The private credit industry has grown rapidly in recent years, emerging as a key alternative to traditional bank lending. Lonsec Research and Ratings has kept pace with this rise by refining their research process in early 2024 to incorporate sector specific risk and challenges.
The rise of private credit
EY has estimated the size of the Australian private credit sector to be A$188b in assets under management comprised of A$112b in business related loans and A$76b in commercial real estate loans (EY, 2024). The IMF has estimated global private credit at approximately US$2.1 trillion (IMF, 2024). This expansion has been driven by several factors, including banks’ retreat from riskier lending following the GFC.
Retail investors are following institutional investors and superannuation funds, by allocating capital to private credit as part of their portfolio diversification strategies, attracted by its historically strong risk-adjusted returns and low correlation with public markets.
Darrell Clark, Deputy Head of Research & Manager, Alternatives, Lonsec Research and Ratings, comments “Private credit can present compelling opportunities for both investors and borrowers but it also brings significant risks and challenges. Balancing opportunities with risk management is essential.’
The Lonsec approach
Foreshadowing the growth in Australian private credit funds, in early 2024 Lonsec updated its seven-factor private markets model and the governance framework overseeing the initiation of coverage.
Lonsec currently researches and rates 28 private credit funds, 20 of which are Australian Private Credit. In contrast to the global peer group which is heavily focused on direct corporate lending, Lonsec’s Australian peer group is 55% focused on multi-sector approaches and 45% on real estate lending.
In addition to the growth seen over the past three years, Lonsec has also declined to initiate coverage on multiples of those that have been contracted.
One key component of Lonsec’s research process is robust scoring models that have been developed over time and are reviewed on an ongoing basis by senior members of the Lonsec Research team. ‘We use a seven-factor model as the foundation for research ratings, with the Product factor specifically designed to evaluate the structure of the investment product under review. Prior to our Alternatives Sector Review last year, we enhanced the Product factor within our private markets model to better capture the additional risks associated with private market funds, such as illiquidity and valuation governance’, says Darrell Clark.
Lonsec also vets all requests for coverage looking at areas of heightened risk such as governance, vertical integration and/or related party issues, overall firm resourcing including workout staff, credit quality, and portfolio diversity and, only if a product meets minimum requirements, can it move forward into the Lonsec ratings process.
The focus areas outlined in the table below represent a selection of minimum hurdles or ‘gates’ and showcase examples of managers and funds unlikely to move forward in the Lonsec rating process
Lonsec remains vigilant to evolving market dynamics and ASIC’s ongoing review of private markets, ensuring our approach aligns with industry best practices and regulatory expectations. ‘Lonsec has been providing product ratings to Australian advisers for over 30 years, with our Alternatives rating team having a broad range of private market experience across several market cycles. We are highly aware of the trust placed in us by Advisers and their clients and as such, end investors are top of mind when we evaluate and rate funds,’ concludes Darrell Clark.