In this week’s video insight, Brett Craig, Director at Aura Credit Holdings, our partner in private credit, and I discuss some common myths surrounding private credit. Together, we explore the evolving landscape of lending to small and medium-sized corporates in Australia, shedding light on the risks, returns, and opportunities. Brett provides valuable insights into the Aura Private Credit Income Fund, and we take a closer look at the strategies used to mitigate risks in this growing market.
Transcript:
Roger:
Hi, I’m Roger Montgomery from Montgomery Investment Management. If you’d asked me 10 or 15 years ago to lend to small and medium-sized Australian corporates, I would have said you’re crazy. The only small and medium-sized corporates we’d be lending to back then were those that the big banks had rejected and didn’t want to lend to. It would have been a seriously risky proposition.
But after the global financial crisis (GFC) and the Hayne Royal Commission, related regulatory changes have made it extremely onerous and less profitable for the big banks to lend to these corporates, and so, understandably, they’ve pulled back.
The result is a $200 – $400 billion gap between what small and medium-sized corporates in Australia need to borrow for growth and what lending is available to them. So today, you can lend to the same quality borrowers that only the banks might have previously had access to, and the returns thus far have been excellent.
For example, over the last seven years to the 31st of July 2024, the Aura Private Credit Income Fund has returned 9.64 per cent per year, net of fees and assuming reinvestment of income. What’s impressive is this has been done with no loss to investor capital, and there’s not been any negative months. And that’s what funds like the Aura Private Credit Income Fund do. They lend much-needed capital to quality businesses. Today, I’m joined by Brett Craig from our partner Aura Credit Holdings to dispel some of the myths associated with private credit. Brett, thanks for joining us.
Brett:
Thanks for having me.
Roger:
So, I have to confess, when I looked at the returns you were producing when I first did that, I saw monthly cash income for back then it was five years, and now it’s about seven years. You’d never missed a month; every month was positive. The annual return was about 9.6 per cent or thereabouts. So, it’s an extremely attractive return producing monthly cash income with never a negative month. And I must admit, I thought it was too good to be true.
There must be risks. How do you mitigate those risks? And I know there are three different ways that you do it, or three overarching headings for that process.
Brett:
Yes, so firstly, we look at the underlying businesses who are borrowing the cash from the lenders that we provide capital to. What we want is a high-quality set of businesses borrowing the money. We look at various methods to assess them.
Roger:
So, at the deal level, what you’re saying is that you’re only looking at high-quality borrowers?
Brett:
Yes.
Roger:
Okay, so, you’re not looking for turnarounds or distressed businesses at all?
Brett:
No.
Roger:
No distressed debt?
Brett:
So, no distressed debt there. What we’re looking at is businesses that have a strong track record in repaying debt. So, we’ll look at things such as Equifax scores or CreditorWatch scores, which focus on any negative credit impacts, like missed bills, missed loan repayments, etc.
Roger:
And you’re filtering out those ones that have a lower credit score?
Brett:
That’s correct. Then we’re looking at a balance sheet analysis, so looking at businesses that have lower debt levels in them and the ability to service their loans as well. That’s the quality inputs at the front end of a transaction.
Roger:
So that’s the deal level, if you like?
Brett:
Yes, the deal level. Then we’re looking at the collateral that’s backing that loan. If the borrower falls on hard times and is unable to make their repayments in the ordinary course or within the contractual terms, we will lean on collateral and look to take charge of that and sell down that collateral. That’s the second risk mitigant.
Roger:
And what are some examples of the collateral provided?
Brett:
They’re broad. We’ll be looking at anything from land, livestock, invoices, pieces of machinery – asset finance, etc. Director’s guarantees, general security agreements, fixed and floating charges over the business. So, you’re starting with a quality borrower coming in, and then you look at the collateral backing that loan. And the third element we look at protecting capital with is at a warehouse level. The lenders that we’re providing warehouse financing to are putting their own equity at risk, in a first-loss piece below us. You’ve got borrowers from a cash flow perspective paying through. If they’re unable to pay there, you’ve got the collateral to lean on, and then you’ve got the lenders who are putting their own equity and/ or fees and net interest margin at risk.
