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Caroline Tomasic

The Unregulated Private Credit Boom

Introduction

Private Credit, synonymous with private debt, is an alternative form of capital lending. It is where non-bank institutions lend to small and medium-sized organisations, such as developers within the commercial real estate sector. These non-bank institutions include specialised credit managers, insurance and asset managers, sovereign wealth funds and superannuation funds. This asset class is gaining increasing traction for its high returns and relative stability amongst a backdrop of high interest rates and subdued economic growth. Private credit providers sometimes work alongside traditional banks when the loan is too large for one lender to underwrite. Importantly, private credit loans are not publicly traded and sit within an opaque regulatory environment. 

 

A defensive rather than a growth asset, private credit allows investors to diversify their portfolios away from the traditional 60/40 stock and bond weights. The organisations that benefit from private credit funding usually cannot secure loans from traditional banks. In these instances, traditional bank lending might not be available when it involves complex business structures or high-growth, start-up companies. Companies might seek private credit when they are restructuring, or when they are not large enough to access public debt markets. Additionally, private credit may be sought out when real estate and infrastructure projects require bespoke expertise and flexible capital. 


Investors in private credit funds hope to earn a higher return than they would from a term deposit or equity investment. Like normal loans, the company that borrows the funds must pay interest during the term of the loan as well as the principal amount in the future. 



 

The Rise of Private Credit  

The demand for alternative lending structures such as private credit was catalysed by the 2008 Global Financial Crisis, which heralded tighter banking regulations. Regulators have since placed greater capital requirements on banks, leading to a decrease in the availability of flexible capital opportunities. The Australian Prudential Regulation Authority (APRA) has imposed a range of measures that have hindered major banks, foreign banks, institutions and accredited investors, consequently opening up opportunities for alternative lending. In 2020, there was US $887 billion in Assets Under Management for private credit globally. The RBA estimates that the private credit market is now worth $2.8 trillion AUD. 


As mentioned above, private credit and corporate markets have increasingly sought out private credit financing for corporate strategies such as mergers and acquisitions, recapitalisations and restructurings. This requires the private credit manager to be able to work with complex credit structures whilst providing tailored financing solutions.  

 

Compared to asset classes such as public equities, private credit is an attractive investment because it can produce higher income returns, whilst being characterised by income stability. Private credit has a lower risk than equity due to debt sitting higher in the capital structure in the event of liquidation. This asset class can thereby reduce the volatility of an investor’s portfolio. Private credit plays the role of both a defensive investment that can deliver high-income return, as well as a replacement asset for equities. 



Sources of Private Credit Funding

The five main subcategories of private credit providers include senior debt lending, mezzanine debt, real estate and infrastructure funds, distressed debt and special situations such as opportunistic credit funds. Senior direct lending refers to loans provided to mid-market companies, which are typically illiquid loans with floating coupon rates and maturities between 3-7 years. Mezzanine debt, typically used to fund growth projects for more established companies, allows the lender to convert an equity interest in the company if there is a payment default. Distressed debt refers to significantly discounted bonds bought from companies experiencing cash flow issues, where the investors gain some control of the business. Special situations investment involves lending to companies undergoing events like divestments, M&A, liquidations, restructures, share buybacks, or rights offerings.

 

Recent Capital raising deals for Private Credit 

Metrics Credit Partners recently completed a successful capital raising for the Metrics Master Income Trust fund, a raising of more than $195 million AUD. This capital-raising venture included a placement to wholesale investors and it also allowed retail investors to acquire up to A $30,000 new units through a unit-purchase plan. 


Australian Private Credit

The portfolios of Australian private credit fund managers are mostly concentrated in the property sector, including loans to residential developers and the commercial real estate sector. Australia’s banking regulator believes that property developers are the biggest killer of banks and hence the big banks have largely avoided the real estate sector. The concentration in Australia’s private credit market poses a unique risk versus more diversified foreign portfolios with less property exposure.


Private Credit in Asia

The need for alternative financing, as seen in the Australian and US markets, is similar to that of APAC, particularly among small companies. Significant growth opportunities for the private credit asset class within the Asia Pacific (APAC) region are expected in the near future. This is linked to expectations that a significant portion of future global economic growth will stem from APAC, which is home to two of the world’s three largest economies and is where markets range from fast-growing emerging markets to large developed economies. 


