Private credit market to grow in 2025 as investors seek yield

Peter Szekely

The Australian private credit market is positioned for continued growth in 2025, driven by robust demand and the attractive yields it is offering investors. Rising volatility stemming from the US election of Donald Trump combined with global economic uncertainty could encourage investors to allocate to the stable credit sector away from equities in 2025.

The Reserve Bank of Australia’s (RBA) commitment to curbing inflation has resulted in a series of interest rate hikes beginning in 2022, pushing the cash rate to 4.35%. The RBA’s hawkish stance, coupled with persistent inflationary pressures, suggests that interest rates could remain elevated for some time, with market expectations pointing towards cuts no earlier than February 2025, and potentially later in the year.

This sustained higher interest rate environment bodes well for private credit, particularly given the debt is floating-rate, or linked to market interest rates. As interest rates have risen in recent years, so too have the yields on floating-rate loans, which has made private credit an attractive investment proposition compared to other asset classes.

Indeed, the International Monetary Fund (IMF) recently reported that private credit funds have delivered comparatively higher gross returns than other asset classes historically have delivered. Specifically, the IMF pointed out in its report, The Rise and Risks of Private Credit, that private credit funds’ returns were some of the highest across debt markets and seem to have relatively low volatility.

In addition, according to the US Federal Reserve^[1]: “Over the past decade, the asset class, particularly direct lending, has generated higher returns than most other comparable asset classes.”

That is why Australian superannuation funds are increasing their allocations to private credit assets significantly, led by AustralianSuper, Australian Retirement Trust and Hostplus. They are being drawn by the lure and relative stability of higher returns from private credit and the fact that it is less risky than equity investments.

However, the IMF also cautions that the rapid growth of private credit, coupled with competition from banks, may lead to a deterioration in pricing and non-pricing terms. This deterioration could involve lower underwriting standards and weakened covenants, potentially resulting in higher credit losses in the future and impacting returns.

The IMF recommended earlier this year that regulators closely watch the sector so private credit funds more comprehensively assess risks, including leverage, and enhance reporting requirements for private credit funds and their investors. We have already seen ASIC act on this and the regulator may introduce greater regulation of private credit funds in coming times, possibly as soon as next year. This could help to boost the transparency of the sector and draw investors.

The Shadow of the incoming Trump government

While the RBA’s monetary policy plays a pivotal role in setting local interest rates and the Australian economic landscape, the recent outcome of the US presidential election also has significant implications for global growth and, consequently, the Australian economy.

The incoming Trump administration is expected to be more protectionist, introducing new tariffs with a heightened focus on domestic economic interests. The US president elect wants to impose universal tariffs (ranging from 10% to 20%) on all imports, and a much higher tariff – 60% – on all Chinese imports and has threatened to revoke China’s ‘Most Favoured Nation’ status. This could lead to robust growth within the US but create headwinds for the global economy, particularly for China, a key trading partner for Australia. As a result, Australia could experience a slowdown in export growth and heightened economic volatility.

At the same time, a more inflationary outlook for the US will exert upward pressure on interest rates globally, leading to increased volatility in Australian markets. In this environment, it will be important for investors to focus on industries with inherent resilience and domestic support within the private credit market. For example, financial services is likely to remain resilient. Despite potential headwinds from rising interest rates, the financial services sector remains a cornerstone of the Australian economy, offering opportunities for private credit investments in areas like non-bank lending and specialised financial services.

Education is also a defensive sector. These sectors enjoy significant government support through funding and subsidies, providing a stable demand base and mitigating the impact of economic downturns. Likewise, the healthcare sector is Australia’s biggest industry and is likely to keep on growing with an ageing population and increasing healthcare needs. This sector presents a compelling investment opportunity, offering long-term growth potential and relatively stable cash flows given government backing. The infrastructure sector also benefits from government investment and long-term contracts, offering stable cash flows and reduced exposure to economic fluctuations.

In the technology sector, businesses within this space, particularly those with strong contractual revenue streams from service contracts and proven profitability offer attractive risk-adjusted returns. However, caution is warranted when considering investments in more cyclical sectors, such as hospitality which is exposed to discretionary spending. Construction too has been hit by inflation and higher interest rates and mining services is susceptible to global commodity price fluctuations and economic downturns, so makes private credit there potentially riskier.

A resurgence in deal-making activity

The Australian private credit market witnessed a surge in deal activity in the latter part of 2024, driven by several factors, including greater certainty around interest rates, reduced inflation, particularly in the US, and a more realistic approach to valuations by both buyers and sellers.

I expect this momentum to continue into 2025, with a robust pipeline of deals in the sponsor-backed market, where Tanarra Credit Partners primarily focuses. While the Australian private credit market is not entirely immune to global economic forces, it exhibits a degree of insulation from the volatility experienced in larger markets like the US. The smaller size and lower liquidity of the Australian market has resulted in less pronounced swings in spreads compared to the US, creating a more stable investment environment.

Furthermore, the abundance of domestic capital available for private credit transactions has reduced the reliance on offshore funding, further enhancing the local private credit market’s growth. This dynamic will allow Australian private credit investors to capitalise on attractive yields without being overly exposed to the vagaries of international markets. According to the Reserve Bank of Australia, the size of the local market is around $40 billion, based on data collected by the APRA and London Stock Exchange Group, as the chart below shows.

While the local private credit market is small relative to other business lending, it is growing rapidly. The RBA is closely monitoring its growth and potential risks, which is welcome news for the market.

“Due to its small size, direct risks to financial stability from the private credit market in Australia appear low. Risks stemming from overseas private credit markets also appear contained .. Liquidity risks are low, and so far in the most recent tightening phase, default rates have been lower than leveraged loan or high-yield bond markets. However, private credit markets remain opaque and are expected to continue to grow rapidly. Work by regulators to improve transparency will assist in monitoring growth in private credit and the potential risks to financial stability,” the RBA recently said^[2].

For investors, by focusing on domestically resilient sectors with strong government support and leveraging the relative stability of the Australian middle market, they can position themselves to capitalise on the opportunities presented by private credit. The large-scale deal segment, which often attracts international investors and is more closely aligned with global market trends, is expected to experience downward pressure on spreads. In contrast, the middle market, where Tanarra Credit Partners operates, is characterised by greater stability due to its reliance on domestic capital and it will represent some good opportunities for investors in 2025 to yield relatively high income.

By Peter Szekely, Managing director

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Notes:
[1] https://www.federalreserve.gov/econres/notes/feds-notes/private-credit-characteristics-and-risks-20240223.html
[2] https://www.rba.gov.au/publications/bulletin/2024/oct/growth-in-global-private-credit.html