Roger:
So, what you’re saying is they’re all quality borrowers, but if a borrower happens to default and then you collect on the collateral, but lose, there’s not enough collateral there to support the loan for whatever reason. It goes from a default to a loss, then protecting the investor is the originator or the lender who has also put their equity at risk? And so, what has been the experience in the past to date?
Brett:
To date, we’ve been running this strategy for over seven years now, and we have not had any losses that have impacted our interest or principal as investors.
Roger:
That’s terrific. The second myth I want to dispel is around liquidity. There are some ways to mitigate liquidity risks and I note for example, your funds don’t have lockups, which competing funds do, and they have shorter terms, the loan book itself has shorter terms. Explain to me how that feeds back into a superior or satisfactory or acceptable liquidity picture for investors.
Brett:
Yep, our fund offers monthly liquidity windows to investors. Every Investors has the opportunity to put in a redemption request on a monthly basis. We will firstly pay that redemption out of available cash, which can be incoming investors coming through, or the cash we naturally have sitting in the fund.
The second way which we will look to get liquidity is by, the loans or the underlying assets maturing. So, the principal and interest will be repaid, and that goes back to investors.
Roger:
Let's just talk about an extreme scenario, where every investor wants to redeem at the same time?
Brett:
We would look to firstly pay all the available cash out of the fund.
From that point, you go into a gating procedure.
Roger:
Which is common to all funds, all managed funds?
Brett:
All managed funds in Australia will have some kind of gating mechanism in there to ensure that investors aren’t disadvantaged.
So, what we would look to do at that point in time – if 100 per cent of investors would look to redeem their capital, we would gate the fund, and we would stop all new lending in our warehouses. So, any principal and interest repayments would come through, and everyone would be paid out. All investors would be paid out their pro-rata proportion of that inflow of capital, and we would continue to do that. Just to give you some context on the runoff profile for the fund, at the back end of July, the fund had 75 per cent of its assets or the underlying loans maturing within three months. So, you can see that they do come back relatively rapidly.
Roger:
Brett, another myth; these funds don’t perform in poor economic conditions. I mean, it’s probably the most common accusation that’s levelled at these funds. They haven’t been through a full economic cycle. It’s worth pointing out there are some funds that are relatively new, your wholesale fund is seven years old, and you’re an ex-banker. There are some of these funds that are much younger and aren’t run by bankers. That’s not the case for you.
What’s your experience in tougher economic times, and what’s the experience of the fund?
Brett:
The fund ran through the whole COVID experience. So obviously, that was an extremely disruptive time for every business in Australia and more broadly, globally.
We also had a technical recession at the back end of 2022. Granted, not a deep one; however, it was a technical one. Through that time frame, our fund performed well. The lowest monthly distribution was 60 basis points.
So, no, we still maintained a one-dollar value, even during that trough in economic conditions. And I remember out of COVID, we had something like four million people unemployed. The low point was a 60-basis point repayment that month?
Brett:
That’s correct. And you mentioned I come from a banking background, we look at risk in a very bank-like way. When we’re looking at our underlying portfolios, we’re using long time frames of data to stress test our portfolio. So, as an example, we’re currently using over 50 years of bank and non-bank data in the stress testing of our portfolios. So, whilst we haven’t run through a deep and extended recession as a fund, we explore those downside scenarios with deep and long historical data.
Roger:
And I’ve been asked this question by several people: presumably, we would see a recession coming and if we saw a recession coming, number one, investors could redeem if they wanted to, if they were nervous, they could do that. And alternatively, you’re managing who the money is re-lent to as it’s being paid back. As you’re recycling that capital, presumably, you’ve got a methodology for deciding whether to extend further credit. How do you go about assessing that?