This growth potential is seen in the expected economic growth rate for Asia economies of 4.9% per year over 2024-2026, according to the International Monetary Fund. This significantly dwarfs expected growth rates for the rest of the world. The APAC region’s public equity and debt markets are relatively underdeveloped and thus private credit is suitable for filling the void. Additionally, allocating private credit in Asia can assist global private credit funds by diversifying exposure to North American and European private credit lending. 


 

Key Risks

The main risk facing private credit investors is the risk of loan default. Investors risk losing their capital investment if the borrower’s credit quality deteriorates and the loan default becomes a loss. This risk is minimised by private credit funds diversifying by having many loans in their portfolio. 

 

Another risk is that this is an opaque, unregulated asset class and one that has low transparency standards. As mentioned above, private loans do not trade on public exchanges, and private credit markets are often less liquid and have less price discovery. That is, valuations of private credit funds may not properly reflect loan impairments, which is in comparison to ASX-listed securities that have greater liquidity. 


This risk can be managed by investing in private credit funds that have been quoted on the ASX. This refers to funds that have a Listed Investment Trust structure, where investors buy or sell units in the trusts, both of which have target yields and generally pay monthly distributions. Private credit funds can manage the risk of loan default by taking appropriate due diligence to ensure that the organisation can service the loan under a range of different economic conditions, such as a rising interest rate environment. Private credit funds can also structure the loans to include sufficient lending protections, ensuring that the organisation will still pay the loan if its credit quality deteriorates. 


The success of the underlying assets within the private credit portfolio relies heavily on the managers behind them. The managers must appropriately assess and monitor the loans, managing risk, to ensure that investors receive high returns alongside low risk. 


Furthermore, the Australian Financial Review (AFR) reports that private credit funds are reluctant to inform investors of loans that perform poorly and to write off such loans. The AFR also comments that some private credit funds have questionable due diligence practices, including lending to companies that go broke. This is demonstrated in the case of Sydney-based alternative investment firm AquAsia, which gave a substantial loan to a listed legal financier company LawFinance in 2021. LawFinance breached its debt covenants and underwent painful restructuring only three years later. 


AquAsia did not immediately communicate the performance of the loan to investors. In fact, one investor was told in 2021 that the loan portfolio was sound and was given little details on how the LawFinance restructuring was occurring. Despite this, AquAsia has incurred only one negative month since launching. It is approximately worth a staggering $490 million AUD and it had an estimated return of 14.1% over the 12 months to July 2024. 


 

Conclusion

The demand for private credit remains strong and growth in this asset class is expected to be sustained over at least the next five years. As banks face increasing regulatory restrictions and place higher requirements on borrowers, more small and medium-sized companies will turn to non-bank lenders for capital funding. Private credit will thereby carve a greater role in supporting companies that require additional and bespoke funding to expand and pursue growth projects. This growth opportunity should also be recognised along with the risks that are associated with the opaque private credit industry and the need for extensive due diligence as well as experienced and skilled private credit managers. 


 

References

AAustralian Investment Council. (2024). Private Capital Series: Introduction to Private Credit. https://aic.co/common/Uploaded%20files/Investment/AIC_Private%20Credit%20Fact%20Sheet.pdf


Dillar, B., et al. (2023, November). Private Credit in Asia Pacific: A Region on the Rise. KRR. https://www.kkr.com/insights/private-credit-in-asia-pacific


Muzinich & Co. (2024, May 20). Five things to know about Asian private credit. https://www.muzinich.com/opinions/2024-05-20-five-things-to-know-about-asian-private-credit


Klyne, S. (2024, August 15). Private credit firms find $1trn target in rich Australians. The Australian Financial Review. https://www.afr.com/wealth/investing/private-credit-firms-find-1trn-target-in-rich-australians-20240813-p5k1zt


Weinman, A., and Shapiro, J. (2024, July 1). ‘Marking their own homework’: Inside Australia’s $200b unregulated private credit boom. The Australian Financial Review. https://www.afr.com/companies/financial-services/investors-realise-private-credit-is-a-two-way-street-right-20240621-p5jnm2


Metrics. (2024). Understanding private credit. Metrics Credit Partners. https://metrics.com.au/news/understanding-private-credit/


Joye, C. (2024, September 6). Is private credit becoming the next subprime crisis? The Australian Financial Review. https://www.afr.com/companies/financial-services/is-private-credit-becoming-the-next-subprime-crisis-20240906-p5k8gp

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