Private credit investing is booming. As more of our clients seek advice on this asset class, we’ve prepared this article to dive into everything you should know about investing in private credit funds.
In 2023, EY published a report on the current state of the Australian private credit market. They found that the market has grown rapidly since the GFC, to A$188 billion with around 60% in loans to business and 40% in real estate related loans. In the aftermath of the GFC banks were required to hold more capital on their balance sheets for each loan they provided, which meant they had to charge higher rates. This created an opportunity for competing sources of lending to increase market share. Before we look at how to invest in this type of private debt, let’s understand what it is.
What is Private Credit?
Private credit is typically a loan to a business, land owner or property developer by any non-bank lender. Other less common areas that private credit funds may invest in are Residential Mortgage Backed Securities (RMBS), Asset Backed Securities (ABS) such as car loans, supply chain finance and other specialty finance areas.
Loans are typically senior in nature and secured over the assets of the business or property, which means the loan provider will be the first in line to recover funds in the event of a default. Some private credit funds do invest in subordinated or unsecured loans. These loans are higher risk given the recoveries in the event of a default are likely to be lower, and investors get compensated through higher levels of expected income.
How Does Investing in Private Credit Funds Work?
Essentially private credit providers package up loans in their specialist investment areas into a fund. The grouping of loans allows for diversification of credit risk rather than an investor taking the risk of a single borrower. The funds are then typically distributed via investment advisors or financial planning groups. There are some private credit funds listed on the ASX.
Investors are often attracted to the high levels of income and low volatility that private credit funds offer. Returns have increased strongly in the last 18 months on the back of the rising RBA cash rate, given the underlying loans effectively add on a credit spread to the underlying cash rate. Income levels typically range from 7.0% to 10% for the lower risk end of private debt funds, with higher returns available on more risky unsecured or subordinated loans.
The fund manager charges a management fee on the fund, which is often quite high (between 1-2%) given the work involved in either originating or sourcing the loans and then applying their credit due diligence process in the selection of loans that make it into the fund.
The Mechanics of Investing in Private Credit
Unlisted Private Credit Funds
Some unlisted private credit funds require investors to meet the sophisticated investor test . Alternatively, investors may be able to fill out an application form. Most funds will offer 1 month or quarterly liquidity and some may have a minimum investment size of $50,000 to $100,000.
Listed Private Credit Funds
The advantages of ASX listed funds is they have no minimum investment size, are easy to access and offer investors the ability to buy and sell whenever the market is open. The main negative is that in market downturns, when many investors rush for the exit, the funds can trade well below the value of the underlying loans.
Risks and Rewards of Private Credit Investments
The rewards of investing in private credit are much higher levels of income than what is available on term deposits or government bonds. The main risks are defaults on the underlying loans leading to a loss of capital. Unlisted funds may also halt withdrawals if there is a wave of redemption requests, so an investor's money may be locked up for months or years.
For ASX listed funds the underlying credit risks remain and the possibility of the fund trading at a discount to asset backing means an investor wishing to exit may have to take a loss much bigger than has occurred on the underlying loans. Income is also typically taxable each year as opposed to unrealised capital gains , which investors need to consider when looking at total after tax-returns.
Comparing Private Credit to Fixed Income Investing
Traditional fixed income investing, a popular investment option for retirement , has often been focused on investing in the bonds issued by governments or large corporations. Individual investors would usually access these funds through a listed or unlisted bond fund. Typically the returns on these funds are lower than for private credit given they’re predominantly to higher quality borrowers.
Many bond funds are invested in fixed coupon bonds, which means the value of the fund will fluctuate with movements in the underlying interest rates. When interest rates rise, as has occurred over the last 2 years, these bond funds can fall in value and vice versa. These funds will normally offer investors daily or monthly liquidity to get in and out of the investment.
Private credit funds in contrast typically display lower daily volatility and higher returns. However this comes with higher underlying credit risk and in times of market stress the liquidity available to investors to exit their positions may be heavily reduced or locked up for a certain period.
Underlying loan defaults are also likely to be higher in times of economic downturns given the lower quality of the borrowers. The true long term volatility of private credit funds is probably underestimated by recent investors who have had a bening economic environment for much of the last decade.
How BlueRock Selects Private Debt Funds in Australia
Long Track Record
At BlueRock, we only invest in private credit or debt funds with a history of working through the economic cycle. This is important given the recent influx of new providers and the last decade has been quite benign from a default experience given steady economic growth and low interest rates.
Mature Firms with a Larger Amounts of FUM
Scale allows for deep credit assessment teams. Perhaps more importantly, bigger teams have the resources to help manage and work out any defaults to maximise the return of capital in an adverse situation.
Risk Spectrum
We tend to favour lower risk funds, which can still yield 8-10% and have senior security over assets. In some cases, the fund manager will provide a buffer to take a certain amount of the first losses in the event of a default.
Loan Maturity
Most of the unlisted funds we invest in will have a typical loan length of up to 2 years, meaning the average maturity of the loans in the fund will be around 1 year. This means if there was a market downturn and liquidity was locked up, it should not be for many years given loans will be constantly maturing.
ASX-Listed Funds
Given the market experience over COVID when many ASX listed private debt funds sold down to big discounts, we prefer to invest in these funds when they are trading at a discount.
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Disclaimer: The information in this article is intended as general information only and should not be considered as advice on any matter and should not be relied upon as such. This information has been prepared without taking into account any individual objectives, financial situation or needs. You should therefore consider the appropriateness of the information before acting or seek advice before making any financial decisions.
