Rhizome’s credit risk specialists will be publishing a series of risk insight articles exploring the risks and opportunities for private credit investing as it relates to the superannuation industry. In this first article we provide an overview of the asset class and the imminent risks.
Later articles will explore what Responsible Superannuation Entity Licensee directors and executives should be asking to ensure that they are challenging and testing their approaches to credit assessment and investment.
An introduction to private credit
Growth in private credit has surged with current exposure reaching US$2.1 trillion (as shown in the chart below) and significant demand continues to push projections higher. The relatively high returns are attractive to investors but the growth trajectory presents a complex landscape of opportunities and risks that investors must navigate with a forward-looking approach.
Financial market FOMO never ends well…
Central bankers have raised the alarm over the past 6 months on the rising risks in so-called ‘shadow banking’ including private credit. One official at the European Central Bank (ECB) has recently said the “remarkable growth of private funds and other sources of finance outside the regulated banks is the biggest threat to the stability of the Eurozone’s financial system”. In April 2024, the IMF raised concerns that existing vulnerabilities to private credit “could become a systemic risk for the broader financial system” recommending that authorities should adopt “…a more active supervisory and regulatory approach to private credit funds, their institutional investors, and leverage providers” focusing on monitoring and risk management, leverage, interconnectedness and concentration of exposures.
In Australia, APRA and the RBA’s concerns and attention are on the interconnectedness between superannuation and banking industries. Private credit is a hot area, attracting significant volume of investment capital from investors, and with that comes the risk that everyone follows without sufficient understanding of the actual risk profile and understanding of the interconnectedness and correlations of exposures when there is significant downturn in this segment. These supervisory concerns will likely bring further scrutiny of Responsible Superannuation Entity Licensees (RSELs) and their investment teams.
Understanding private credit
Private credit encompasses a range of lending strategies provided by non-bank lenders via bilateral loans or small club deals. Borrowers are typically highly leveraged, have a higher risk of default and as a result, do not have access to more traditional forms of debt capital via bank debt or public bond markets. This broad classification includes various sub-asset classes, each with its own set of risk and return characteristics. Private credit is typically unlisted, illiquid, and unrated, introducing challenges for effective risk management and oversight. Information asymmetries abound, and instruments are mainly variable rate, in contrast to their fixed-income securities counterparts like bonds that provide a fixed coupon rate, are externally rated and can be traded in public markets.
Understanding the distinctions within private credit strategies is crucial for investors as each strategy has its own risk-return dynamics. Private credit markets require different skills and experience that are hard to come by – one size fits all is not a fit. Lending strategies can vary greatly, influenced by corporate segments (e.g. middle-sized corporates, large corporates, private equity owned companies), type of collateral (e.g. commercial real estate, infrastructure assets, asset-backed, cash flow lending), geographies with different lending market dynamics and legal protections, and position of the loan in the capital structure (e.g. senior loans, mezzanine, through to equity loans). Other strategies can involve investing in non-performing credit (i.e. referred to as distressed debt or opportunistic credit).
The IMF’s Global Financial Stability Report published in April 2024 has highlighted that credit losses for private credit have not historically exceeded losses in high-yield bonds and have been comparable with leverage loans. However, the IMF’s analysis is based on historical data where lenders have benefited from favourable conditions. These conditions have changed which means that this historical data is unlikely to be representative of the future.
Everyone else is doing it, what could possibly go wrong?
Australian superannuation funds are now investing in this space either directly by their in-house investment teams or through third-party private credit fund managers.
For many, this is a new asset class and given the illiquidity of private credit, superannuation funds need to consider their fund’s capacity to assess the risk, manage it on an ongoing basis and effectively oversee the underlying risk exposures. Investment decisions at superannuation funds need to ensure that mindsets and beliefs do not shift in to thinking that they have access to a permanent source of capital when investing in this space. Private credit is difficult to value, illiquid and this brings challenges for superannuation funds, particularly given APRA’s intensified scrutiny of valuation practices[1]. How do you ensure liquidity for investors and generate a daily unit price where valuations are not assessed and audited as frequently (as they cannot be valued using market prices given that these loans typically do not trade)?
Success of the past does not guarantee future performance
Many private credit funds were established post-Global Financial Crisis (GFC), have thrived during a prolonged period of economic growth and low-interest rates. These favourable economic conditions suppressed losses well below long term averages. But the world has changed, and in the higher for longer interest rate environment these favourable conditions no longer exist. Past default performance of these funds is not a predictor of the future, nor does it replace the imperative for superior credit analysis.
