Private credit as a global investment sector is forecast to almost double in size to $US2.8 trillion ($4.3 trillion) by the end of 2028.
By comparison, the Australian sharemarket is valued at around $US1.5 trillion.
Private credit, also referred to as private debt, is defined as loans that take place outside traditional bank lending or public debt markets.
Private credit markets are largest in the US and Europe and typically private credit firms charge a variable rate of interest above a reference rate (such as the cash rate), which means investors can benefit from rising interest rates.
Pengana Capital Group chief executive Russel Pillemer says the private credit opportunity has arisen because regulators are discouraging banks from lending to companies to reduce financial system risk, such as that which occurred during the global financial crisis.
In Australia, private credit funds tend to heavily feature real estate, and write loans of shorter duration (less than two years), typically for property developments, according to Atlas Funds Management chief investment officer Hugh Dive.
This makes them more susceptible to a property market downturn, he says.
Pillemer believes that the most favourable segment of private credit is bilateral loans to stable mid-market corporates in the US and Europe.
A bilateral loan is one made between one borrower and one lender, as opposed to a syndicated loan; mid-market corporates are those with market values of between $US500 million and several billion.
Healthy returns
It is rare for stable, profitable, high cash flow generating mid-market companies to default on their loans, provided they have modest levels of gearing, he says.
Many Australian credit funds offer exposure to this segment of the market.
The targeted returns from private credit are around 5 per cent to 6 per cent above a base rate such as the RBA cash rate.
These increased returns are not without risk, and one of the key risks of any credit investment is that the borrower defaults on the loan.
The underlying loans within private credit are generally not traded, and therefore not valued on a regular basis, which limits transparency.
Most investors associate increased loan defaults with recessions. History tells us that all recessions have increased loan defaults (known as a default cycle), but not all default cycles have a recession.
In the late 1990s, we had Long-Term Capital Management [a hedge fund bailed out by the US government], the Russian rouble crisis, the Asian financial crisis and the dotcom collapse, but no recession.
In 2015, the energy sector experienced a default cycle that was a major event for the fixed income sector and a few banks, but didn’t trigger a recession.
Regardless of a recession, default cycles are, by definition, cyclical.
We have not experienced a default cycle for some time, but Australian high-profile short seller John Hempton cautioned investors recently by announcing that he is shorting credit as conditions have allowed some “very suspect companies to obtain billions of dollars of debt”.
This makes the selection of fund manager even more critical, to reduce risk of loss in a default cycle.
Dive highlights the other key risk for investors in private credit, which is liquidity. For listed private credit funds, while the underlying asset value may not be volatile, when investors head for the exits at once – such as when COVID-19 first hit – the share price can be very volatile.
Max 5pc allocation
During the GFC, when credit markets were stressed, many unlisted funds froze redemptions for a number of years. Investors should therefore consider whether this forms part of the defensive part of their portfolio.
The Future Fund as at the end of 2023 had 10.7 per cent of its portfolio allocated to the credit sector, of which private credit forms a part.
Metrics Credit Partners managing partner Andrew Lockhart believes a balanced portfolio should have no more than 5 per cent allocated to private credit.
Investors can access private credit through funds listed on the ASX or via unlisted funds.
Pillemer says investors would be wise to use experienced management teams with strong credit skills that have been tested through previous credit cycles.
Many credit funds on offer today did not exist during the last credit cycle but many of the individuals were in the industry working in significant roles.
He also says the funds need to be reasonably large so that the loan book is diversified, and that the manager also should have strong relationships with corporate and private equity buyers to source exclusive deals.
With banks vacating parts of the lending market, there are opportunities for investors, but it is essential to partner with an experienced credit manager and be aware of the liquidity risks.
