Should you invest in private credit?

What you need you know

Private credit is booming in Australia, making up 14% of all corporate loans and 17% of real estate lending, according to some estimates. Opportunities once reserved for big institutions are now available to everyday investors, with some platforms allowing entry for as little as $2,000. But with more access comes more risk.

So, should you invest in private credit? Here's what you need to know.

How private credit works

Private credit is simply lending money from one private party to another. Instead of borrowing from a big bank, businesses or individuals borrow from private credit funds, otherwise called nonbanks or private lenders.

Investors provide money to a private lender who uses it to pool funds and lend to its borrowers.

Borrowers repay the loan with interest, and the private lender then gives a fixed share of this interest to the investor as income after deducting any fees.

The benefit is that private credit generally offers better returns than traditional fixed income such as bonds or cash. Many private credit funds also offer protection against inflation and access to diverse opportunities underserved by banks.

The kicker is that if the borrower defaults, the investor may share in the loss. The investment is also illiquid, meaning it's locked away for a period.

The private credit sector is also unregulated compared to traditional banks, which has resulted in questions over transparency. Investors could lose sight over what happens with their money.

Types of private credit

Private credit comes in different forms. For example, MA Financial, a private lender in Australia, focuses on three main types: direct lending, direct asset lending, and asset-backed lending. Here's a look at each:

Direct lending: MA Financial lends directly to companies that may struggle to get loans from banks. These businesses get faster access to funds, while MA Financial and its investors earn interest.

Example: A software company needs $5 million for new products but can't meet strict bank criteria. MA Financial steps in, providing the loan with flexible terms.

Direct asset lending: These loans are backed by physical assets like property or equipment. If the borrower can't repay, the lender can take the asset.

Example: A property developer borrows $5 million to build apartments, using the property as collateral. If they can't repay, MA Financial can take over the property.

Asset-backed lending: MA Financial provides funds to other lenders to help fund their loan portfolios, such as car loans or business loans. This offers diversified real-world exposure.

Example: A lender issues car loans to Australian drivers. The private lender funds the auto lender, earning returns as drivers repay their loans.

Why can't banks just finance everything?

Importantly, nonbanks are not trying to replace banks. Instead, they fill the gaps where banks can't or don't want to lend.

According to Frank Danieli, head of credit at MA Financial Group, these specialist lenders have taken over activities that were previously handled by banks, which have sold off their loan portfolios.

"One of the key features of the banking industry is that banks are heavily regulated institutions, and this regulation has only increased over time," says Danieli. "As a result, banks make decisions based on capital rules and regulatory requirements, which can limit their ability to lend to certain borrowers or pursue certain types of loans."

"There are many areas where it's more efficient for multiple parties to work together to provide loans to borrowers who need capital. This partnership approach is driving growth in the asset-backed lending space, and we expect to see continued expansion in this area."

How to invest in private credit

Australian retail investors have two main options: Unlisted managed funds or listed investment trusts (LITs) and listed investment companies (LICs).

Unlisted funds are managed by fund managers who pool investor money and lend it out to businesses through their own platforms. They offer potentially higher returns but are less liquid.

While most buy-ins for managed funds start at $50,000, Pengana Capital Group's managed fund, TermPlus, offers unprecedented access to retail investors from only $2000.

On the other hand, LICs and LITs are available on publicly listed exchanges, such as the ASX.

For example, MA Financial's MA Credit Income Trust (ASX: MA1) launched in March, provides exposure to 165 private credit investments, spread across direct asset lending, asset backed lending, and direct corporate lending.

The difference between LITs and LICs is just the asset class, according to Danieli.

"Listed investment trusts are generally used for fixed-income interest-earning underlying assets, whereas LICs are more for equity securities or hedge funds," he says.

"The distinction is structural. The big distinction is whether you want a listed fund or an unlisted fund."

Why is private credit booming?

Globally, private credit has been growing exponentially. Total private credit assets-under-management (AUM) grew to US$2.1 trillion in 2023 - ten times the 2009, according to a McKinsey report. And it shows no signs of stopping; BlackRock estimates private market could grow to US$20 trillion by 2030.

Danieli says the main reason for this is down to portfolio construction.

"The traditional model was the 60/40 split - 60% in growth assets like equities, and 40% in more defensive assets," he says.  "But what started to happen, initially at the institutional level, was people began rethinking that mix."

"They asked: do I really need all of that 40% to be in assets with daily liquidity? Or can I trade off some of that in exchange for a premium return?"

At the same time, more companies are staying private.

Whether it's the US, Germany, or the UK, stock markets have seen a public listing plummet in recent decades, and while ASIC says it's not yet a trend here, the ASX delisted 156 in the FY2023-2024.

"There's a huge world of private companies out there. For example, in the US, if you look at companies with more than $100 million in revenue, there are six times more private companies than public one," says Danieli.

"I say to investors, why cut yourself off from that universe if you don't have to? That's really what's changed as the industry has matured."

Private credit faces scrutiny

There has also been a dark side to the private credit boom.

In January, the Australian Financial Review reported that private lender Gemi Investments told investors it could not redeem money because its borrower repayments were overdue.

Others have been forced to do workouts - where the company is forced to buy a stake in a business due to loan defaults.

Cases like these led to ASIC releasing a discussion paper in February about the risks surrounding private credit. And that came after the regulator set up a taskforce monitoring private credit in August last year.

Consequentially, SQM Research, one of four firms that rate the sector, put the sector on "watch".

A spokesperson from Zenith, another ratings agency, told Money that "for some retail investors" superannuation should be the way they invest in private credit.

"Their exposure comes through their super fund, allowing professional investors to make those decision for them," they said.  "It's partly an education thing; you shouldn't invest in things you don't understand. That message needs to be out in the marketplace. "

What makes a good fund manager

While the public market offers you disclosure and the ability to do your own research, private markets, by design, rely on illiquidity and internal modelling.

With that in mind, Danieli says its essential that retail investors pick a good private credit manager.

"A good credit philosophy should be boring, focusing on avoiding losses rather than picking winners," he says. "The goal is to lend money with a high chance of repayment and earn a steady income. A good credit manager should be able to deliver the promised return on loans."

When considering an investment, Danieli says there are several factors to keep in mind.

These include the manager's track record, experience, and presence in the market, as well as the fund's product terms.

"For me, the key differentiating factors are:

•              Does the manager have skin in the game, meaning they are invested alongside you?

•              Do they have access to new deal flow, which can provide a genuine edge?

•              Do they have the capability to do workouts if things become challenging?

These factors can help investors make informed decisions and choose a suitable investment."

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