The global private credit market stood at some US$1.6 trillion in assets under management last year according to estimates by BlackRock. At the same time, according to EY, Australia’s market reached $188 billion in assets despite challenges in 2023.
With inflation easing and rate hikes tapering, EY anticipates a favourable environment for increased deal activity among private credit lenders this year.
However, as private credit continues to grow, criticism from naysayers, especially those advocating for stricter regulatory standards, has gained momentum. Pete Robinson, head of investment strategy, fixed income at Challenger Investment Management (CIM), explained that while the regulation of private credit in Australia mirrors that of public credit, it’s the transparency concerns that underlie key issues.
“When people talk about the issues around regulation and private credit, they are talking about the lack of transparency in the asset class,” Robinson told InvestorDaily. “That investors don’t have the benefit of independence in valuations and risk assessment (i.e. credit ratings) as well as transparency as to how the manager is compensated.”
He acknowledged that this lack of transparency, alongside investor complacency, has allowed poor practices to infiltrate the market.
“I don’t think anyone who seriously follows the market would dispute this. But with growth comes scrutiny and we’ve been pleased to see more focus around governance issues,” Robinson said.
He believes that as the asset class gains in popularity and attracts more managers, the veil of transparency will gradually lift.
“Private credit is no longer operating in the shadows; there are more managers coming to market and they need to reveal more in order to win money, the more strategies that are out there the more investors can compare and contrast to assess what risks they are comfortable taking and what they aren’t,” Robinson said.
“Upfront fees are a good example; we find almost all investors ask about whether we take any of the upfronts. When they go with a manager who keeps some or all of the upfront fee they are doing so with their eyes open. We still think there is more work to do, but things are moving in a positive direction.”
One reason investors have been willing to accept the trade-off in transparency is simply due to the returns offered, Robinson explained.
“When you engage in private markets, you are lending directly with a single borrower. By not engaging with an external rating agency and syndicating the debt to dozens of other investors, you make the issuance process much more cost effective, particularly for smaller issues,” he said.
“This saving in execution costs can be added back to the interest margin. Effectively you are getting an interest rate of around 2 per cent per annum higher than what you would get in the public markets for the equivalent credit risk.”
Tempering perceptions of growth in private credit
Robinson emphasised the importance of distinguishing between private commercial real estate (CRE) lending and non-CRE lending when discussing the growth of private credit as an asset class.
The former has grown at a CAGR (compound annual growth rate) of 21 per cent over the previous four years through December, versus 11 per cent in non-CRE lending and 14 per cent in US private credit.
“Now, to be fair, even the 11 per cent p.a. growth in private lending ex CRE is higher than non-financial corporate lending by ADIs, which is more like 7 per cent p.a. over the same period, but in our view, this is much more of a reflection of the opportunity in private direct lending than a sign of excess growth,” Robinson said.
“At an aggregate level, non-financial credit as a percentage of GDP is still relatively low compared to other nations – total credit to non-financial corporations is 60 per cent of GDP in Australia versus close to 80 per cent in the United States.”
Nehemiah Richardson, CEO of Pengana Credit, believes that comparing private credit in the Australian market with global private credit in markets like the US and Europe is like comparing apples and oranges.
“Private credit has played an important role in the US economy since the GFC as the banks retreated from corporate lending due to tightening in the regulatory environment. Europe has had the same dynamic. It’s a mature industry and a massive market and the structural gap continues to grow. In the US and Europe, 85 per cent of mid-market corporate lending is done by investment managers,” Richardson said.
“Australian private credit is very different, it’s a much smaller market with the Australian banks providing 90 per cent plus of credit lending. As a result, the majority of loans are related areas where banks do not have credit risk appetite, for example commercial property and subordinated positions in asset-backed structured finance vehicles.”
Indeed, Australian banks have significantly reduced their exposure to commercial real estate, slashing it from approximately 10 per cent of total assets in 2009 to just 5.5 per cent today.
Namely, following the Global Financial Crisis (GFC), regulators aimed to reduce banks’ risk exposure to safeguard the banking system against future external shocks. This included scaling back banks’ involvement in commercial real estate and limiting their market activities. As a result, a significant capital gap emerged in the marketplace, which private credit has stepped in to fill.
Insolvencies and private credit
Private credit lenders in Australia have navigated recent economic challenges, including COVID-19 and shifts in interest rates and inflation, with resilient portfolio performance, according to EY.
However, private credit’s exposure to insolvencies impacting the commercial property market has particularly concerned investors.
While corporate insolvencies have notably risen, primarily affecting smaller firms in sectors like construction, EY’s research says that existing loan portfolios have generally weathered these challenges well. EY noted that in cases such as leveraged loans and real estate development, private lenders have successfully negotiated loan amendments, extensions, equity contributions, and deal restructures.
“Some of these situations have benefited from the more recent moderation in inflation levels and construction costs, along with the better than forecast consumer spending levels and real estate values,” EY said.
Acknowledging the presence of loan defaults and insolvencies for those unable to work through the challenges within their businesses, EY said these levels remain “manageable” and in line with the traditional bank lending markets.
“With the continued economic difficulties heading into 2024, there is still caution needed and we expect private debt lenders to remain selective in this environment,” EY said.
“However, the stable loan portfolio experience to date, combined with the growing market space for private debt lenders in Australia, certainly provides a positive platform for sustainable growth in coming years.”
For Richardson, the appeal of private credit lies in its attractive yields, low volatility, defensive characteristics, and the potential for capital preservation, bolstered by strong underlying structural protections.
However, he does not discount the importance of diversification.
“We believe to make the most of the attractive characteristics of the asset class, diversification is key to minimising downside risk and maximising returns through economic cycles. This means diversifying across geographies, industry segments, managers, strategies and individual loans. This level of diversification is a proven strategy for consistency of income returns, and to spread risk through the portfolio,” he said.
“Diversifying returns across different investments, and the emergence of asset classes such as global private credit, adds another option to the investor’s toolkit.”
Maja Garaca Djurdjevic
Maja's career in journalism spans well over a decade across finance, business and politics. Now an experienced editor and reporter across all elements of the financial services sector, prior to joining Momentum Media, Maja reported for several established news outlets in Southeast Europe, scrutinising key processes in post-conflict societies.
