A report in last Wednesday’s Australian Financial Review sparked alarm with some investors in private credit. According to the AFR: “One of the country’s largest financial planning networks is recommending its advisers sell holdings in at least three funds run by Metrics Credit Partners, launching a wide-ranging review of private credit to assess whether the returns are still worth the risk.”
Count Financial, which has a network of almost 550 financial advisers, was conducting an out-of-cycle review of private credit after an increase in instability of the asset class, and had also placed a “sell” recommendation on three funds – the ASX listed Metrics Master Income Trust (MXT) and Metrics Income Opportunities Trust (MOT) and the unlisted Metrics Income Fund.
As a result, the prices of the ASX listed entities got hit. However, by the end of the day, they had largely recovered as cooler heads prevailed and investors took the opportunity to buy investments below NTA (net tangible asset value). On Friday, the Metrics Master Income Trust (MXT) closed on the ASX at $1.98, a fraction below its NAV (net asset value) of $2.0088.
The apparent alarm goes to the critical questions for investors about whether investing in private credit is worth the risk and just how safe it is. And if you are an investor or planning to invest, what should you look out for?
Let’s address these questions, but first, a look at the private credit market.
What is private credit?
Private credit is a type of financing provided by non-bank lenders, such as private equity funds, hedge funds, and specialist credit funds. Unlike traditional bank loans, private credit typically involves loans that are negotiated directly between the lender and borrower, without accessing public markets. These loans often come with higher interest rates to compensate for greater flexibility, reduced bureaucracy, and the ability to cater to the specific needs of borrowers.
In Australia, private credit has gained significant traction in recent years, reflecting broader global trends. Several factors contribute to the increasing popularity of private credit in the country, both among borrowers and investors.
One major driver is the tightening of regulations on traditional banks. Post-Global Financial Crisis reforms, such as the Basel III framework, have imposed stricter capital requirements on banks, limiting their capacity to lend, particularly to small-to-medium enterprises (SMEs) and businesses considered higher-risk. As a result, borrowers who may have struggled to secure funding through traditional avenues are turning to private credit providers, who can offer more flexible terms and faster decision-making processes.
Who are the big players in Australia?
The major players in Australia include groups such as MA Financial, Metrics Credit Partners, Qualitas, Pengana, Ares Wealth Management Solutions, La Trobe Financial and Revolution Asset Management.
Most retail investors access private credit through unlisted funds, but there are also several ASX listed funds. These include:
- Metrics Master Income Trust (MXT)
- Metrics Income Opportunities Trust (MOT)
- MA Credit Income Trust (MA1)
- Pengana Global Private Credit Trust (PCX)
- Qualitas Real Estate Income Trust (QRI)
What returns do investors get?
Private credit can present an attractive opportunity in the current interest rate environment. Private credit investments typically offer higher returns than corporate bonds, driven by factors like illiquidity premiums and bespoke loan structures.
For example, the Metrics Master Income Trust (MXT) targets a return to investors of the RBA Cash Rate + 3.25% per annum, net of fees. Over the last 12 months, it has delivered consistent monthly distributions, with a yield of approximately 8.75%.
The Metrics Opportunity Trust (MOT), which invests in “riskier” loans and assets and has the potential for upside, targets a cash yield of 7% pa and a total return of 8% to 10% pa. The MA Credit Income Trust seeks to provide consistent monthly distributions and targets a return of the RBA Cash Rate + 4.25% pa.
What are the private credit funds investing in?
Historically, private credit funds invested in real estate loans, that is, first or second mortgages over commercial property or development risk through subordinated debt and other loan structures.
Today, they invest across the borrowing spectrum and have exposure to different industries/sectors. From vendor finance through to large scale equipment finance, working capital facilities for private companies and project finance. Sometimes secured, sometimes not. Metrics Credit Partners, for example, is a major lender to Healthscope, Pacific Hunter Hospitality (the owner of Rockpool and Spice Temple) and disability service provider Oncall.
