Private credit is having a ‘Goldilocks’ moment, with higher-for-longer interest rates driving double-digit returns. Once an overlooked investment class, Australia’s private credit market has exploded in recent years and is on track to reach $200 billion of assets under management, growing at a compound growth rate of 23% p.a.
EY estimated private credit assets under management to be $188 billion in 2023. This includes $112 billion in business loans and $75 billion in commercial real estate loans. On a global scale, private credit has now surpassed the $1 trillion (US$1.49 trillion) mark.
This rapid growth in private credit can be traced back to the 2008 financial crisis. As banks scaled back their lending due to stricter regulations, private credit firms stepped in to fill the void, offering attractive interest rates and capturing market share.
What began as a niche financing option for companies deemed too risky or too small has evolved since then, with institutional investors such as super funds and insurance companies investing in them.
Real estate leads private credit
The private credit market offers various investment opportunities for income-seeking investors, such as real-estate debts, agribusiness funds, infrastructure funds, and also listed options like investment trusts and ETFs that provide investors with direct exposure to the corporate loan market.
In Australia, private credit transactions are predominantly led by real estate, driven by banks reducing their commercial real estate exposure from 10% of total assets in 2009 to 5.5%.
Real estate private credit has also become more popular due to its tangible asset backing and the potential for secured returns.
Australian private credit breakdown
Interest in non-bank commercial real estate debt has never been stronger. Valued at $75 billion, it accounts for 16% — compared to the banks’ 84% — of the $447-billion commercial real estate credit market, according to Foresight Analytics.
Looking ahead, it is expected to nearly double, reaching $146 billion and 22.7% of the total market by 2028.
Despite some recent challenges, such as the high-profile collapse of John Adgemis’ Public Hospitality Group, interest in the sector remains robust. Non-bank lenders have increased their exposure to residential development, stepping in as banks withdrew. This is even as more than 2,000 construction firms have entered into administration.
But, defaults don’t necessarily result in losses for these funds as senior (first mortgage) holders often control the recovery process and are thus able to secure full repayment.
When it comes to returns, real estate debt funds typically yield 8-12% p.a. from portfolios of diverse assets with returns in floating-rate averaging 5-6% above the cash rate.
For example, Adelaide-based Capital Prudential Wholesale Real Estate Income Opportunity Fund, which invests in mid-scale specialty commercial has an expected return of 11.3% p.a. Similarly, the MFEG Diversified Real Estate Credit Fund, which provides exposure to a diversified portfolio of loans secured by real estate, has a target return of 6-6.5% p.a. above the 90-Day Bank Bill Swap Rate, around 4.3%.
Opportunities in business lending
While many private credit funds have traditionally focused on real estate, there’s been a growing shift towards sectors like infrastructure, technology, and manufacturing. This comes as the banks have been pulling back from certain markets, creating fresh opportunities for investors.
With private credit representing just 12% of Australia’s business loan market, there’s room to grow, covering areas like direct lending, middle-market loans, SMEs, distressed debt, and venture capital.
Amid today’s macroeconomic uncertainty and higher- for-longer interest rates, these areas offer attractive yields, with senior lending to middle-market companies generating yields as high as 10-12% p.a.
Some top funds in this space include the Aura Private Credit Income Fund, an unlisted fund backed by secured SME loans, which has delivered an average return of 9.6% p.a.
Another notable fund is the recently launched Pengana Global Private Credit Trust, a listed fund that provides loans to mid-market companies with earnings of US$50-$250 million. It targets an attractive cash yield of 7% p.a., paid out monthly.
A crucial point to consider here is the difference between public and private markets. Public markets offer liquidity and transparency, with immediate price adjustments but also higher volatility. In contrast, private markets can provide higher returns due to less competition and illiquidity premiums.
A diversifying role to play
Private credit is becoming a popular alternative to traditional fixed-income investments like corporate and high-yield bonds.
In 2023, private credit funds delivered returns exceeding 10%, while Australian 10-year bonds yielded just 5%. Additionally, private credit avoids the ‘mark-to-market’ risks typical of most unlisted asset classes, and is thus able to provide steady income with minimal stock market correlation. Hence, private credit is appealing to both income-seeking and growth investors.
For example, for defensive investors, private credit funds focused on low-risk, senior secured, investment-grade debt can be a solid alternative to traditional bonds. Such debt funds generally return 8-9% p.a., making them attractive compared to low-yielding bonds corporate and government bonds and cash.
And for investors seeking growth, funds investing in mezzanine or sub-investment grade debt can offer equity-like returns.
Balancing returns and risk
Private credit investing also entails a couple of noteworthy risks.
Unlike bank deposits, where the bank assumes default risk, in private credit investors bear this risk themselves. However, private debt ranks ahead of equities in the event of corporate failure, and loans often include safeguards to help manage this risk.
These investments are also less liquid and loosely regulated around disclosures. Coupled with low transparency over underperforming loans and fees, this means investors should ensure they understand the associated risks before investing.
Stay informed and cautious
Overall, investing in a well-diversified portfolio of private debt can offer substantial benefits, including diversification and downside protection. However, it’s essential to understand that while the returns can be attractive, private credit comes with its own set of challenges. Balancing the potential for high returns with an understanding of these challenges is key for investors aiming to capitalise on the opportunities in this space.
Source: Unlocking money-making opportunities in private credit, Ankita Rai, for Investment Markets Magazine