CPD: Australian Private Credit – is history about to repeat itself?

Allocations to Australian private credit continue to grow, driving new borrowers, asset managers and investors into the market. While there may be a place for Australian private credit in some clients’ portfolios, it is vital that investors understand the risks of such an investment in the face of slick marketing and seductive yields.

While predicting future events is challenging, past lessons can serve as early warnings. The Global Financial Crisis (GFC) highlighted the dangers of excessive risk-taking and inadequate oversight. Similarly, China’s shadow banking sector’s lending to property developers has created financial instability. These incidents underscore the systemic risks of unchecked lending practices. As they say, history rarely repeats itself, but it often rhymes.

The Australian private credit market is showing troubling signs of repeating past mistakes. Firms borrowing from private credit lenders are typically smaller, highly leveraged, and thus riskier than their public market counterparts. These borrowers, like home loan mortgagors, are more vulnerable to interest rate hikes due to the floating rate nature of their loans. With lower free cash flow, the knock-on effect requires them to borrow more, increasing their leverage further. The sector, having never faced a severe economic downturn at its current size and scope, could see a delayed realisation of losses followed by a spike in defaults and large valuation markdowns. Domestically, private credit lenders are made up of a few large institutions and a growing portion from retail funds. This relatively large pool of lending assets (on a global scale) continues to compete for the small pool of domestic borrowers. With all of this in mind, it’s logical to ask what are the known risks, the unknown risks, and how can we identify and quantify them? The past may not return to haunt us, but we must remain aware that it could, even if predicting the trigger and the extent of the fallout is challenging.

Buyer beware: potential risks associated with Australian private credit

1. An unregulated sector

Regulators basically forced banks out of this space as the capital required to be put aside for poorer credit quality loans meant they would never hit their required financial metrics (e.g. ROE). Private lenders are not regulated by APRA, have no RBA oversight (or lender of last resort liquidity) and their loans are not rated by recognised agencies (e.g. S&P, Moody’s). As such, anybody can put up a shingle and seek to attract capital.  Other public debt is subject to comprehensive disclosure requirements, which act as safeguards for investors.

2. No transparency

As private lenders are not regulated, there is nobody looking at what they are doing to protect investors. Investors have no transparency and even if they did, they do not have the resources to assess the validity of the claims the lenders make about the loans they hold. As with the GFC, loan to valuation ratios (LVRs) are only as good as the V, which is not known. The more that competition for loans intensifies, the more the likelihood of credit controls slipping increases, and without transparency or regulation, the risk escalates.

As it stands, covenants are being relaxed in some markets already due to the build-up of money entering the sector (note – there is a large overhang of unplaced capital in the private market), loan documentation is being reduced (down to low doc loans, as in the GFC), loan arrears and delinquencies are rising, and valuations of assets is always variable. It’s very hard to evaluate and manage risks you can’t see.

Private lenders typically value their loans on a “market to model” basis, a system which also applied to lower credit quality debt in the GFC, which Warren Buffett described as “marked to myth”.  It leaves investors subject to significant moral hazard as valuations tend to be subjective and often stale or undertaken intermittently. An example of a practice which can go unnoticed is that of capitalising interest on loans which are non-performing, known as paid-in-kind interest. A borrower which is experiencing difficulties in meeting scheduled payments can have their interest capitalised, hence increasing the credit exposure to the borrower. While this is often accompanied by a punitive interest margin addition for the remainder of the loan, in a concentrated market like Australia, this practice could be going on across a loan portfolio without investors’ knowledge.

Depending on how asset managers disclose their defaults, a build-up of what could otherwise be described as non-performing loans (or defaulting loans) may be occurring without investors’ knowledge. Coupled with subjective valuations, existing investors could be lulled into a false sense of security, not to mention new investors buying units in pooled vehicles at prices above what an arm’s length valuation would suggest. While no data is available on Australian private debt, reports suggest paid-in-kind interest has doubled since 2019 in some areas of private debt in the USA (where better disclosure is available in some segments of the market) as interest rate rises have placed increasing strains on lower credit quality borrowers.

3. Lenders don’t put their own balance sheets at risk

Most private lenders act as agents of their investors and have no principal at risk, so are incentivised to write loans whatever the cost. While any lack of alignment of interest between investors and asset managers is a risk, it is particularly relevant where defensive assets are involved, as investors rely on them for protection.

