January 15, 2025

The Year Ahead

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As we begin a new year, we reflect on the successes and challenges of the past twelve months and how these will shape our outlook for 2025. In some respects, 2024 played out as anticipated: we held the view that rates would stay “higher for longer” entering the year. We witnessed inflation pressure on our borrowers and the significant market volatility driven by global geopolitical tensions and key elections in major economies.

In contrast we enter 2025 believing the market is now too conservative about impending rate cuts in Australia and inflationary risks. The slowing economy, in our view, is inevitable as Government spending cannot maintain the year-on-year growth that has been the impetus for tight job markets and pressure on construction costs over the last two years. The crowding out of the private sector will likely see a dearth of new supply in many hard asset sectors for years to come. After decades of no consequences for ballooning fiscal deficits, we believe the bond market is starting to ration governments around the world if they do not exhibit more budgetary discipline. The deflationary pressure that will likely come from excess Chinese industrial supply combined with the early stages of artificial intelligence-led productivity gains points to a more balanced inflation outlook.

This understanding of the operating climate for private credit prepared us for a year marked by the active management of maturing loan positions and the redeployment of repaid capital into opportunities offering strong risk-adjusted returns. Despite pressures on asset prices, the Funds performed well through the cycle. The Merricks Capital Partners Fund delivered 8.1%* return for the 2024 calendar year, while the Merricks Capital Agriculture Credit Fund achieved 10.4%*. These returns include 1.5% of credit provisioning and a 0.6% cost for the macro hedge (CDS) held by the Merricks Capital Partners Fund. Some of this provisioning may prove conservative but we have a bottom-up process of revaluing our loans to enable a fair market value that enables investors to have confidence in deploying into our Funds during all parts of the credit cycle. The two loans in our universe with administrators/receivers in place now have clearly defined exits with sales processes well advanced.

In our commentary over the last six months we have highlighted that the positive velocity of agricultural loan repayments has surprised to the upside and that we expected October 2024 to mark the bottom of the commercial real estate (CRE) market. In hindsight, our call on CRE was premature and believe Q1 2025 could be the bottom as forced sales by several weak handed property owners will be met with the waves of cash sitting on the sidelines looking for opportunistic buying.

The evergreen nature of most private credit funds in Australia allows for investors to come in and out of the Funds quarterly making less liquid loan portfolios tradable. Integral to the process is that new investors are confident in a fair mark and the interest upside for the coming years. With our Funds having averaged returns of approximately 10% per annum over most of the last decade, we continue to enjoy equity risk premium in a less risky asset class. However, we are always keen to reiterate to our investors that senior secured private credit is not riskless but rather offers a better risk adjusted return for those that can tolerate the less liquid nature of the asset class. With all Merricks Capital staff invested in our Funds, we, like our clients, take comfort in the limited downside of senior loans when asset security is well-managed.

Looking ahead to 2025, we expect similar conditions to prevail: ongoing market volatility, active management required for a handful of our 70 portfolio loans, and continued opportunities to diversify away from CRE with a particular focus on increasing infrastructure and agriculture exposure. We pride ourselves on our ability to move between the hard asset sectors with various unique origination sources and deep domain expertise that allows us to step into manage distressed situations when on occasion needed. Merging into Regal Partners has given the Merricks Capital team more depth and resilience, a broader lens across multi asset classes and access to one of the best mid-market sources of deal flow in the country. While the majority of hard asset focussed private credit funds in Australia will be competing to deploy into mid-market residential development loans we have a wide spectrum of loans currently in due diligence.

2024 Key Outcomes

Capital Deployment and Repayments

Merricks Capital deployed $900 million into new loans in 2024 and managed $707 million in repayments, a 77% increase from 2023. This reflects an improving environment for asset transactions, particularly in Q4, as global rate cuts began to take effect. In the past three months, $251 million in repayments were finalised, with an additional $200 million in assets under contract, ensuring further repayments in Q1 2025.

Reduction in Office Exposure

Recycling capital from maturing office sector loans was a core focus, with the Merricks Capital Partners Fund reducing its office exposure from more than 30% to below 24%. Key outcomes included the refinancing of two completed A-grade office developments in Melbourne and two-construction projects – one in Melbourne and one in New Zealand. Of the remaining four loans, three are progressing toward asset transactions with outcomes expected in Q1 2025, while the Lindrum project in Melbourne’s CBD transitioned into a construction facility with substantial credit enhancement from strong guarantors.

