Private credit is increasingly popular with investors but do you really understand what you’re buying?
A boom in private credit demand as investors chase higher yields and portfolio diversification is raising concerns around how asset managers are handling valuations, fees and transparency.
The fast growing Australian private credit market is estimated to be worth some $40 billion, prompting scrutiny from the Australian Securities and Investments Commission (ASIC) amid concerns that some private credit investments remain untested in market stress scenarios.
It’s important for investors to get ahead of any regulatory changes and do their own due diligence on their private credit investments to ensure they capture the attractive returns offered by private credit without taking on unnecessary risk.
It is important for investors to be asking questions.
It’s only when there is real market distress that it will really become an issue – but it’s something many investors haven’t been thinking about and probably should, ahead of that time.
Transparency, valuation
ASIC is seeking feedback on how private markets should be regulated, noting concerns about transparency, valuation of illiquid assets and how managers are dealing with potential conflicts of interest.
Traditionally the preserve of institutional investors, who are presumed to be better placed to look after their own interests than retail investors, private credit is increasingly popular among retail investors through managed funds and superannuation.
Valuation questions
Investors should look closely at their private credit exposure to understand how their manager is handling valuation, fee structures, credit ratings and potential risks that may not be immediately apparent.
There is evidence of managers leaving asset valuations unchanged despite broader market downturns – with some managers leaving asset values at par even during periods of extreme dislocation like the pandemic.
The question to ask is: are your assets marked to market? When assets become impaired, are you marking them down to reflect that? This is the kind of thing that’s fine until it’s not.
Failing to appropriately mark down distressed loans can pose even greater risks for investors if managers are perceived to be hiding losses.
This is important for investors. – If they are marking them above what they could actually sell them for, then managers create a risk of creating a run on the fund.
If they are marked too high and there’s questions around that, then the investors that are out of the door first will get a good price – but eventually, they will have to gate the fund because those aren’t really the true values.
You want people to have liquidity, but to not disadvantage investors that are staying in the fund.
Credit ratings
Some managers use self estimated credit ratings instead of independent ratings from agencies like S&P or Moody’s.
That’s a bit like marking your own homework – saying ‘we like this deal, so of course it’s investment grade’.
They generally get auditor sign off, but don’t really push back on those in the way you would if it was done by a proper rating house.
Conflicts of interest
Investors also need to watch out for conflicts of interest that can distort investment decisions away from the best interests of investors.
Some private credit managers retain a proportion of the upfront fee typically paid by borrowers to secure financing, rather than leaving it within the fund.
This can create conflicted incentives, as it may encourage the manager to prioritise deals with higher upfront fees over those with the best long-term risk return for investors.
You don’t want investors going for deals just because they have the highest upfront fees.
It’s best practice to have a flat management fee, so you’re aligned to investor outcomes.
Source: Perpetual