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Is private credit the real deal, or is it ‘more sizzle than steak’?

It's been lauded as anything from a '"short-term fad" to the next great diversifier, but while private credit polarises investors it continues to provide robust, stable returns. Are private credit managers good enough to maintain their rapid ascension in the private capital arena?
Private debt

Last week the offices of alternative asset manager MA Financial played host to a microcosm of the debate that is currently raging across Australia’s financial services industry: does private credit really represent a structural evolution in the alternatives market?

For: MA’s head of credit investments and lending Frank Danieli. Against: Charlie Callan of research house Bond Advisor. And while the debate was technically to do with public vs private credit, it quickly became a referendum on the latter.

Callan argued that private credit is plain old overheated – “more sizzle than steak” – and that the growing interest in it resembles mania, with everybody trying to grab as much as they can. There’s no consensus on how loans should be marked to market, which becomes “particularly acute” when they get into distress; protections are getting worse, and so are credit fundamentals, and as the market grows its newest participants are placed at a disadvantage.

  • “If you think about public credit and equities and private credit, as the market increases in size the price goes up because these things can trade,” Callan said. “In private credit, when more money comes into the market, you can’t just go and buy a new loan.

    “So a manager can sit on their cash – which they aren’t incentivised to do – or they can write a new loan. As private credit gets bigger, the outcomes for investors get worse because the incremental risk of the loans significantly increases through time. It’s not like public assets where the value goes up and it’s great for existing investors and fair for new investors.

    How the west was won

    But Danieli said that the supposed “short-term fad” of private credit has been outperforming traditional fixed income assets globally for more than two decades by as much as 1.6x-2.6x, with annualised returns in the 9-10 per cent level and very low volatility. Private credit is not “the wild west”, and the interest in it is no bubble. It’s popular because the number of private companies has increased and banks that would traditionally lend to them are packing up – and have been for some time.

    “What is going on here is that there has been a long-term consolidation trend in the banking sector. The number of banks globally has declined 50 per cent, and as banks have gotten bigger they’ve also changed the types of things that they do. As you get really, really big you need to move into a factory mindset; you need to do things that are vanilla and fit into a box. You can’t customise things.”

    “In private credit the manager is arguably more important than in any other asset class. You have to be certain that your manager is first class: first class on valuations, first class on how they treat investors and first class in how they manage risk.”

    Charlie Callan

    Or, in Danieli’s example: you can always walk into a department store and buy something off the rack, but you need to go to a tailor to get something designed specifically for you. The banking sector is a department store, Danieli says; US bank loans were once heavily weighted towards industrial and commercial sectors, but they now mostly do vanilla real estate lending.

    “And to come back to that first point about private credit being a bubble, how much of private sector debt has been attacked so far by private lenders? It’s relatively small – mostly in sponsor-backed lending, funding private equity buyouts, but that’s a tiny part of private sector debt. Most of it is outside of that in a range of other asset classes that might be five times bigger than what we’re talking about.”

    Garage bands and snake oil salesmen

    But all of these issues are besides the point, Danieli argued, which should not be the hype that surrounds an asset class – or what’s written about it in the media – but “the nature of the underlying loans if it’s done right”. The right kinds of alternative assets added to the traditional 60/40 portfolio will imbue it with a higher return and lower volatility by around 20 per cent.

    “It’s about portfolio construction, and digging down into the details, and thinking about where the best risk-adjusted return is in the fundamental sense rather than the asset class level,” Danieli said.

    And while Callan took plenty of potshots at private credit, he and Bond Advisor are “actually big fans of it” – but like always, diversification is the only free lunch. New private credit funds are popping up everywhere, largely run by a “couple of blokes with a Bloomberg”, and they might have nothing in them, or only a handful of loans.

    “In private credit the manager is arguably more important than in any other asset class,” Callan said. “You have to be certain that your manager is first class: first class on valuations, first class on how they treat investors and first class in how they manage risk.”

    “The downside you expose yourself to when you take a 10 loan portfolio versus a 100 loan portfolio is enormous. Your manager matters – are they diversified in terms of their counterparties? Because that’s what’s going to protect you against correlated downside risk. Don’t open yourself to cases of fraud; it happens in lending, it’s inevitable. If you have one loan go bad in a 10 loan portfolio… that’s a huge impact on your capital. In a 100 loan portfolio, it’s virtually nothing, and the income you receive will offset it.”

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