Private credit has attracted a lot of attention in local markets over recent months. One could say it’s the new ‘black’ of the investment world.
In this piece, I’ll provide my thoughts and opinions on the sector, specifically some of the risks and pitfalls investors should be wary of if considering an allocation. In doing this I’ll also articulate why we don’t participate in this part of the market. A few recent publications linked below also shed some light on the asset class and the risks that come with it.
Private credit is generally defined as non-bank lending where the debt is not issued or traded on public markets. It is also known as ‘direct lending’ or ‘private lending’, where the loan is directly negotiated between the lender and borrower. The private credit market is roughly half the size of the public credit market, but is growing. I’d caveat that by saying private credit numbers are somewhat rubbery.
Why the growth in private credit?
To some extent growth has been a function of banks stepping away from lending to riskier parts of the economy, which has been driven by post financial crisis regulatory developments (higher risk weights and resulting cost of capital). Commercial property lending is a good example referenced in one of the above articles. Super funds and other fund managers have stepped into the void.
Investor appetite for private credit has also risen as investors look to diversify their portfolios beyond stocks, bonds and traditional credit investments (public). Private credit investments can offer diversification benefits and may also help investors enhance risk-adjusted returns by adding an alternative asset class to their portfolios. Private credit also offers flexibility and customization. Deals can be tailored to meet specific needs of borrowers, offering flexibility in terms of loan structure, covenants and term or tenor.
Private credit can be attractive in a low interest rate environment, where investors might seek high-yielding investment opportunities. Private credit can offer yield premium over traditional fixed income securities, which is enticing at face value. That’s the sales pitch, but there are no free lunches, so here are some risks….
Before I go into the risks of private credit investments, let me say I am not entirely adverse to these investments. I have invested in them in past lives, which opened my eyes to the required skill, diligence and expertise, as well as resources needed to take on the risks safely. Private credit investing is labour intensive – or should be, if it’s done right. And, while private credit offers a higher premium than public credit, generally, this premium reflects higher risks, mainly liquidity and default risk.
What’s the difference between private credit and public credit?
One of the most obvious differences between private credit and public credit is tradability and valuation transparency. Public credit is, as the name suggests, publicly traded. It has an observable price at which it can trade, it is transparent. Private credit on the other hand is a negotiated loan outside of the public market, with no trading functionality – other than bilateral negotiation, which is time consuming, complex and often not viable. Private credit is typically valued at par in a fund, which is the face value of the outstanding amount. Once a fund is invested in a loan, it’s generally a buy and hold investment, in it to the bitter end.
Private credit transparency…what’s under the hood?
Some firms specialize in managing private credit portfolios, it’s all they do and it’s all they put in their funds. Investors would go into these funds knowing underlying liquidity is limited. Other managers dabble in both public and private credit, often blending exposures to both credit classes in the one fund. Investors need to be mindful of this when investing in such funds. If a blended fund has meaningful redemptions (withdrawal), remaining investors may be left with a greater exposure to private credit than perhaps they’re comfortable with.
Blended funds can also have misleading portfolio metrics. Let’s say a blended fund has 40% of the fund in private credit, which is typically valued at par. During periods of market dysfunction or heightened risk off trends such as the covid outbreak, spreads would typically widen on public credit, which would see valuations decline. Private credit investments on the other hand can be left at par, which is not a true or fair reflection of risk.
Using our own experience as a proxy, the Mutual Income Fund lost -2.11% in March 2020, the onset of COVID, while the Mutual High Yield Fund lost -2.50% over the same month. Modest moves in the context of movements in other asset classes, recall the ASX 200 lost almost -34.00%. A fund with private credit would fall less, if at all given the underlying loans are likely not marked to market. On the surface that’s great, no loss of wealth. Unless you need your capital back.
That’s liquidity, what about credit risks?
Generally public credit is of ‘better’ credit quality in that the public credit market is largely rated, and predominantly investment grade. Private credit on the other hand is typically unrated more often than not. Investors in funds populated with private loans put faith in the fund manager to do the necessary due diligence to ensure an appropriate risk vs return dynamic is maintained. And, to take necessary action to protect their capital if an underlying loan is materially deteriorating. The recent articles linked below touched on examples where fund managers failed to do so.
And recently, ASIC Chairman, Joe Longo, singled out the sector for some attention, “we don’t know what’s really going on there because of lack of transparency and data, and we could end up with some unexpected or unintended consequences of this activity.” And… “I think that’s a serious subject. I think we’re doing a lot of work with market participants, which I’ll have a little bit more to say about, trying to figure out what’s going on in that space.” (AFR)
So, is private credit a bad investment?
No, of course not. But, caveat emptor, make sure an exposure to helps meet your investment goals while remaining true to your risk tolerance and risk capacity. Mutual has the capacity and required skill set to add private loans to a couple of our funds, but elect not to. A core philosophy of the business and focus for all funds we manage is to provide investors with steady and predictable income streams with minimal capital downside, all the while ensuring ready access to their funds as and when required. Private credit does not meet our investment goals or risk tolerances, nor is it required to meet fund investment targets.
Further reading:
A couple of good AFR articles, linked below, have also shed some light on the asset class and the risks that come with it:
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