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Not all private credit providers are created equally, and due diligence is crucial for investors. But what separates the wheat from the chaff?

Private credit continues to offer higher yields than public markets, making it an attractive proposition for investors looking for reliable sources of income.

Globally, private credit – also known as private debt – is now estimated to be a $2 trillion-plus market, double what it was in 2015. In Australia, private debt represents approximately 10 per cent of the total corporate loan market and is expected to grow towards the levels seen in offshore markets where non-bank corporate lending accounts for a much higher share of the market such as 40 to 50 per cent in Europe.

Private debt appeals to borrowers as it comes without the inefficiencies and poor service that can occur when borrowing from banks. Many small and medium sized businesses are also finding it increasingly difficult, and expensive, to get loans from the banks, opening up opportunities for non-bank lenders in this space. Furthermore, there are many loans now offered by some private credit funds that were never the domain of banks, such as stressed or distressed lending and forms of subordinated lending.

These market developments have led to a proliferation of various private credit strategies from asset managers globally. However, not all private credit fund managers are created equally, and the end investor needs to conduct their own due diligence when considering which private credit strategy and asset manager best suits their targeted investment criteria.

Sorting the wheat from the chaff

Investors in funds comprised of listed securities can be reasonably confident they are investing in companies that are meeting their legal and other regulatory obligations – such as providing annual financial accounts, having annual general meetings etc.

However, as a private markets investment, investing in private credit funds requires a bit more investigative work and with a number of key investment considerations for investors:

Transparency

How transparent is the fund? What information is provided to fund investors on the quality of the loan portfolio? Are they only providing aggregated data which evidences the quality of the underlying portfolio or are they more specific? Investors should be able to find information about loan criteria and quality in the fund’s documentation.

Ratings

Can the manager quantify the risk of their loans through the use of credit ratings? Are those credit ratings credible in that they are supported by third-party credit models? Debt ratings should be supported by  reputable third-party ratings models such as Moody’s or S&P. Investors might also want to look at how many favourable overrides (when exposures are approved outside the lender’s credit assessment criteria), have been applied versus unfavourable overrides. It is also important investors understand how the manager determines the recovery rate i.e., the rate at which defaulted debt can be recovered.

Valuations

Private credit funds need to have the proper mechanisms in place to ensure portfolios are valued accurately. This is best done independently, and funds should have appropriate checks in place to do this. Other questions to explore include if a loan is being traded materially below par in the secondary loan market, will the private credit fund adopt that valuation and what will the impact be on the investor? Also, when will a fund manager inform investors if a borrower is underperforming?  Waiting until a receiver has been appointed is very late if the private credit manager purports to be actively managing their portfolio. Obviously, the sooner this disclosure happens the better, but not all funds do this.

Structuring of loans

The structure of the loans in the fund, and who creates them, is also important. For example, syndicated loans are typically created by parties (such as investment banks) looking to sell-down into the market, which typically result in weaker loan structures than directly originated bilateral loans that are held directly by the lender that put the loan in place.

Monitoring

Funds need to closely monitor every loan they invest in. But they need timely and accurate information to do this well (ideally monthly) and should also be in a position to share this information with investors where appropriate. Investors should also understand factors such as whether the borrower must work through an agent bank and how many lenders are providing the borrower with capital. Additional layers in the process and larger groups of lenders participating in a loan can create inefficiencies in dealing with problems as they arise and also additional costs.

Independent oversight

A healthy fund will have robust independent oversight. A third-party trustee would be preferable to an internal trustee, along with a third-party compliance manager and enlisting the assistance of global leaders in funds administration, loans administration, valuations, credit ratings and audit.

Supply and demand

This is arguably the most under-diligenced area of private credit. If a typical borrower is seeking financing in the fund manager’s target market, how many parties can they approach?  Syndicated loan borrowers typically have over 100 parties they can borrow from. Similarly, there are dozens of property lenders but very few middle-market corporate cash flow lenders.

What isn’t being said?

Private credit funds can be guilty of the sins of omission. Beware fund managers who talk to “secured loans”, and not “senior secured loans”. A portfolio of secured loans could mean a portfolio full of subordinated loans, which rank below senior debt when it comes to claims on assets.

True to label

Are the fund managers doing what they say they are doing? If they say they are investing in non-cyclical loans, only to have a portfolio full of exposures to consumer lenders or property developers, then they are not true to label. Similarly, if the fund manager suggests they are a direct lender, but the majority of their loans are originated through syndications teams and publicly rated bond issuances, this is a red flag too.

Finally, be wary if the fund manager says their market opportunity is due to the retreat of the major banks, but the major banks have never provided capital to the target market in question.

These are all very important areas for investors to explore if they are considering investing in private credit. Ultimately, like all investments, the focus should be on asset quality. In private credit, asset quality is determined by the borrower type, the structure, security and loan documentation, and the ability of the lender to take action through proper portfolio management.

*Joe Millward is a founding partner at Epsilon Direct Lending