ASIC has confirmed it will pay closer attention to this area in the future.
In an exclusive statement released to InFinance, an ASIC spokesperson confirmed, “we are expanding our supervision of private equity and private credit funds, by establishing a dedicated private markets unit who will be out there speaking with private equity and credit firms, hedge funds and others to reinforce and test our expectations around governance, reporting and managing conflicts of interest.”
This comes as ASIC also highlighted it will pay more attention to private debt markets in the regulator's latest equity markets report.
Private credit refers to credit or loans provided by non-bank financial institutions, credit funds and private lenders, as opposed to traditional banks. It includes direct lending, venture debt, mezzanine funding and other forms of alternative financing. Loans are often packaged up and on sold to be warehoused and securitised.
Private credit is often used by businesses and individuals who may not qualify for traditional bank loans due to their higher risk profile, the nature of their business or the stage of their business development. Private lenders may offer more flexible terms and are often willing to take on higher risks in exchange for higher returns.
Rising interest rates have increased the attractiveness of private credit returns as a hedge to inflation, given a large portion of the lending done by private credit funds is on variable rates. Super funds are also contributing to heightened demand for private credit, with Australia’s largest super fund AustralianSuper tripling its exposure to private credit.
Mariana Paul, UBS O'Connor investment specialist and head of sales and distribution for South-east Asia, explains regulations such as Basel II have increased banks’ cost of capital. This has structurally changed the lending landscape and supported the growth of private credit over the last 10 years.
“While the supply of credit from traditional sources such as banks has contracted, the universe of borrowers, ranging from corporates to large family offices, has grown as their need for capital has also risen,” she says.
Investors in private credit benefit from an illiquidity premium to compensate for the long-term nature of the investments, with a pickup in spreads relative to corporate bonds.
“Private credit and private debt managers may provide more flexible capital solutions to borrowers that align to both parties’ objectives. For instance, private credit involves less stringent disclosure requirements, which may create a more comfortable negotiation process for borrowers,” says Paul.
Private credit no great risk in Australia
At its current size, the local private credit market is not thought to be large enough to pose risks to Australia’s financial system. The RBA notes non-bank lending only accounts for five per cent of the local financial system. Nevertheless, Daniel Yu, Moody’s Ratings’ vice president and senior credit officer, says risks could emerge if the sector continues to grow strongly.
“Given private credit tends to focus on more risky borrowers, such borrowers are likely to drive losses during economic stress,” he says. Yu notes banks may also feel pressure to lower their underwriting standards to compete with private credit providers.
The IMF’s April 2024 Global Financial Stability report acknowledges private credit creates potential risks. These include infrequent valuation, unclear credit quality and lack of oversight on systemic risks, given the interconnection between private credit funds, private equity firms, commercial banks and investors.
Against this backdrop, credit funds have a range of different checks and balances they use to manage their risks. These include how fast they deploy their capital, matching assets to liabilities and managing their ability to return capital to investors.
“One of the biggest challenges is the speed of money coming into the sector versus the number of credible investments,” says Andrew McVeigh, managing partner of Remara, a private credit investment manager with just over $1 billion in assets under management.
McVeigh says his business only invests in quality assets and is not incentivised to take credit risks, which is one way to manage the heat in the sector.
To manage risks, investment managers also look for a robust investment process and risk management framework. This includes sound underwriting standards, an elevated position in the capital structure, tight covenants and high-quality collateral around the loans.
“What’s key is to be fully aware of the possible risks associated with these loans at the macro and company level,” says Paul.
Scenario analysis is also vital, for instance to understand how the fund may be impacted if rates go higher, given borrowers’ costs rise as the interest rates associated with these loans increase.
“Also consider whether there is a clear resolution pathway in times of default or when covenants are triggered,” says Paul.
Strengthening private wealth fundamentals
As private credit continues to grow, strengthening your private wealth fundamentals is more crucial than ever. Our specialised courses are designed to enhance your understanding of private wealth management, equipping you with the skills to navigate and excel amidst the growing challenges in private credit.
Finance professionals can develop the ability to build trust-based relationships with customers, appraise their creditworthiness and propose suitable products and services to meet customers’ needs in a competitive marketplace.
The Essentials of Private Equity
Stay ahead of the curve and fortify your financial strategies with insights tailored to address contemporary complexities and opportunities in the Private Equity universe.
