Private credit is being tested. Here is what matters now

Since then, the domestic market has evolved dramatically. What was once an embryonic industry, characterised by limited awareness, smaller investment sizes and relatively few participants, has progressed into a distinct growth phase marked by significantly increased scale, investor demand and competition.

Today, however, the market is entering a more testing phase. Inflation remains elevated, interest rates are restrictive, economic activity is slowing and parts of the property market are adjusting to changes in policy, investor demand and the cost and availability of capital. At the same time, a series of highly publicised problems in parts of the unlisted credit market has unsettled investors and intensified scrutiny of the broader asset class.

ASIC's focus on governance, valuations, conflicts and disclosure is an important part of this. However, for investors concerned about their money, the more immediate question is not simply whether a manager complies with good governance practices. It is how the underlying investments are likely to perform if economic and property conditions deteriorate from here.

This is the point at which the rapid growth of an industry begins to be properly tested. When asset values are rising, refinancing capital is readily available and borrowers have room to absorb higher costs, weaknesses in lending structures or investment discipline can remain hidden. A more difficult environment exposes the decisions that were made before conditions changed: what was financed, what assumptions the transaction relied upon, how it was structured and whether the expected return adequately compensated investors for the risk.

Over our 11-year journey, we have witnessed both strong governance and lending practices, as well as isolated examples of poorer behaviour. Practices that create misalignment between fund managers, lenders and end investors remain difficult to defend. However, alignment alone cannot make a poor loan good. Ultimately, the quality of a credit manager is demonstrated through the assets they choose to finance, the risks they avoid and how they respond when a transaction no longer performs as expected.

While this adjustment may create short-term challenges for parts of the industry, it is also a natural and necessary stage in the market's development. It should improve standards, redirect capital towards stronger managers and encourage investors to look beyond the broad label of private credit to understand the risk they actually own.

Understanding the asset class

In digesting media attention on private credit throughout the year, I'm not convinced that all of it has been constructive. Private credit is often discussed as though it represents a single, uniform risk. It does not.

Lending against a large parcel of land on the outskirts of a city, or financing a development that depends on construction being completed on time and on budget, presales settling and refinancing remaining available, is very different from lending against an average priced house in a Sydney suburb. It is also different from lending against a diversified pool of existing residential mortgages, auto loans or other receivables supported by established borrowers and observable cash flows.

These distinctions are not semantic. They determine what needs to go right for a lender to be repaid and how exposed an investment is to changes in property values, construction costs, consumer demand and refinancing conditions.

This does not mean that one category of lending is always sound and another is always poor. It means the risks are fundamentally different and should be assessed and priced accordingly. Broad headlines about "private credit" can obscure these differences and create contagion between parts of the market that have relatively little in common beyond being privately originated.

It is also too simplistic to argue, with the benefit of hindsight, that a credit fund should have anticipated every market development and simply exited a transaction. Credit cannot be managed on that basis. The more relevant questions are whether the transaction made sense when it was originated, whether investors understood and were appropriately compensated for the underlying risk, whether sufficient protection was built into the structure and whether the manager acted appropriately as circumstances changed.

Practical guide to understanding your private credit holding

The following considerations are not exhaustive, but they can help investors distinguish between managers and strategies at the higher and lower ends of the quality spectrum.

Know what you are investing in

Most investors recognise that private credit is not homogeneous, but broad fund descriptions can still conceal substantial differences in risk.

If it is a corporate lending strategy, which businesses and sectors does the manager finance? Are the borrowers profitable? What are the average and largest loan sizes, how concentrated is the portfolio and what security is held? Most importantly, what is the expected source of repayment and what happens if that assumption proves incorrect?

If property is involved, is the fund financing established houses and existing borrowers, or land acquisition, construction and development projects that depend on future completion, sales and refinancing? What leverage is being used and how much genuine equity sits beneath the lender?

Understanding the underlying assets, how they generate cash and the circumstances in which losses could arise is more important than the label attached to the fund.

Experience matters, but relevance matters more

Too often, private credit managers point to the founding team’s previous banking experience without explaining what that role involved or how it relates to the assets being managed today.

Running a credit fund requires more than experience originating loans in favourable conditions. It requires the people, systems and judgement to structure transactions conservatively, monitor them closely and respond when performance begins to deviate from plan. Investors should ask whether the team has managed the same type of credit through arrears, covenant breaches, workouts, changing asset values and periods of reduced liquidity.

A long track record is not simply evidence that a manager has been in business for a certain number of years. It gives investors an observable history of the decisions that manager has made across different economic, property, interest-rate and liquidity environments.

This matters because markets will always change. The objective is not to find a manager who claims to predict every change. It is to find one whose experience and investment discipline mean they are not relying on conditions remaining benign.

Incentives matter

Many private credit models pay the fund manager a substantial fee when a transaction is originated, with considerably less earned over the life of the loan. Investors should understand who benefits when a loan is written, who retains risk if it underperforms and whether the manager or originating lender has meaningful capital at risk.

Where a manager has not invested alongside its investors, contributed first-loss capital or otherwise retained exposure to the performance of the transaction, its alignment warrants closer examination. Incentives do not replace sound underwriting, but they can materially influence the type of loans originated and how those loans are managed once the initial fee has been earned. As Charlie Munger put it, ‘Show me the incentive, and I'll show you the outcome’

Transparency matters

Commercial, legal and privacy constraints may prevent a fund from identifying every underlying borrower. They should not prevent investors from understanding the portfolio's principal exposures, concentrations, leverage, arrears, realised losses and sources of repayment.

Where institutional investors, reputable research houses and fund auditors have access to the underlying source data and loan information, this provides an additional layer of scrutiny. It does not replace an investor's own assessment, but it is more meaningful than relying on a headline return or a broad description of the strategy.

Transparency becomes particularly important when conditions are changing. Investors should be able to see whether portfolio performance is evolving, understand how the manager is responding and assess whether the risks remain consistent with what they originally agreed to take.

The investment opportunity

A more selective market is not necessarily a negative environment for experienced credit managers. In fact, it can create some of the most attractive conditions in which to lend.

As some providers of capital become more cautious, reach capacity or withdraw from parts of the market, competition for high-quality transactions reduces. Managers with capital available and the discipline to remain selective can negotiate improved pricing, lower leverage, stronger covenants and better lender protections.

This is not a private credit version of "buy the dip", nor does it mean that every transaction offering a higher return is suddenly attractive. The opportunity arises at origination and rewards managers that are prepared to avoid areas where the risk is difficult to price, even when those areas appear lucrative.

No manager can predict every macroeconomic change or eliminate credit risk. The more useful question is whether a portfolio has been constructed with sufficient discipline to navigate conditions that will inevitably change over its life.

Avoiding riskier and more economically sensitive areas of the market, maintaining diversification, negotiating appropriate protections and actively managing exposures are not decisions made in response to a difficult headline. They must be embedded well before one appears.

Our 10+ year track record in this strategy is underpinned by a team whose experience managing credit extends back to the 1980s, including across multi-billion dollar portfolios and through the early 1990s recession, the Asian financial crisis, the dot-com downturn and the global financial crisis. Collectively, that represents more than 150 years of credit experience. Markets change, sometimes abruptly. The importance of disciplined underwriting and having experienced people making decisions does not. 

The current shakeout will not make all private credit unsafe, just as the rapid growth of the market did not make every strategy sound. What it should do is make investors more discerning. For experienced managers that have remained disciplined and retained capital to deploy, the same conditions exposing weaknesses elsewhere can also create an unusually attractive opportunity.