Part 1: What investors should know about private credit (but probably don't)

This article originally appeared on Livewire, authored by Hans Lee.

Before it's even had a chance to find its footing, private credit has already captured the market's attention. And it seems everyone has an opinion on it.

Its proponents will say that a combination of tailwinds, namely increased regulation on big banks, the need for solid income in a high-inflation world, and the negative impacts of high public listing costs have all come to fruition at once. With more corporates choosing to stay unlisted and access debt through non-traditional avenues, there's a lot of growth to be had.

To its critics, private credit is an unregulated industry with few checks and balances, full of investors who just want to make a quick buck while the theme is hot right now. And if economic fundamentals worsen much further, a lot of businesses could default on their debt leaving investors out in the cold.

But given this is such a new asset class and it is a trending topic right now, we thought it would be prudent to give you a masterclass in private credit, with the help of Keyview's Kevin Hua and Justin Lal. This wire is the beginning of a three-part series looking at the space and dispelling some of the misconceptions surrounding it

What is private credit?

Put simply, private credit refers to the provision of a loan or debt capital provided to companies (or individuals), which is not traded on public markets. It is, for all intents and purposes, a part of the non-bank finance asset class.

One of its biggest benefits is the customised nature of deal originating.

"A key benefit that is often overlooked in private credit, is the means for structuring a tailored funding solution to a borrower, which attracts a return premium. The dual benefit of these bespoke features is that while the borrower often can achieve the flexibility objectives they require, the financier can often better protect the risk by a tailored set of controls and protections," Hua and Lal said.

Who is providing this money?

"Private credit providers range across insurance and fund managers, specialised credit managers, superannuation funds and family offices," they said while adding that many of these organisations have been around a long time.

What is new, however, are two things. One is the set-up of specialist fund managers who originate deals, provide loans and then return whatever profit is made on those deals to investors. The other is the breadth of private credit providers now available in the market:

• Australian banks - tend to issue loans with very standardised and strict terms.
• Global investment banks – tend to focus on large transactions across a range of market segments. These firms often use their balance sheet/internal funds to underwrite transactions and sell down to secondary market participants.
• Real estate credit funds – the largest sector of growth in Australia. Typical transactions can include land banking, construction loans, and loans against completed or income-producing assets.
• Corporate/cash flow credit funds – funds focused purely on corporates outside of real estate. These funds cover a broad spectrum of transaction sizes and sectors.
• Special situation funds – specialised funds that focus on complex situations that typically require higher-cost/risk transitional capital.
• Distressed debt funds – a variant of specialised credit funds that seek to take control of distressed companies through the purchase of debt below par/face value. Typically cover all sectors and transaction sizes of at least $50 million.

How can the opportunity set be broken down?

As the asset class continues to grow, so does the number of funds that want to differentiate themselves from the competition. Here are the main ways that the private credit umbrella can be broken down, according to them:

• What is the strategy/type of loan? - in broad terms, there are five loan types offered by private credit providers (senior debt, subordinated debt, opportunistic credit, distressed credit, and specialty finance).
• Where is the loan sourced from? Bilateral – directly between the borrower and the private credit provider; syndicated – where a panel of private credit providers contribute a percentage of the total loan.
• Fund leverage – Private credit fund managers can manage their assets without leverage or use exploit subscription line financing to bolster returns.
• Sector choice - Most of the industry has bifurcated into real estate credit versus corporate credit (though Keyview's sector-agnostic offering is a rare exception).
• Size – Certain managers focus on small/mid-market borrowers and others focus on large borrowers.
• Diversification – Certain funds will run large portfolios with a significant number of underlying positions. Other funds hold a more concentrated portfolio of loans, which typically indicate more tailored loan products and targeted risk mitigation.
• Jurisdiction – Some of the global credit funds can offer investors exposure to private credit investments inside and outside of Australia.
• Liquidity – The private credit industry is moving towards offering more liquidity to investors (e.g. ability to redeem monthly).

There are misconceptions...

One of the key assumptions surrounding private credit is the risk that is undertaken by the creditor. The problem, critics say, is that these loans are not just regulated but they can be illiquid and carry high default risks. But, as Keyview points out, risk in private credit is dependent on the construction of the deal and the quality of the borrower.

"It is typically a highly customised form of debt financing that is highly appealing to borrowers looking for alternative forms of capital outside the traditional banking market. This customisation, when structured and executed properly, will often result in high-quality investments with appropriate risk mitigation, capital preservation and return outcomes," Hua and Lal said.

There can also be extraneous factors at play:

"There are esoteric circumstances as to why a traditional bank may not be able to provide capital to a borrower, which is not always associated with the borrower’s risk profile," Hua and Lal added.

In other words, risk in private credit follows a spectrum, just like any other asset class.

...but some concerns are valid

For one, the size of the Australian private credit market itself has grown more than three times in just five years, and by all accounts, it's made this growth in a near-zero interest rate environment in a straight line. Keyview says the valuation of some private credit funds is a genuine concern worth discussing.

"While it must be acknowledged that the asset class is less liquid than public markets, there should be rigorous discipline (and third-party validation) in the valuation of investments, particularly those that are not performing to plan," they said.

Media reports have also suggested that there are instances of investment values being written off in full and in one go. But they say this is rare.

Most importantly - each fund is different

Just as no two small-cap funds or two fixed-income funds are alike, no two private credit funds are alike. This, they say, is the key sticking point they have with the coverage to date about the private credit industry:

"There are private credit funds that may exclusively focus on junior debt (e.g. mezzanine) exposures, chasing higher returns – we acknowledge the higher return is associated with higher risk. However, a big segment of the market is focused on senior secured loans, which don’t often carry the same risk profile," they noted.

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