A beginner's guide to private credit

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One of the fastest growing asset classes in the world today is private credit (also known as private debt).

Traditionally only available to large institutional investors, the range of options for retail investors to access private credit funds is rapidly expanding.

There are many different types of private credit funds, but most offer a similar objective: preservation of capital with regular and predictable income at a premium to what is available for other defensive investments such as corporate and government bonds.

a beginners guide to private credit

What is private credit?

Private credit is lending outside the traditional banking sector by credit funds and finance companies called 'non-bank lenders'. Non-bank lenders make loans directly to a consumer, business or corporate borrower.

Unlike government or corporate bonds, which are regularly bought and sold in public markets, private credit is a direct arrangement between the non-bank lender and the borrower negotiated on individual terms.

Non-bank lenders (or private credit funds) are looking to uncover lending opportunities to finance consumers or businesses, or in types of lending where it is no longer efficient or economical for a bank to participate.

Good private credit funds hold very large and diversified portfolios of loans across a range of borrowers. Some funds lend against many different types of assets. Just like a bank lends to a customer by holding a mortgage over the property, non-bank lenders use different types of assets for security and protection against the money they are lending.

When a private credit fund makes a loan, it is typically secured against real assets or collateral. As a lender, the private credit fund is entitled to be repaid its principal and interest in priority to equity (such as the borrower's shareholders).

The focus of good private credit lenders is to ensure the borrower can service interest payments through different market conditions and that there is sufficient value coverage to ensure the lender is going to be repaid its principal, even if market conditions become more challenging for the borrower.

This is an income generating, defensive asset class, not an asset class that attempts to deliver capital growth (like shares, private equity or venture capital).

How do you make money from private credit?

Investors in private credit funds earn income based on the interest payments on the portfolio of loans. Since the loans are contractually agreed, the income is predictable and consistent.

Private credit loans are usually floating rate (this means they are linked to the official Reserve Bank of Australia (RBA) cash rate or other financing benchmark). Investors receive a premium or margin over the RBA cash rate or financing benchmark, ranging from 4%-8% (depending on the type of lending the fund offers).

This means today, with the RBA cash rate currently at 4.35%, the income return on a private credit fund ranges from 8.35%-12.35%. Given the defensive nature and relatively low risk of secured private credit, this is an attractive return.

How do you invest in private credit?

Investors can access private credit through both unlisted and ASX-listed funds.

Unlisted private credit funds offer the advantage of not being subject to market movements in unit price and volatility, unlike all investments that are publicly listed on the ASX.

All private credit funds are managed by a private credit asset manager. So, what are the key questions investors should ask when considering investing in private credit?

  • How sophisticated is the manager and how diversified is their loan portfolio?
  • Does the manager source their own deal flow directly and have genuine origination capabilities?
  • How is risk and governance managed? What is the private credit manager's process to diligence, evaluate and manage loans?
  • What is the experience of the lending and investment team? Expertise in lending across all types of market conditions is critical.
  • Does the manager have in-house 'workout' experience in case a borrower defaults on obligations or repaying the loan?
  • Finally, a proven track record of investing and managing through multiple economic cycles is important.

What are the risks of private credit?

Although private credit offers secure protection for investors and regular income, like all asset classes, there are risks that should be considered.

  • Credit risk - the possibility of a borrower defaulting on their loan obligations and what arrangements are in place if this happens.
  • Liquidity risk - are investors able to access their money if required at short notice?
  • Market and economic risk - how does the economy impact the consumers or businesses taking the loan or the performance of the security underlying the loan?

How much private credit should I add to my portfolio?

As with all investment decisions, a financial adviser can determine how much of your portfolio should be in growth assets (e.g. shares) or defensive assets (e.g. bonds and cash).

Private credit is considered a defensive asset as preserving capital is the primary focus. It also has low correlation to other asset classes. This means they generally move in a different direction or are less volatile than traditional investments such as shares and bonds which tend to react in-kind to market shifts.

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John Sheffield is the managing director of Asset Management at MA Financial Group. He has previously worked at Lumi, NAB and CBA. John holds a degree in business with a specialisation in accounting and Finance from Charles Sturt University, and is a CPA.