Private credit: Is it really worth the risk?

Ten years ago, the private credit market in Australia was not all that well known.

It certainly was not seen as its own asset class like Australian and global shares, listed property and fixed interest asset classes.

Instead, it was often seen as another type of alternative asset, that an investor might have a very small allocation to in their portfolio.

Why has private credit exploded in Australia?

However, today the private credit market in Australia alone is close to $200 billion, and has been growing at around 20% a year for close to the past decade.

The main reason for this growth is that banks (particularly following the Global Financial Crisis) stopped lending to certain parts of the market.

The biggest was property development and other types of real estate lending, mostly corporate loans.

The home mortgage market remains the favourite place for banks to lend, so private credit stepped in the bridge the gap.

There are a few private credit funds that have been around for decades and have become very specialised in their lending.

For example, some just lend on property developments in a certain part of a city. But thanks to the significant growth over these last few years, many more private credit funds have sprung up and are now available to investors.

What about risk?

With a lot more money invested these funds, and therefore more competition between them, do they now need to take on more risks to find borrowers to lend to?

It is a fair question and unfortunately one that many investors aren't asking. Too often investors just look at a headline interest rate, think it looks very good, and invest with them.

However if there was a fund with a 8% return that had never had a default with a loan, and another fund that was paying 12% but had, say, 20% of loans in default, investors should be aware that the higher interest paying fund is much riskier and there is a very good chance they will lose a large portion of their investment.

Just like Australian shares, there is a wide variety in the risk within private credit funds.

Unfortunately, being able to see 'under the bonnet' of these funds is not as easy as with equities.

Privacy and commerciality are often the excuse to not provide details of non-performing loans. Some credit funds with non-performing loans are taking over the distressed business and being left with the equity in the business.

However this is not their job, nor are they likely to have the skills required to run a business.  Furthermore, this is not what investors chose to invest in.

Why is the ASIC inquiry good for the sector?

ASIC is currently undertaking a review of the private credit sector and ASIC chair Joe Longo has recently stated 'there probably needs to be some adjustment to our regulatory settings around data and transparency'.

This is good for the sector. Underperforming funds may struggle to keep investors, but the good quality funds will continue to deliver strong returns.

A realistic expected return from private credit should be around 8% a year - this is a very good return, particularly when share markets have started to become more fully valued and will struggle to produce similar returns.

Investors can diversify their portfolio into private credit and not suffer from lower returns.

But they should be aware of the risk profile.

How has private credit performed during times of volatility?

On the risk curve, private credit funds with good quality managers are not as risky an investment as shares and should not suffer a 30% fall in a bad year.

However they will have negative years when the economy goes through a rough patch and bad loans cannot be fully recovered.

During the GFC in 2009, private credit losses were around 6%, which is not terrible compared to the share markets at the time.

However lower quality private credit funds are much higher on the risk curve and there is a greater chance investors could lose their money.

There is good reason why private credit has grown so much over the last 10 years to become a stand alone asset class that should be considered in an investment portfolio with an appropriate allocation depending on the level of risk being taken.

But unfortunately for investors who do not have access to advisers or research houses, there can also be many hidden risks, and often it is with the funds that spend a lot on advertising.

If the returns look to good to be true, this is a good sign to stay away.

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