New Zealand Transactions

The Merricks Capital Partners Fund reduced its New Zealand exposure from 35% to approximately 25%, as full and partial repayments were achieved across CRE and agricultural loans. Transactions included the Mangawhai development loan, 80km north of Auckland, sold to an institutional purchaser, and the sale of South Island cherry orchards to an experienced horticultural operator. With cash rates in New Zealand now below Australia’s (4.25% vs. 4.35%), we’re seeing transaction momentum building heading into 2025.

Construction Project Completions

2024 was significant for completing delayed construction projects. Construction risk across the funds remains modest, with Merricks Capital Partners Fund’s exposure reduced to less than 20%, down 10% from the start of the year. A key challenge across the Funds was managing project delays of 6-18 months which impacted developments initiated in 2021-2023. Despite attachment points at 60-65% LVR positions, capitalising interest on delayed projects where practical completion has been pushed out by such a large margin significantly erodes equity positions. Across our loan book, we’re taking conservative valuations on delayed projects, often not accruing default interest in Fund performance until a clear path to repayment is established and we will continue to do so as we believe this approach is in the best interest of investors.

Proactive Risk Management

Within our portfolio of approximately 70 loans, we found that roughly five required active management at any given time throughout the year to address project risks or repayment delays. The Melbourne Place Hotel exemplifies our proactive approach. Despite the borrower’s insolvency and construction challenges, the asset is now operational and receiving favourable reviews as a landmark offering and experience in the Melbourne CBD. We’re proud of this outcome and the dedication it took from our team and eco-system to deliver. It also serves to demonstrate that even when enforcement is necessary on real estate-backed credit, the downside risk can often be confined to a reduced IRR over the loan term, rather than resulting in principal impairment.

Key Themes for 2025

Increased Asset Transactions

With rate cuts anticipated in the first half of 2025, the gap between buyers and sellers is expected to narrow, leading to an increase in asset transactions. We foresee higher liquidity and more opportunities to support borrowers monetising assets or acquiring undervalued properties.

Replacement Cost vs Valuation

Traditionally lending below the cost of building new assets proves to be a very defensive characteristic of senior secured lending. However, as we experience the cycle lows there will be a few assets that sell below replacement cost, and this will prove challenging for the economy as it discourages activity and new supply. This will also lead to more conservative independent valuations requiring our borrowers to put more equity into new loans. This more conservative footing should establish a high quality of vintage on new loans written.

Higher-Quality Borrowers Turning to Private Credit

As banks maintain restrictive lending policies, ultra-high-net-worth borrowers and institutional investors are increasingly seeking private credit to finance opportunities with strong pre-sales and modest leverage. These conditions are creating a new vintage of high-quality borrowers who historically would not have engaged with non-bank lenders. As an example, the only exposure we have to office in the more challenged market of Melbourne is the development of the Lindrum Hotel site. The personal guarantees from significant family offices are key to underwriting this asset.

Residential Sector Growth and Build-to-Rent Expansion

Residential exposure will increase as significant development projects progress. A notable example is our $226 million Melbourne-based Build-to-Rent (BTR) initiative, positioned to meet the growing demand for affordable, long-term rental housing. Additionally, we expect continued repayment of office sector loans reaching maturity, further reallocating capital to residential projects.

Specialised Infrastructure Investments

Opportunities in mid-market specialised infrastructure will expand in 2025, with projects like processing plants and port assets attracting investment. These assets, typically valued between $30 million and $300 million, offer resilience and meet critical infrastructure needs with defined market demand and shorter delivery timelines. For example, the financing of the development of the new port in Broome will be one of the bigger loans in the portfolio by mid-year.

Resilience and Growth in Agricultural Credit

Global food demand and capital dislocation will continue to drive agricultural credit opportunities. We anticipate growth in irrigated cropping, livestock operations, and permanent plantings such as orchards and vineyards. These income-generating assets provide significant portfolio diversification and a natural hedge against inflation due to the commodity linked nature of their revenue.
As we start the year, we remain focused on the quality of a new vintage of loans in due diligence whilst managing a significant wave of maturing loans. As we approach, what we believe, is the bottom of the real estate cycle there may be some borrower stress, but overall, the Funds are projected to deliver equity-like returns of 8-11% IRR, underscoring the resilience of private credit through economic cycles.

We thank our investors and capital partners for their continued trust and support and look forward to building on this strong foundation in 2025.

 

 

 

*These returns are stated net of fees and costs.

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