In a constantly evolving investment landscape, private credit stands out as an important opportunity, especially for those seeking alternatives to traditional income solutions and volatile public markets. Private credit is an option for investing that, for example, can generate potentially superior income streams to those from owning bank shares, but without the risk to capital that comes with the stock market.
Moreover, the current macroeconomic environment is one private credit investors have been waiting for. The unprecedented pace of interest rate hikes and consequent volatility in public markets have provided abundant private lending opportunities. Some institutions, such as Pimco, suggest the next few years “will be great vintages…across the private opportunity set for a wide range of investor objectives. With demand for capital outstripping supply, investors won’t need to take large risks, in our view, to generate compelling returns.”
This promising sector, characterised by its non-bank lending approach, has experienced notable growth in Australia, capturing the attention of both borrowers and investors alike. But what exactly is private credit, and why is it becoming a pivotal component of investment portfolios for an increasing number of advisers and their clients?
The heart of private credit
Private credit distinguishes itself by operating outside traditional banking and public debt or bond markets. This lending can be bilateral – that is, direct, between a borrower and a single lender, or via a warehouse, which is a bespoke, privately negotiated vehicle that acts as the first home for new loans issued by a non-bank lender.
The types of loans are diverse, encompassing corporate loans often supported by private equity, asset-backed loans, and those secured by commercial real estate. The allure of private credit lies in its spectrum of risk and return, ranging from conservative senior secured loans – the type we prefer – to higher-yielding distressed company loans – the type we prefer to avoid.
The growth of private credit in Australia is attributed to several factors. Shifts in banking practices, regulatory changes, and a growing awareness of private lending’s advantages have all contributed. Moreover, an uptick in mergers, acquisitions, and private equity sponsorships has also spurred demand for non-bank lending solutions, particularly for transactions such as leveraged buyouts.
Despite its expansion, the Australian private credit market remains nascent, especially when compared to the mature markets of the U.S. and Europe, where high net worth, ultra-high net worth and family offices have had the private credit sector to themselves.
Despite its relative novelty in Australia, private credit offers a plethora of benefits for investors, from diversification and lower volatility to potentially higher returns, making it an essential consideration.
Why investors are turning to private credit
The illiquidity premium
Since private credit investments aren’t publicly traded, they tend to be held until maturity, which garners an illiquidity premium. This premium can significantly enhance returns for investors, especially those who are comfortable with reduced liquidity levels compared to traditional fixed-income assets. For perspective, while many private credit funds have lock-up periods, others offer monthly liquidity and no lock-ups.
Appealing risk-adjusted returns
Private credit can potentially offer higher returns than those found in public markets. Private credit’s infancy in Australia means it’s less efficient and less competitive. Inefficient markets are always a source of relatively attractive potential returns. In this case, they also allow borrowers to negotiate capital solutions that are more tailored to their needs. Investors (lenders), in turn, are often compensated with higher returns, thanks to attractive loan margins.
Diversification and lower ‘vol’
Historically, private credit has demonstrated lower volatility (‘vol’) than its publicly traded counterparts. This characteristic and the sector’s diverse borrower base allows private credit to serve as a ‘stabliser’ within investment portfolios, providing a buffer during market downturns and contributing to smoother overall returns.
Protection against interest rate fluctuations
Many private credit loans feature floating rates (be sure to find out for the fund you are considering) so investors can find solace in a measure of protection against the impacts of rising interest rates. If the portfolio of loans is offered with floating rates, the returns from the private fund would normally rise alongside rising official rates. This aspect not only reduces correlation with fixed-income and stock market assets that are usually inversely correlated to interest rate changes but also enhances portfolio diversification.
Downside protection
Some private credit funds focus exclusively on secured lending, offering robust protection against losses. Many deals in this space are anchored by tangible assets, insurance agreements, and even directors’ guarantees, offering a safeguard in the event of defaults. This, coupled with strategic covenants, fortifies investors’ positions by minimising potential downsides.
Navigating the risks
While private credit presents a promising avenue, it’s crucial for investors to be cognizant of the inherent risks. The illiquidity of investments, credit risks, and potential income fluctuations are factors that require thorough consideration and understanding. It’s imperative that investors partner with an experienced manager who exhibits a profound grasp of these risks and can demonstrate a proven ability to navigate various market and economic cycles.
The Australian private credit market continues to grow. Enquiries here at Montgomery continue to accelerate because private credit is a compelling proposition for investors. With its unique blend of benefits, including attractive risk-adjusted returns and lower volatility, private credit is increasingly being recognised as an integral component of a diversified and resilient investment portfolio.
Importantly, the role of manager selection and risk assessment is as crucial as ever.
To find out more about Private Credit opportunities, call Toby Roberts or David Buckland at Montgomery Investment Management on (02) 8046 5000.