Private Credit Series - Part One

October 2024

Summary:

• What is it – private lending taking the place of banks
• Why invest – better returns than equities long term
• How to invest – know the market and have careful selection
• Where did it all start?

Private credit has a ‘bad wrap’. There is a lot of noise out there on the ‘crowded trade’, systemic risk and warnings of a wave of defaults.  But why are the savviest fixed income investors and mum and dad wholesale investors flocking to it? With over 200 private debt funds in Australia, and more than 1500 funds globally, there are a lot of products on offer. Confused by the choice? That’s a natural reaction.  Let’s dig into the story from the beginning to help us better understand this fast-growing asset class.

What is private credit?
Private credit, also known as private debt, is the funding of loans from private sources. Mostly it is in the format of a loan, from one lender to a borrower with some variations. It is different to public debt which is the more tradeable form issued by governments, corporates and agencies and bought on ‘over the counter’ broker markets by institutions and some individuals. Many buyers of public debt are compelled to buy it (over private debt) by prudential regulators like APRA, to back liabilities of superannuation schemes, insurance companies and sovereign wealth funds.  Private debt buyers aren’t as restricted by regulations, rather they are seeking higher returns being forced up the risk spectrum from a zero rate world, prior to the post Covid inflation and interest rate rises. Today private credit still provides a healthy yield premium above equivalent public market debt, continuing to attract investors.

The fundamentals are clear. Banks are pulling back from lending, forced by regulations. Businesses, property developers and individuals need credit to keep the economy in motion. The writing has been on the wall for top talent at banks over the last couple of decades with the most talented leaving early to start their own non-bank lenders before the financial crisis years ago, joined in recent years by a wave of startup challengers.
Both Australian and offshore private credit is on the rise, with the origins in the US.

Why invest in private credit?
On a risk-return basis, it is possible to get a better return than long term equities, with much less volatility. That hasn’t always been the case with lower interest rates. Due to lack of competition in Australia initially, interest rates were higher, and much was fixed rate, however in the US, private credit was floating rate with a credit spread over a zero base rate. It’s not unusual to see a range of private credit in Australia from 7% up to 13% with many now exceeding 10%. Some funds will be more sustainable, others not.

There are also different factors driving returns and diversification available within private credit and a different mix to public credit. For example, property lending, financial corporates, non-financial corporates and agriculture is available.

How to invest
With such a wide range of product out there, and financial planners being continually approached by new and old private credit fund managers, it’s easy to be overwhelmed. However, there are some starting principles to assist in the research and selection of these managers. The first is track record and experience in lending. If a manager has a team that has history through a business cycle of lending, and can work out investments, that is a good start. The quality of the credit research is another key point.   Risk management through a comprehensive review and credit review committee helps. Ongoing monitoring is essential.  If you are selecting strategies without some experience in credit, then get some independent help on selection.

Where did it all start?

Junk bonds
The origins of private credit are from the public markets in the 1980s as another related debt market was on the rise.  High yield bonds, the sanitised term for junk bonds at the time, were a solution to a problem of funding for lower rated corporate borrowers. The market that arose helped investment bank and private equity corporate raiders of the time finance leveraged buyouts of mature companies. Michael Milken and Drexel Burnham Lambert brought this market to life and was a key conduit between the companies that needed finance, the private equity buyout firms, and convincing a new wave of institutional buyers.  Many of today’s largest private credit firms have their origins connected to people from Drexel Burnham Lambert. While junk bonds were a start, with a one issuer to many investor relationships, the next step was a 1:1 borrower to private lender for private credit to develop further.

Bank consolidation
Following this time, many smaller US banks consolidated through mergers, meaning that many smaller banks that serviced small and medium sized borrowers declined, which also reduced the number of relationship lenders at those local bank branch offices.

Syndicating the risk
US Banks could also reduce individual lending exposures by syndicating loans across large groups of banks with common terms, and then create an interbank trading market. The new liquidity and tradability allowed some moderate regulatory capital relief while spreading the risk.

Repackaging loans
Investment banks created new products of corporate loans which where pooled and sliced up into collateralised loan obligations or CLOs. With each slice paid in order of preference of capital and interest, and rated by rating agencies, new investor segments were serviced. Money market funds were big buyers of AAA rated tranches, and lower rated investment grade helped give yield enhancement to credit funds.

Bank regulations
The biggest shift was post GFC when banking regulations changed with Basel II to address bank systemic risk. This built on the original Basel I capital adequacy regulations in the last 1980s. The intention was to make banks more resilient to shocks by raising capital charges which disincentivising perceived higher risk lending to corporates and real estate. Perversely the capital risk charges on residential mortgages rose and banks loan books increased residential lending and decreased corporate and real estate lending.

Pushing borrowers to private lenders
Those corporate bankers early on who left saw an increased pipeline of willing borrowers turned away by banks which tightened lending criteria and increased loan approval timelines. High net worth private investors were willing buyers of private debt funds that funded the new wave of lending. Institutions soon followed with one of the earliest institutional mandates written by AustralianSuper just after the GFC for Qualitas to accelerate property lending here in Australia.

Staying private longer
A trend in private equity ownership rising and public equity listing declining has also supported private credit. As more mid-sized companies attract financing and buyouts from private equity, they will also need some debt funding. Both private equity and private debt helps smaller and mid-sized companies stay private longer and avoid the public exposure, and cost of regulation of share markets.

Rising base rates
Post Covid, we have seen another trend, the rise in base rates, a one in 200 year crash in public bond values, and returns holding up with little losses in private credit. This has drawn more money into private credit, but also impacted funds as floating rate base has risen.

Next time

Private debt is here to stay. It is fulfilling a useful purpose and helping to keep the banking system more stable. But there will be risks and not all funds will have a smooth ride.  
Having understood the historical influences in Part 1, following instalments will dig into:
•    the myriad of choices out there for investors
•    more evidence of why private credit, and more detail on how to invest.
•    portfolio construction i.e. how to weigh up building private credit fund portfolios alongside other private markets that complement public markets, very important for investors and advisors.

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Graeme Bibby
Advisory Board Member

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Disclaimer

This article is intended for wholesale investors as defined under the Corporations Act 2001 (Cth) and is not intended for retail investors. The information provided herein is for general informational purposes only and does not constitute financial, investment, or professional advice.

The views expressed in this article are those of the author and do not necessarily reflect the official policy or position of Kings Gate Capital Partners. While every effort has been made to ensure the accuracy of the information, Kings Gate Capital Partners makes no representations or warranties, express or implied, as to the completeness, accuracy, reliability, suitability, or availability of the information contained in this article. Any reliance you place on such information is therefore strictly at your own risk.

Investing involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decision, you should seek independent financial, legal, and tax advice tailored to your specific circumstances.

This article may contain forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those expressed or implied in such statements. Kings Gate Capital Partners disclaims any obligation to update or revise any forward-looking statements to reflect new information or future events.

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