Key Points
- Due diligence is crucial when investing in private credit
- Private credit can offer an attractive income stream and diversification benefits
- The opaqueness in operations of private credit funds increase risk
A smooth ride can become trouble
The risks and benefits of private credit funds can be likened to buying a used car sports car – it can offer great performance but fail to do your research and it could deliver a boot-full of headaches.
Picture this: the sale is complete, you’ve picked up the keys and smiling ear to ear as you drive your new wheels home for the first time. Several months later you book your pride and joy in for a service and – uh oh. The problems lurking under the bonnet start to emerge. Faulty water pump, oil leaks, cracked head, the list goes on. A seasoned mechanic could have spotted these issues and help determine if the risks were manageable before the sale, but instead you’re now left with an asset that may chew through cash and be difficult to rectify or dispose of.
Private credit: the emerging engine of the investment world
Private credit is a type of non-bank lending, where a fund manager raises money from a range of private investors for lending to specific projects and/or companies. We regularly see a variety of new investment groups popping up but what we have noticed is a rapid increase in the number and variety of private credit investments on offer.
There are several factors that have created conditions for its accelerated growth, which has seen the private credit market almost double of the last five years. That is creating increased caution among some investor commentators about the quality of some of the underlying loans and some of the managers that have entered the market to cash in on the boom. So, what has created this investment environment?
The private credit market boom has been driven by traditional lenders, such as banks, altering their lending practices. This shift in lending philosophy saw many banks exit property development lending and tighten up on loans to small to medium enterprises. It left the door open for private investors to step in and fill the gap, through pooled funds operated by private credit managers. Historically, low interest rates from late 2020 through to mid-2022 further fuelled the attraction to private credit as investors armed with piles money were desperately searching for yield on their assets.
Turbocharging returns: the risks of leverage
Internationally, growth has been even more pronounced thanks partly to the more aggressive approach of funds using leverage to boost funds size and hence their fees. This layering of leverage is akin to carrying out major engine performance modifications to your car. Yes, it can turbo charge returns but equally it can blow up the engine if pushed too far. That is why internationally such financial engineering has started to raise eyebrows of regulators.
The hidden risks of opaque operations
While default rates on the loans within these funds have been subdued, there is a risk that if the economic conditions become tough, some credit funds’ may be reluctant to call out their bad loans. Instead, they may prefer to renegotiate terms with their borrowers to avoid a crisis in confidence among investors, which would be more damaging to the fund’s reputation.
And when it comes to valuing their loans, although private credit funds generally follow accepted accounting principles, however the rules for asset valuations are complex and can be inconsistently applied. Therefore, valuations could become even more precarious if a macroeconomic shock prompts widespread reassessment of asset values. The real issue here is the opaqueness in the private credit funds operations which increases potential risks.
As demonstrated by last week’s interest rate announcement, the Reserve Bank has stated it is not in a hurry to cut interest rates aggressively which together with stagnating growth in many sectors, some of the more marginal credit providers could start to misfire.
The importance of a pre-investment inspection
The right private credit fund, like a great performance car, can be a worthwhile purchase. Potential advantages of private credit include the generation of a strong income stream, improved diversification and offering protection from rising rates, given their typically floating rate nature.
It can have a place in a well-diversified portfolio where the investments are made through high quality, experienced and disciplined private credit fund managers – which is why it requires a sound pre-investment inspection to ensure you understand what you are getting yourself into.
Christian Golding (248 906) and Pitcher Partners Wealth (WA)Pty Ltd (127 4651) are Authorised Representatives of Sentry Advice Pty Ltd, (ABN 77 103 642 888) AFSL 227748. This information is for general information purposes only and is not (and cannot be construed or relied upon as) personal advice. No investment objectives, financial circumstances or needs of any individual have been taken into consideration in the preparation of the content. You should always obtain professional advice to ensure products and strategies are suitable for your circumstances.
