FEATURED IN THE AUSTRALIAN FINANCIAL REVIEW: Fortunes to be made as the private credit boom is going public

Once a cottage industry, private credit is now attracting billions of dollars, reshaping the financial system and minting new fortunes.

Jonathan Shapiro, Senior reporter
Published on Jun 7, 2024 – 12.00pm

It’s a winning trade that is being pitched around the world to investors of all sizes – from little old ladies to sovereign wealth funds.

The opportunity is earning double-digit returns by lending money to small businesses, big companies and real estate developers that have been left hanging by the banks. Lending money is reliable, stable and thanks to higher interest rates, is a compelling investment.

Private credit, or direct lending, is in a boom phase that is attracting wall-to-wall media coverage, billions of dollars in capital and has turned into a lucrative money spinner for asset managers that are seizing the moment.

In Australia, a string of transactions has turned private credit into a public equities story as listed fund managers fork out hundreds of millions of dollars to get into the lucrative lending game.

“Investors are seeking good risk-adjusted returns, and private credit is offering equity-like returns from less than equity-risk,” Merricks Capital’s Adrian Redlich tells AFR Weekend.

Redlich set up Merricks as a hedge fund in 2007 with the backing of Melbourne’s wealthy Liberman and Abeles families. But it’s foray into direct lending fuelled a rapid growth in assets. This week, Phil King’s Regal Partners paid $235 million in cash and shares to buy out Redlich and his backers.

Just weeks earlier, David Di Pilla’s HMC Capital paid $127 million to buy Payton Capital, another Melbourne-based real estate lender.

And earlier this year, Australian businessman Paul Weightman made global headlines when he poached the entire private lending team from British private equity firm Barings, sparking a high-profile legal stoush. While credit analysts can earn million dollar salaries, the prospect of equity stakes in these fast-growing businesses has been enough to entice mass defections.

The impressive growth of Metrics Credit Partners, which is 35 per cent owned by ASX-listed Pinnacle, to a manager of $15 billion in assets has also propelled returns for the high-flying funds management group.

Private credit, which is also referred to as private debt or direct lending, describes any lending that is not in the form of a security such as a bond.

Banks and insurance companies have traditionally lent money sourced from depositors and policyholders to businesses and projects on behalf of their shareholders. But more lending is being done by private lending funds of all sizes by investors of all sizes. The activity ranges from individuals tipping their savings into a property loan marketed to them on the internet to a sovereign fund cutting a billion dollar cheque to a private markets titan.

As banks have become increasingly constrained by regulators, these private lenders have ramped up their activity. And now that base interest rates have increased, private lending is generating double-digit returns.

But rapid growth has prompted talk of a bubble. The International Monetary Fund published a paper outlining its risks to the financial system; JPMorgan banker Jamie Dimon says there’d be “hell to pay” when loans go awry.

Only 4pc of market

But Redlich tells the Financial Review that private credit is still in its relative infancy as it eats into the $5 trillion loan pool of the Australia’s largest banks.

“We are $200 billion out of $5 trillion, which is 4 per cent. That is not significant penetration,” he says, adding that the constraint on growth for private credit funds is not raising money, but being able to source the lending opportunities that exist in the economy.

“You’re having to replace thousands of business bankers to find, prosecute and manage these loans,” he says. “The macro suggests that we have to be a much bigger industry for Australia to keep providing credit growth.”

“One of the basic tenants of GDP growth is if you don’t have credit growth in an economy, you can’t grow the economy. So as a country, we have to find different ways to support that growth.”

The multi-trillion dollar lending retreat by the banks is also set to create the next generation of asset manager wealth. This once sleepy corner of the fixed income market is both large and lucrative.

Regal’s disclosures revealed that Merricks earned average management fees of 2.2 per cent. Macquarie analysts estimated that Payton Capital’s fee-take was in the region of 3 per cent of assets under management.

That is more than five-times the margin that long-only fund managers can charge for managing listed equity portfolios.

In Australia, commercial real estate lending is proving particularly enticing. Private lenders often charge structuring and arranging fees on loans that are subject to refinancing within two years.

There are naturally sceptics who worry about poor transparency and light regulation that governs private lending, both in Australia and abroad.

Among them are the International Monetary Fund, which has encouraged policymakers to increase their surveillance of the sector.

Future risks

“The migration of credit provision from regulated banks and relatively transparent public markets to more opaque private credit firms raises several potential vulnerabilities,” the international financial agency says.

Most of its concerns relate to the lack of transparency about loan performance, and valuations, and fears that a loss of investor confidence could reduce the availability and increase the cost of borrowing.

Dimon, the chairman of banking giant JPMorgan, is also warning that there are future risks associated with private credit’s rapid growth.

At The Australian Financial Review Business Summit in March, he questioned whether private credit funds would be as patient and helpful with borrowers as banks, if conditions worsened, or if the lender hit a rough patch. “Private credit may very well cause some problems as it gets bigger and bigger but right now, it’s a not systemic,” he said at the time.

His main worry is that private credit has attracted inexperienced operators that will cause collateral damage by writing bad loans.

“I’ve seen this before with rapid growth, There are a lot of very capable people, but that doesn’t mean they all are. The ones who aren’t capable, they may very well cause a run on the bank.”

A few bombs have already gone off in private credit. In Australia, investors in Gemi Investments have been told they’ll have to wait several months before they are repaid in full. In Canada, commercial real estate lender Ninepoint has been forced to suspend cash distributions in three funds.

But that’s not nearly enough to slow the boom.

While private credit’s merits are a point of contention, there is good reason why investors are flocking to it.

AustralianSuper has said it plans to triple its exposure to private credit from $7 billion by appointing managers and writing loans directly.

The lure of double-digit returns

“Lending margins have increased due to heightened macroeconomic risks, base rates have gone from zero to 5 per cent [and] so you are now looking at yields of 10-12 per cent for senior lending to middle market companies,” the super fund’s head of private credit, Nick Ward, said earlier this year.

The Future Fund is also allocating more funds to floating rate credit, enticed by the relatively attractive returns on offer. “We think that that’s been quite well rewarded and if interest rates stay high, or indeed have to go higher – which isn’t likely but possible – then that would flow through to the returns,” the fund’s chief executive, Raff Arndt, said at its January briefing.

While the merits of private credit are being debated, the sector is becoming the bedrock of institutional portfolios.

One consultant tells AFR Weekend that more institutional investors are allocating billions of dollars to large well credentialed private credit managers to earn double-digit returns – and to cash to earn the risk-free rate and retain some flexibility. The blended return of 7 to 8 per cent has now become the hurdle-rate for all other investments, and is hard to clear.

For individual investors, there is no shortage of private credit managers marketing their products via brokers, on the internet and in the media. Fund research firm Morningstar tracks the returns of about 25 private credit funds, but dozens of lenders are soliciting funds.

The high and reliable returns from private credit are enticing. The double-digit returns are part of the appeal but so too is the comfort that loan values are only infrequently revalued, creating the perception that they’re safe.

But other than the fees and the advertised yields, it can be difficult for investors to determine if they’re getting a fair deal or whether their investment is deteriorating.

Redlich says investors should appreciate that while the returns are relatively attractive, the asset class is not without its risks.

“This is not a deposit. This is a private credit. It has a very attractive risk return profile, but you’re still taking risk,” he adds. “When you educate your investors on that, it’s not a great shock if something takes a bit longer to repay, or if you have to charge default interest. They understand that.”