Just because a loan is secured doesn’t mean that it is easy to realise. Realising a commercial property mortgage can be quite costly. Unlike residential mortgages, commercial property mortgages tend to get into trouble during the development phase. If the builder has gone broke and the sub-contractors have walked off the job, it can be very expensive to restart a building project and get it into a shape to sell.
What are the main risks?
While private credit investments can be lucrative, they come with several risks that investors should carefully consider:
- Illiquidity: Private credit investments are often long-term and lack the liquidity of public markets. Investors may find it challenging to sell their holdings or access capital in emergencies.
- Credit Risk: Borrowers may default on their loans, particularly during economic downturns. Defaults can lead to losses, especially if the loans are unsecured or collateral proves insufficient.
- Economic Sensitivity: Private credit portfolios are vulnerable to macroeconomic conditions. A recession or market instability can increase the risk of borrower defaults and reduce returns.
- Limited Transparency: Private credit transactions are less regulated and less transparent compared to public investments. This can make it harder for investors to assess the quality of their investments.
- Managerial Risk: The performance of private credit funds depends heavily on the expertise and decision-making of fund managers. Poor management decisions can lead to losses for investors.
- Interest Rate Risk: Rising interest rates can affect private credit investments, especially fixed-rate loans, by reducing their relative attractiveness compared to other fixed-income assets; and
- Concentration Risk: Many private credit funds invest in a specific sector or type of loan. If that sector faces challenges, it can impact the overall portfolio’s performance. If the fund is significantly exposed to one borrower, and that borrower runs into problems, the overall portfolio performance could be significantly impacted.
Are they safe and what should investors look out for?
In the main, I think they are “safe”, but obviously, this is going to depend on the particular private credit fund. They are clearly higher risk.
When thinking about a private credit fund, the first consideration is the “promised” or “target return”. Risk and reward go together, so the higher the promised return, the riskier the investment and the less safe it is. For example, The Metrics Master Income Trust is “safer” than the Metrics Income Opportunities Trust.
Importantly, just because an investment promises a high return, that doesn’t mean it won’t repay all your money. It just means that the prospect of a loss on your capital is higher.
Next, consider what the fund is investing in. What are the borrower industries or sectors (e.g. commercial real estate, healthcare, retail etc)? What are the loan structures? What is the security? What are the concentration risks? And what is the credit worthiness of the borrowers? The latter might be a little hard to determine, but some funds will target borrowers/loan structures with a weighted average credit rating such as BBB-.
For example, the $2.1 billion Metrics Master Income Trust (MXT) has 321 loans with a weighted average credit rating of BBB- (the lowest ‘investment grade’ rating). The largest exposure is 2.2% of the portfolio (about $50 million), the average 0.3% (about $6 million). The average loan has 1.7 years to run, and 97% are floating rate interest (variable). By industry, 51% are for real estate, with the other top sectors being financial at 14%, consumer discretionary at 10% and industrial at 8%. On 31 December, there was only 1 loan in arrears and 14 loans on the Manager’s watchlist.
Transparency and reporting are key issues. If the Manager is vague about loan and borrower information, I wouldn’t readily invest in it. Preferably, detailed monthly reports about performance and loan and borrower behaviour should be available, and ideally, a regular NAV (net asset value) is published. Hopefully, the NAV is verified externally on a regular basis.
The track record of the manager (length, experience, consistency, size) is an obvious consideration. But as with most assets, diversification across managers (which means investing in several funds) is usually an advisable strategy.
Finally, many of the private credit funds are rated. While Rating Agencies aren’t infallible (e.g. the GFC), they are now closely regulated and there is no denying they have considerable expertise. In the case of the Metrics Master Income Trust (MXT), it retains a “highly recommended” rating from Bond Adviser, Lonsec and Zenith and “recommended” from Independent Investment Research.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.