Private Credit - A Wolf in Sheep's Clothing

In recent years, there has been a massive surge in demand from investors looking to place money into private credit. These investors have typically been investing in funds managed by people with experience in bonds, corporate debt or banking. The fund managers have spotted gaps in the market where the big banks once operated. As the banks have become increasingly conservative, it's been difficult for some borrowers to finance deals, from property groups and developers through to businesses. By helping match higher-risk borrowers with investors seeking higher fixed-income yields, the Australian private credit has emerged as a reported $200 billion dollar market. While Australia leads the way, it is also a worldwide phenomenon as the market globally passes $US1 trillion.

Despite their popularity, I would be very wary of investing in these funds. In many cases, these funds have been positioned as being less volatile because they are unlisted. However, that's only true in relation to the day-to-day unit pricing. The underlying assets are still only worth whatever they can be sold for. This will become a problem if higher interest rates result in defaults, or the economy deteriorates. We are already seeing dramatically increasing signs of insolvency here in Australia with the September quarter up 45.5% from the same period in 2023. If a borrower could borrow from a bank at a lower rate they would, so, many of these loans are being made to higher-risk borrowers and projects that the banks avoid. While the banks are simplifying their business the higher-risk end of the market is moving to private credit. The big banks are as focused on profit as any entity in the country, so they have good reasons for avoiding this part of the market.

Like all markets, there will be good and bad operators, and it’s the poorer performers where the risks will emerge. When fund managers have millions or billions of dollars to manage there is a fight to place the funds and provide finance. It’s a different system to how banks manage risk. Often the private credit funds are paid high management fees to manage the loan book. There isn’t the same financial risk for them in the event of a default as there is by a bank. Those who lose money on a bad loan from the bank are the bank as the loss sits on their balance sheet. Those who lose money on a bad deal from the private credit fund manager are their direct investors. The billions of dollars in private credit now looking for a home means there are deals getting funded now that wouldn’t be in a normal market. It's not their money, and it potentially leads to outsized risks being taken. It’s creating a bubble. Not only is it a bubble, but this is also an unregulated and opaque sector.

The higher-risk end of the market that the banks are moving away from is still there, it’s simply being transferred elsewhere in the system to private credit. With interest rates still relatively high, it's possible that these higher-risk loans see increases in defaults. That raises serious questions for investors to consider when things go wrong. Unlisted assets can’t be easily sold. When things go wrong you simply can’t exit, there is almost no way to get your money out. However, you can generally sell a listed asset, perhaps for a lower price but you can sell. When it’s an unlisted vehicle, the mechanisms for redeeming the investment when things go wrong evaporate. The funds are tied up and redeeming your funds can be a multiyear process.

We have stayed clear of many of these unlisted funds, from hedge funds to private equity and especially in the private credit sector. It is a great business model for the operators but there are potentially significant downside risks for investors in the event of broader issues in the economy. In many respects, part of the issue is the simplistic nature of investors' mindset with these investments. They see an interest rate and assume it is a better version of a term deposit or bond. It could not be further from the truth when you look at the underlying investments and structure. In some cases, these are junk bonds, in others they are chopped up and mixed like they did in the GFC. As popular as these unlisted funds have become, there is a real risk it will not end well. My priority for the fixed interest portion of our portfolios is for it to be defensive and do the job we want it to do. If we want growth-style returns, that is for the equity part of the portfolio. I would strongly urge investors to be aware of exactly the risk they are exposed to.

General Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.