your corporate structure – typically a limited liability partnership – then make sure you comply with your licensure and insurance requirements. Retaining an accountant goes without saying.
Then comes the harder parts:
- Finding potential investments,
- Assessing and selecting potential investments and
- Getting to “yes” and pushing the funding out to your new portfolio companies.
It’s really not that hard getting your name out as a private lender. It’s as easy as registering an account with any of the crowdfunding platforms. Besides that, you can take advantage of the same marketing and advertising tips and tricks that any business services operation can access. Just because regulations govern how companies solicit interest in their securities doesn't mean similar regulations govern the buy-side.
There's a reason businesses want to borrow money from you rather than the bank: The bank already said "no." The bank has rules and protocols and policies – as well it should, considering how many other people's money it's holding. Because you're accountable to nobody but yourself, you can make exercise more discretion. That's all the more reason, though, that you should do your due diligence concerning creditworthiness, proof of identity and address, income verification, and bad-actor history.
Understand that it's the higher-risk opportunities that will be coming your way; if you don't have a risk appetite, then this isn't the business for you. Even so, there's such thing as too much risk, and you need to know when to walk away from the table. Also, be aware that the company’s management is also taking a risk on you. There is a many-to-many relationship between lenders and borrowers, and they can and should talk to other private investors as well.
But let’s say all the hoops have been jumped through. You’re willing to lend; they’re willing to borrow. You need to hash out terms. Secured or unsecured? What’s your recourse in case of default? And of course, what's a fair interest rate, and how many months does the borrower have to pay off the note?
A quick word about interest rates: This might be the only place where you run into legal compliance issues. Most states have usury laws that define the maximum available interest rate. The Credit Union National Association has curated them for you.
At the close
Ultimately, any new business is a small business. It's always advisable to stay within yourself. Don't lend more than you're comfortable losing. Don't pour money into industries with which you're unfamiliar. If you're the tactile type, who needs to see how the funds are being deployed, stick to lending to local businesses.
If you’re successful, you could make between a 10% and 15% return on invested capital, according to Tampa-based commercial lender Tony DeCresie. If not, you could see those profits eroded by unfavorable tax treatment, inflationary pressures, and, of course, bad picks. Be aware of the cons as well as the pros.
William Freedman writes about business, technology, and finance for Global Finance, Macrotrends, AlphaSense, Sharestates, and other news outlets. He holds an MBA in international finance from The American University and serves on the board of governors of the New York Financial Writers’ Association.
