Steward Wealth has been an enthusiastic supporter of private credit since 2017, and we continue to believe good private credit investments represent a compelling risk-return proposition. However, we also believe you need to be very careful who you invest with.
Private credit is where you invest in a loan made by a non-bank lender to a borrower, who could be anything from an individual to a company listed on the stock exchange. It’s ‘private’ because the loan is between a lender and a borrower and isn’t traded like a public security. It’s essentially like investing in a mortgage.
As an asst class, private credit has exploded in popularity, not only in Australia, where ASIC estimates it to be a market worth well over $200 billion, but also in the US, Europe and the UK. It started after the GFC of 2008, when bank regulators placed a heap of restrictions on how much commercial banks could lend to different types of borrowers.
Here in Australia, the banking regulator, APRA, made significant changes to bank regulations in 2016, after which it became far more profitable for the big banks to focus on lending to mums and dads buying a family home to live in, so they reduced their lending to commercial borrowers, particularly in areas like property development. There has always been plenty of demand for funding by property developers, so, not surprisingly, non-bank lenders stepped in to fill the vacuum.
And it has proven to be a very lucrative area. The lenders raise funds from investors, ranging from superfunds to individuals, and then on-lend to borrowers at what sounds like very high rates. For example, a good borrower with a well rated project will currently pay interest rates of around 11-12%.
Because of the ongoing unmet demand, together with the appetite for high yielding investments, there has been a proliferation of private credit firms entering the market. Unfortunately, as yet, it is not a tightly regulated market, which makes it all the more important to do your homework before investing.
We were very pleased to see ASIC undertake a review of the private credit sector, culminating in a preliminary report in September, followed by a final report in November. Notably, they acknowledge the importance of private credit as a critical source of funding for a variety of sectors that collectively make a huge contribution to Australia’s economy.
After analysing the sector overall and 26 different funds specifically, ASIC concluded private credit is of such a scale and commercial significance that a better regulatory framework is required, particularly around standards of transparency and the management of conflicts of interest. It is very likely they will impose stricter regulations, which we, and more importantly every one of the private credit firms with which we invest, welcome.
In light of ASIC’s review, we revisited the criteria we set for recommending private credit investments and our preferred providers, and concluded we remain very comfortable with the parameters we’ve set:
- We restrict our investing to Australian domiciled funds. The number of overseas lenders offering investment products in Australia has leapt over the past couple of years, but Australia has a history of lenders being able to insist on debt covenants that are far more favourable than those typically available offshore.
- We only deal with well-established firms who have sufficient end to end resources to properly manage a private credit book, including sourcing loans, full credit assessment, loan structuring, ongoing monitoring and managing loans that run into difficulties, which is an inevitable part of lending.
- We will not invest in a fund that uses gearing. That is another reason we avoid overseas funds; we have yet to find one that doesn’t juice its returns by using leverage.
- We prefer loans that are predominantly secured by hard assets, such as property, compared to being secured against a borrower’s cash flow.
- We prefer to invest in ‘evergreen’ funds, which means the fund is ongoing rather than just existing for the life of a single loan. A huge advantage of these funds is that they can be invested across hundreds of separate loans, which reduces an investor’s risk.
- We only invest in funds that offer liquidity, enabling investors to retrieve some or all of their money rather than being tied up for potentially years. That liquidity is normally offered on a monthly basis.
- We prefer funds that maintain a relatively conservative average loan to valuation ratio (LVR) of around 65%. That means if a loan turns to custard, the lender has 35% headroom to recover the loan amount.
The fixed income portion of a portfolio is supposed to fill two roles: first, to provide income, which we think private credit does an excellent job of, and two, to provide an investment that is not correlated with the growth part of a portfolio. Given all the private credit funds we use have never had their unit price deviate from $1 per unit, that means they are indeed perfectly uncorrelated to share markets.
Although none of the funds we use have encountered a financial crisis comparable to the Global Financial Crisis, they have faced significant credit market challenges — such as the COVID-19 pandemic, the inflationary period of 2022, and the tariff correction in April. Pleasingly, none of the funds we use reported any issues navigating these events.
We are not as sanguine about the potential for problems arising in the US and UK markets, where some private credit providers have been loosening their lending covenants to win business, and loans to highly leveraged private equity deals are very popular.
Given the significant role private credit investments play in many of our clients’ portfolios, we wanted to reassure you that we are well aware of the issues raised by ASIC in its review of the sector and that we continue to carefully monitor the firms we recommend, and are very fussy about those we bring on to our recommended list.