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Inflation, security, duration central to opportunity in private markets

In a challenging environment plagued with uncertainty and volatility, rising inflation has turned investors away from risky growth assets.

In a challenging environment plagued with uncertainty and volatility, rising inflation has turned investors away from risky growth assets, and into other asset classes that provide more stable income sources and less downside risk.

Among the more popular alternatives to valuation-challenged equities and interest-rate-sensitive government and semi-government bonds have been real assets and private credit. In fact, portfolios are increasingly relying on these two asset classes to carry the load of income production.

Private credit is quite straightforward; it simply involves mobilising investors, with the support of fund managers, to make loans and provide capital to the businesses involved in growing and managing the economy.

Property-backed debt, whether commercial, residential, construction or the many other types, has always been a tightly held space dominated by the big four banks. But the private credit market in Australia has grown significantly in size in recent years following the departure of the major banks from many parts of the sector.

Driven by regulatory changes that effectively reduce the profitability of commercial and construction lending, groups including Alceon have stepped in to fill the void. Yet at the core of private credit is an incredibly important funding source for the many small, medium-sized and large businesses that employ the vast majority of Australians.

It is easy for ASX-listed companies to raise more capital via debt or equity raisings, and it’s similar for private equity-backed companies, but for those people building new homes, seeking to acquire more assets and businesses or simply looking to refinance their loans, the opportunities have been limited, until now at least. 

With this as a backdrop, private debt has been supported for many years by institutional investors due to the unique portfolio and inflation hedges it offers.

Private loans are seeing a surge in interest because of their limited correlation to listed equity markets, but also to the current inflation malaise in which we find ourselves. In periods of high inflation, the unique floating or variable-rate structure of private credit is invaluable. As is the shorter length of these loans, which vary from just 12 months to three to five years. And that is without mentioning the significant security and asset-backing on which every loan is based.

According to EY, private debt is now estimated to be a US$1 trillion-plus market globally, and $133 billion in Australia at the end of 2021, which accounted for 11 percent of the total corporate and business lending market.

So, what does this all mean?

As a financial adviser, constructing a client portfolio in today’s environment clearly requires a multi-asset approach but with a particular focus on identifying alternative asset classes that have exhibited less correlation to markets and the economic in general.

The private debt market is broad, ranging from senior secured to subordinated and mezzanine, however, the majority is issued on a senior secured basis, affording lenders a great deal of protection in the rare event that something goes wrong. Ultimately, investors in the sector are gaining exposure to the other side of the capital stack, as opposed to equity.

Some of the most quotes advantages of holding private debt to tell your clients:

• Uncorrelated diversification – Private debt has become a new asset class in its own right, one that is largely uncorrelated to equities and fixed income due to the unique characteristics of each loan.
• Inflationary hedge – The floating-rate nature of many private loans provides a natural inflation hedge in that interest payments increase as interest rates do.
• Yield alternative – Private debt funds aren’t marked-to-market like fixed-income bonds, they are held to maturity or repaid in full, meaning they exhibit little day-to-day volatility.
• Rate rise = Good thing – Because private debt is floating-rate in nature, if interest rates rise your returns should rise, too. Unlike bonds, you won’t miss out on higher.
• Low volatility – They provide stable returns through all market conditions.

What does the sector look like?

Alceon Group is among the leaders in the sector having managed more than $3 billion across private markets following its establishment in the aftermath of the GFC. The group manages a ‘high-quality’ private credit strategy that typically lends in the range of $10m to $50m to a diverse range of lenders in the property sector. These loans are secured over high-quality assets, via registered first-ranking mortgages held over Australian property, mostly on the east coast of Australia. The loans finance a mix of real estate development, construction, and ownership.

With an annual return of 8.03%, the Alceon fund performed above its return target range of 5% to 7% for the calendar year 2021 and was, in hindsight, a solid yield alternative to equities or bonds. With all loans secured by underlying real estate with a portfolio weighted average loan to value ratio (LVR) of 61% and weighted average loan duration of 12.8 months, the fund carries lower risk and higher return than the average equity fund.

Managing director at Alceon, Damien Cronin, said: “In light of the strong growth from the past year, we are maintaining a conservative outlook for 2022 and assuming an orderly correction in the residential market in the range of 5% to 10% when assessing new transactions.

“With interest rates remaining low and more lenders entering the market, developers are continuing to look elsewhere from large domestic banks who are at times restricted in the amount and circumstances they can lend. This is particularly the case in construction, where borrowers are offered very little in way of timeframes,” Cronin said.