4. High fees.

As with the above, there is little alignment of interest with investors. Note that headline fees (e.g. investment management fees) are not the only ones many managers collect – they also can be paid loan origination (or establishment) fees by the borrowers, which in Australia can be a significant percentage of the loaned amount. This increases the moral hazard of continuing to lend money to borrowers on terms which are not in investors’ best interests.

5. Lack of liquidity

On top of this, even if investors could foresee a credit event about to occur (i.e. time a trigger point), private credit funds are quite illiquid. As valuations are often stale, unit prices may not fully reflect the true value of the investments. Be wary of those who seek to position low liquidity as low volatility – those who subscribe may discover to their peril that they are two very different things. This also creates a possible further equity issue in that first movers in a concentrated market exiting a fund with inflated unit prices could cause some investors to incur more than their equitable share of losses. As the flow of funds into retail offerings is a means of providing liquidity, in periods of financial stress (when net withdrawals are likely to be occurring into illiquid funds), this situation is only exacerbated. It is perhaps that flow of money into retail offerings which is particularly pertinent – while institutional investors are familiar with less liquid opportunities and are often afforded longer investment time horizons, the inability of retail investors to access their money may come as a rude shock to many.

6. Concentration risk

Diversification becomes more important the riskier the asset set is. Being able to diversify by geography and sector is very important when lending money, as avoiding catastrophes is paramount. Private credit markets generally have a high concentration of exposure to property. In Australia, the issue is intensified as we have only two major property markets (Sydney and Melbourne), which is where the majority of the loan exposure occurs. We also have a small cap economy, so the breadth of industry is small to which loans are being forwarded. Concentration risk is an ever-present issue in Australia and investors could be exposed on many levels through the same entity (e.g. holdings in REITS, corporate bonds issued by those REITs and then private loans to the same REITs). While many asset managers suggest they are diversified by number of loans in a portfolio, the fact is that concentration risk exists as the loans may be to borrowers in the same sector or against the security of property in the same city. While on the face of it this may sound well diversified, no insurer covering property damage to 300 homes in Miami Florida would say they are well diversified as one weather event, for example a hurricane, could cause catastrophic loss.

As more monies flood into the sector, loans have also increasingly been lent to developers, up to 60% in some cases. Development is very much at the riskier end of the property spectrum, including potentially highly leveraged exposure to land banks. In a scenario where a loan to a developer becomes impaired it is often hard to find a buyer to take on an unfinished project, with other developers often unwilling to take on half built developments with unknown risks or quality issues. So, while it may be secured, the asset may be worth far less than assumed even with much touted 40% safety margins and insolvency laws.

7. The paradox of the false promise

A further disturbing feature of private credit is the near risk-free return being marketed – 11% style yields, no volatility of unit prices and very high security (as they are lending on a senior secured basis). As borrowers are increasingly property developers (which is the riskier end of the security chain), this should raise red As more money enters the system attracted by the riches being proposed, it seems inevitable that more risk will be required to be taken to keep returns high (as occurred in the GFC). This could be in the form of lower credit quality and/or leverage, neither of which is a beneficial set of circumstances for investors. Recent experience suggests the volume of money chasing available loans is impacting materially on unleveraged yields available. Increased competition from public markets is also attracting higher quality borrowers (due to significantly lower interest rates being charged) placing increasing pressure on private lenders.

Leverage comes in many forms and often congregates in stress across a financial system. Loans to highly leveraged borrowers, where leverage is used in one or many components of a financial structure (e.g. interfund exposure when a fund invests in a leveraged fund managed by the same asset manager), could create a systemic financial problem in times of stress. An example of this could be a leveraged fund receiving margin calls from its lender (e.g. a bank) at the same time the highly leveraged borrower is running into cash flow problems. Not only are the fund and borrower facing financial strains, but the lending bank could also be experiencing stress, which in turn impacts its ability to lend, so credit dries up across a financial system. Investors in the private credit fund could experience financial stress on many levels in such a situation.

In summary, there are clear risks in investing in Australian private credit – risks that are often not given the same prominence as the lure of high yields. As acknowledged at the outset, not all private credit is bad – it may play a useful role in a diversified portfolio. However, its use should be metered and proportionate to the level of risk the investor is willing to take. As discussed, evaluating that risk is hard especially when there is a lack of transparency, and it can’t be quantified. To assist investors, we have put together five questions that investors should ask before investing in private credit funds in Australia.