Brett:
Right now, is a really interesting case study. We’re seeing lenders with a lot of applications coming through; however, the approval rates have gone down because the borrowers are not necessarily meeting our criteria. So, we filter at the front end, and that’s a frustrating time for the lenders. They’re inefficient in their approval rate right now, however, that’s enabling us to retain a high-quality book.
Roger:
Thanks for that, Brett. Well, the next myth that we’ve got is that private lending or private credit is really about lending to distressed businesses. Talk about the quality of the businesses you’re lending to.
Brett:
We do not do distressed debt. So, we do not lend to businesses who are looking to borrow their way out of trouble. What we’ve seen post-GFC, there were some regulatory changes, with the Basel III changes, which basically led to a lot of the big four banks focusing on either residential mortgages in their lending books, or very large corporate loans. And what it did was it left a significant underfunded market for your small to medium-size enterprises (SMEs) through to your mid-market corporates, so a funding gap of circa $400 billion.
These are businesses that are screaming out for debt capital to help them increase their growth or profitability, but it’s not being provided by the big four banks. And that’s where private credit, has become significantly larger because private credit funds are stepping into that breach to provide that debt capital to quality Australian businesses.
Roger:
So, Brett, another way to mitigate risk is through diversification, and one of the myths is that these funds aren’t diversified enough. Now I note that there are many funds that have a concentrated book of very large loans, but you’re managing things quite differently. Talk about that.
Brett:
Yeah, so our philosophy is very much predicated on diversification of risk. Now we look at that from an industry perspective, a geographic perspective, and across a number of lenders as well. So, to give some context, our portfolio has over 13,000 loans, as at the end of July, and that will continue to expand with our funds under management. So, a very well spread book. Average loan size is around $105,000. Now to look at the larger end of our exposures, our maximum concentration currently is running at about three per cent of the book.
Roger:
Right. So, your biggest loan, if you like, or the biggest exposure is just three per cent of the entire book. So that’s a very different picture to many other funds.
Brett:
Yes. It certainly is.
Roger:
There you have it. We’ve dispelled many of the myths associated with private credit. I’m sure you have plenty of questions. And if you do, please email us at: investor@montinvest.com or give us a phone call on 02 8046 5000 and we’d be more than happy to discuss any of the Aura funds with you. We look forward to talking to you again. Have a great day. Thanks, Brett.
Brett:
Thanks, Roger.
Disclaimer
The Aura Private Credit Income Fund is an unregistered managed investment scheme for wholesale clients only and is issued under an Information Memorandum by Aura Funds Management Pty Ltd (ABN 96 607 158 814, Authorised Representative No. 1233893 of Aura Capital Pty Ltd AFSL No. 366 230, ABN 48 143 700 887)(Aura Group).
This information is for wholesale or sophisticated investors only and is provided by Montgomery Investment Management Pty Ltd (ABN 73 139 161 701, AFSL No. 354 564)(Montgomery) as the authorised distributor of the Fund.
An investment in the Fund must be through a valid online application form accompanying the Information Memorandum.
The information provided is general in nature and does not take into account your investment objectives, financial situation or particular needs. Before making an investment decision you should read the Information Memorandum and (if appropriate) seek professional advice from a licensed financial advisor to determine whether the investment is suitable for you.
Montgomery and Aura Credit Holdings Pty Ltd (ACN 656 261 200, CAR 1297296) (Aura Credit Holdings), who is the Investment Manager of the Fund do not guarantee the performance of the Fund, the repayment of any capital or any rate of return. Investing in any financial product is subject to investment risk including possible loss. Past performance is not a reliable indicator of future performance. Information in this report may be based on information provided by third parties that may not have been verified.
Where information provided by Brett Craig, Portfolio Manager of the Fund, consists of General Advice, this is provided as an Authorised Representative (AR No. 001298683) of Montgomery.
Aura Group has entered into a Distribution Partner Agreement (Distribution Agreement) with Montgomery to distribute the Fund to its client base. Montgomery may receive a share of the fees you pay as well as potential equity in Aura Credit Holdings.