A beginner's guide to private credit

The term 'private credit' may be unfamiliar to some Aussie investors, but dig deeper, and it's an asset class that can be quite straightforward.

Broadly speaking, private credit falls within the category of 'interest-bearing investments'.

However, it's very different from something like a term deposit.

To understand how private credit works, it can help to think of it by its alternate name of 'private lending'. That's because private credit involves loans sourced from non-bank financial institutions.

For context, non-banks can't rely on customer deposits as a source of loan funds in the way that banks and other authorised deposit-taking institutions can.

Instead, they rely on funding from investors.

Unlike shares, these loans are a private rather than publicly traded market.

Put these two aspects together, and this is where the term 'private credit' comes from.

Investing is usually via a managed fund

Instead of asking individual investors to directly fund specific loans, non-bank lenders invite investors to buy units in a managed fund.

This allows investors to spread their money across a broad range of loans and borrowers, which helps to reduce risk.

In this respect, there is nothing new about private credit.

What has changed in recent years is the sharp rise in demand for private (non-bank) loans.

There is a simple reason for this.

Following the global financial meltdown of 2008/09, Australia's bank regulator APRA introduced new rules. These have steadily seen a tightening of traditional bank lending to small and medium-sized businesses.

This has created a funding gap, and non-banks have filled the space.

Large-scale investors have been quick to share in the spoils.

Superannuation giant AustralianSuper, for example, has more than $7 billion invested in private credit globally, and it expects to triple the exposure to private credit in the coming years.

This level of support speaks volumes about the potential appeal of private credit.

So, what's the attraction?

Again, that's simple.

Strong returns not linked to equity markets

Private credit has a track record of generating high yields with far less volatility than we see on sharemarkets.

Exactly what sort of yield investors can earn depends on the underlying debt, the nature of the borrowers, and the private credit fund itself.

Remember, this is not a publicly traded market. So, there is no single index of returns as there is for, say, shares or property.

How can I invest?

Private credit is increasingly becoming available to individual investors.

Investment options include unlisted funds though there are also listed options such as the Metrics Master Income Trust (ASX:MXT), which is backed by a portfolio of direct corporate loans.

What are the downsides of private credit?

Private credit is lending to a variety of borrowers. And any sort of lending brings the risk of borrower default.

The Reserve Bank of Australia has commented that non-bank lending can "involve considerable use of leverage" and be "more concentrated...and risky than bank lending".

That's why some basic research is essential.

Check the track record of a private credit fund manager. Read the prospectus to get a feel for what you are really investing in.

Above all, remember the golden rule that higher returns involve higher risk.

It's also worth noting that private credit funds are not the same as bank deposits. They do not come with a government guarantee. You could lose part of your capital.

Restrictions may also apply to when, and how often, you can access your money. This is definitely something to ask about before you invest.

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