As everyone joins the private credit party globally, an easing of standards has taken place and is eroding important lender protections in the form of weaker terms and conditions. Experienced credit managers know that loans written at the peak of the cycle are more vulnerable and incur losses first as the cycle turns. This is a significant risk that credit markets generally face with regards to existing exposures in their portfolios. Funds that maintain patience and discipline during periods of weaker underwriting practices will be better positioned to take advantage of the opportunities that will arise with the imminent threats on the horizon.
Horizon scanning for threats and opportunities in private credit
Two imminent threats loom over the private credit markets:
- Capacity of borrowers to service higher interest costs on debt – This is illustrated in the chart below. The share of public firms with size and leverage characteristics similar to private credit borrowers have shown a deterioration in their ability to service interest payments over the past two years. It represents a significant and growing concentration of borrowers that are struggling and less likely to survive.
- Approaching refinancing wall – Oaktree Capital’s Performing Credit Quarterly has estimated that there is over US$ 1 trillion of corporate debt that will need to be refinanced over the next two to three years. It will be borrowers with unsustainable levels of leverage originated when interest rates were at record lows that will find it most challenging when it comes to refinancing their debt at interest rates 2% to 3% higher. These borrowers (public and private equity owned) will need to look at ways of deleveraging via asset sales and/or liability management strategies (such as extracting write-offs or debt for equity swaps). These factors will pose challenges for investors with portfolios exposed to these loans and create opportunities for those who can effectively navigate the landscape. When these disruptions occur, we have found that few banks have sufficient problem loan management capability and experience to manage this effectively, let alone investors.
We are already starting to see public and private equity sponsored companies take advantage of weak creditor protections in existing loan agreements, to the detriment of investors who thought they were protected as senior secured / first ranking in the capital stack. Some fund managers have flagged the potential for more “creditor violence” following recent examples (e.g. Atlice France) where borrowers have taken advantage of weak loan agreements to play one class of creditors against other classes of creditors to extract value out of the more senior ranking creditors when implementing strategies to reduce leverage. This is something the market has not experienced before.
The Financial Times reported in March 2024 that bondholders in Altice France were “wrong footed” when the company revised is pledge to reduce net debt to adjusted earnings from current levels of 6.4 times, to 5 times and then to a “new target” of “well below 4 times” adding that “creditor participation in discounted transactions” would be required to achieve this as reported in the Financial Times.
Rhizome Advisory has consistently flagged weak loan documentation as a significant risk, including the prediction that weaker loan agreements would impact recovery rates. Refer to our post US Loans – Covenant lite and easy lending. We are now seeing a discernible trend where today’s recovery rates are lower than historical experience in past downturns. JP Morgan Chase has reported in August 2023, recoveries for high-yield bonds and leveraged loans over the last 12 months were 19.6% and 39.7%, well below its 25-year and 24-year annual averages of 40.2% and 64.3%, respectively.
Disciplined approach to credit assessment
The private credit market offers a dynamic and challenging environment for investors. As the market continues to evolve, so too must the strategies employed to manage the associated risks and capitalise on the opportunities that arise.
The greatest risk to private credit is complacency: relying on historical success. Current strategies and credit assessment disciplines at many private credit fund managers have not been tested through a downturn. Investors must be proactive in addressing the risks ahead to ensure continued success in this evolving asset class.
In our next article we explore several questions that executives and directors at RSE should ask as they look to increase their concentrations to this asset class via internal investment teams or third-party managers.
[1] APRA updated its Prudential Guidance SPG 530 last year, and recently published Observations from SPS 530 valuation governance framework self-assessment survey in June 2024.
This publication is provided for information only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or financial instrument. The opinions, estimates, strategies and views expressed in this publication constitute our views as of the date of this publication and are subject to change without notice. The information contained herein is as of the date of this publication and Rhizome Advisory Group does not undertake any obligation to update such information. Any market prices, data or other information contained herein are not warranted as to completeness or accuracy and are subject to change without notice. This document does not purport to contain all of the information that an interested party may desire and provides only a limited view of a particular market, product and/or service. This document does not constitute advice by or on behalf of Rhizome Advisory Group and nothing in this document should be construed as legal, regulatory, tax, accounting, investment or other advice. No reliance should be placed on the information herein. The recipient must make an independent assessment of any legal, credit, tax, regulatory and accounting issues and determine with its own professional advisors any suitability or appropriateness implications and consequences of any transaction in the context of its particular circumstances. Rhizome Advisory Group assumes no responsibility or liability whatsoever to any person in respect of such matters. Transactions involving securities and financial instruments mentioned herein may not be suitable for all investors.