Investor checklist: Five questions you must ask your private credit manager

1. Who is your manager looking after?

Unlike banks, there is no balance sheet risk for managers who arrange private credit – the investor bears all the credit risk. Fees come in many forms when it comes to Private Credit.  In some cases, managers are paid an arranger fee for bringing an investor and a borrower together.  Is this part of your return?  So how does the manager align their interests with clients? Does the manager co-invest alongside clients? All investment products involve the charging of fees and accrual of costs; as always, the focus should be on how transparent those fees and costs are and are they appropriate – for Australian private credit funds, those fees and costs can amount to over 2% before performance fees are accounted for. Where possible, apples-to-apples comparison of fees and costs should be sought to ensure they are comparable and fair.

2. What is the revaluation process?

As highlighted, an apparent lack of volatility can reflect a lack of regular pricing rather than an indication of low risk. Where a new price is issued, but it is based on out-of-date valuations that do not necessarily reflect current market conditions or loan health, you should ask the manager how often they revalue the portfolio and who does the revaluation.  Be aware that standards around regular and independent valuations in Australia are below those of many international markets. Investors may be left unaware of problems brewing in the portfolio, potentially leaving them dangerously exposed to building risks.

3. Can they provide a workout scenario case study for when a loan breached its covenants or defaulted?

Sometimes things go wrong, so the test is how was the issue identified, how did the manager act to protect investors and how was this communicated to investors? Ask your manager for an example of how they identified an impaired loan and how and when was that reported to investors. Was the loan restructured and assuming the loan was secured, did other lenders have security against the same assets? Has the manager ever written off a loan and if so, what percentage of loans in the portfolio have breached their covenants, been restructured or written off entirely over the last 12 months.

4. How much of their portfolio is exposed to property and how much is lent to developers?

Ask to see a breakdown of the portfolio’s exposure. It is unlikely you will be provided a full list of each loan, but a manager should be willing to provide a breakdown of the loan characteristics by sector and geography. Is the manager willing to share the average loan rating, the type of property or development the loan is issued against and in which geographical market? How many names is the book spread across and what is the average time to maturity. In theory, diversification should help to spread risk.

5. How quickly and easily can you exit the Fund, considering its liquidity profile and gating mechanisms?

In most cases investors should be able to freely transact in and out of the fund as required per the terms in the PDS. Here we are seeking to identify some of the potential risks, to help ensure investors can fully evaluate them when deciding how much of their capital to commit. If there was to be a market event, or realisation of one of the potential risks highlighted, liquidity may become a significant issue. First, how liquid is the Fund in normal times; i.e. how often does the Fund process redemption requests and are there any limits? Second, should a large investor seek to redeem, are there mechanisms in place to ensure other unitholders are not adversely impacted as a result? These impacts may be from changes to the portfolio and/or realisation of gains. In times of stress most private credit funds will have the ability to gate redemption requests. This means they will stack up requests and allow a portion of requests to be met at set intervals. In such cases, it may be months or even years before investors are fully able to redeem their investment. The details will be in the PDS, and it is important to understand what redemption conditions may be applied and to seek clarity if required.

Does private credit meet your clients’ needs?

Acknowledging that private credit can provide a useful role in portfolios, consider the following when assessing sub investment grade opportunities:

1. Going global – provides geographical diversification
2. Consider bank loans – a regulated space
3. Infrastructure bonds – enhanced liquidity
4. Bigger, broader markets – provides sector and issuer diversification
5. Tactical tailwinds – exposure to long term trends e.g. energy transition, aged healthcare
6. Manager tenure – look for experience and track record

Investing in sub-investment grade debt requires a more hands-on approach than investing in investment grade debt, and expertise is essential. This requires good analysis before and during the term of a loan or debt, as well as remediating the situation should things not go as planned.

Given the idiosyncratic nature of private debt, while investing in larger and broader markets (like USA) is a worthwhile first step, it is not a panacea for success. Many experienced Australian investors have not realised their expected outcomes in overseas markets, so having structures in place to avoid bad credit events or recover large proportions of their capital if not, will weigh the odds heavily in investors’ favour.  Engaging local specialist lenders, who are experts in specific markets (so know the industry and players intimately), provide the parameters to constrain the risks inherent in this segment of the market.

While the headline yield may not be as attractive, building a well-diversified portfolio with daily liquidity may ultimately provide investors with much better risk adjusted returns. With banks and asset managers beginning to flag these risks, investors would be well served to be cautious. Betting big on Australian private credit may regrettably become a gamble rather than an investment.

By Tony Breen, Investment Specialist, Credit 

 

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