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Take a hard look at leverage in private lending: Challenger

As many as half of all Australian private lending managers are using leverage to juice their returns, according to Challengers Investment Management, exposing themselves and their investors to mark-to-market risk.

There’s been an explosion of new private debt managers in Australia since Covid, and Challenger head of investment strategy for fixed income Pete Robinson estimates that 50-60 per cent of the 100 or so managers operating in Australia today are using leverage to enhance the overall returns of their strategy – potentially creating hidden risks for their investors.

“The danger with leverage is that you take an illiquid asset class that is not exposed to the volatility of private markets – certainly not to the same degree – and you overlay mark-to-market risk on it,” Robinson told The Inside Network’s Alternatives Symposium.

“You’re getting two to three per cent per annum in additional interest for taking on the same amount of credit risk in private markets. And that’s all well and good until you have to sell the asset. And that’s what leverage can do.”

  • Robinson “implored” investors to ask questions around how their managers are using leverage, specifically on what their mark-to-market triggers are and whether they are matching their funding.

    “Because one thing you don’t want to be in an illiquid market is a forced seller.”

    Meanwhile, the influx of new investors into the market will inevitably compress spreads and lead to weakening of terms, Robinson said, but there are other, more positive effects that aren’t appreciated.

    “The other factor that I think isn’t as well appreciated is that as new demand comes to the market, there becomes a greater awareness of the opportunities that exist within private markets for borrowers,” Robinson said.

    “What we’re starting to see, maybe counter-intuitively, is more borrowers becoming aware of the alternatives that private lenders can provide. Invention is the mother of necessity, right? If you did a commercial real estate loan two or three years ago at a two times interest coverage ratio, that’s probably at 1.2-1.3 times now. You may have had a bank lending to you in 2021; that’s not a bank loan as we sit here today.”

    And as banks continue to pull back from the private lending markets, borrowers that go to private lenders often find those stalwart institutions lacked “speed of execution”.

    “Banks are not good at doing things quickly. They’re not good at outside of the box, and they’re not good at speed… That’s another reason why borrowers will go to alternative lenders or private lenders – to provide speed, and certainty of execution.”

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