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Private debt – the new growth sector

Fixed Income

It is no longer hype to talk up the growth in private lending. While some metrics on its size are questionable, typically including nearly everything that is not in the public domain as well as lending that is well out of the ambit of the private credit funds, the overarching theme remains intact. The traditional banking sector is increasingly limited in scope, while the character of borrowers is widening. Banks are likely to dominate the mortgage sector and investment-grade credit for general purpose capital for many years. It is project- or asset-based capital requirements as well as leveraged buyouts that are the go-to segments for non-bank lenders.

In the adage of “build it and they will come,” the sector is likely to create a momentum of its own as borrowers become aware of the growth in the number of participants that may fund their debt. The story also goes a lot further than just restrained bank capital, offering a much more responsive interaction, such as in approvals, terms and maturity. 

Unhelpfully, there is nowhere for potential investors to observe the available universe, much less delve into the differentiation of opportunities. Credibility comes from competition rather than exclusivity. If this sector is to reach the potential that so many talk of, it needs to lift its cloak.

  • Judging the key members of a fund manager’s team is complicated by their unfamiliarity relative to, for example, equity teams where there is easy access to their performance history. The recency of most funds adds to the challenge. 

    In any riskier investment option (it is hard to dispute that this does not fall in the defensive category) there will be some managers with weaker-than-expected performance and even capital losses. Unhelpfully, the risks are commonly downplayed, which is likely to result in much finger-pointing when things do not turn out as the marketing material implied.

    The onus lies squarely on the fund team to cross the t’s and dot the i’s on every detail in the lending documents. Of the few deals that have soured, there is inevitably a dispute on something in the agreement which drags out any settlement and exposes some wriggle-room for the borrower by voiding the claimed security over assets or cash flow. This process is a million miles away from equity investment, in which there are often numerous broker reports, independent sources and the companies themselves. Rated corporate credit has similar informational advantages.

    There is a common refrain that competition in the sector is increasingly (belying the notion that its size is really as large as sometimes cited). “Scope creep” can infiltrate such as in loan maturity, loan-to-value rations (LVRs) and sector concentration to grow the fund and cling onto promised returns. Given the potential for lumpy exposures – with examples up to 15% to one entity – median maturity and LVRs may be quite different to the average.

    By limiting disclosure, the sector undermines its merits. It raises the question of why a borrower is prepared to pay what seem like usury real interest rates? For SME businesses, it is often based on their growth ambitions, where the owners can achieve outsized payback. In the case of property development, it’s the ease and flexibility combined with the urgency to complete the project to realise capital gains. These sectors are part of the backbone of the economy and if they are able to access reasonably priced debt capital with investor support, why not make this a headline rather than leaving all the dark on who the participants are?

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