Credit where credit is due. Or not.

Any lender will have loans that go sour. It is an accepted cost of doing business. The whole point of collateral is to allow you to recover the loan when the inevitable occurs. When a bank makes a loan, its capital provides a buffer between the value of the loan and its ability to make depositors whole. It is called equity capital because we all understand that this investment is at risk, and we expect an additional premium for taking that risk. Obviously, banks have various tiers of capital, across which risk and relevant premiums arise. However, outside of Hybrids and Coco Bonds, it is exceedingly rare for more senior levels of bank debt to be 'bailed in' when losses cause equity ratios to fall below prudential limits.

Private credit is different. The only thing standing between the investor and a loss is the value of the collateral the manager has negotiated with the borrower. If a borrower defaults and the lender takes possession of the collateral, the investor now has an equity stake. The value of her investment is no longer subject to the cashflow vagaries of the borrower. Indeed, where the manager has decided to assume ownership of the collateral and develop or otherwise enhance the value of the asset, the original cashflow expectations of the investor have reversed. Interest income is no longer expected, and development expenses can be anticipated.

The decision to develop or otherwise enhance the value of an asset, with the expectation that this will optimise the eventual sale value for the investor, is obviously one the manager needs to consider. The possibility is no doubt anticipated in the offer document. Nevertheless, it is unlikely the original considerations of the investor included a stake in a property development or the running of a business, however temporary. Furthermore, it is not obvious that these are within the skill sets of the manager. No doubt relevant managers would outsource for expertise lacking, but the point is, this was not what the investor signed up for.

At this time defaults remain modest, and any such outcome highlighted above is exceptional. However, Private Credit is not a free lunch. Almost any other credit-based investment sits above a layer of equity capital that takes the first loss. Private credit is wholly reliant on the analyst's evaluation of the creditworthiness of the borrower and her valuation of the collateral. Investors need to be aware that part of their investment can easily mutate into an unintended equity position.