Private credit sector review: where ASIC may focus

Yet, beneath the headline returns, there are worrying practices emerging across the sector that deserve closer scrutiny. These practices, while not explicit breaches of regulation nevertheless undermine the integrity of the asset class and expose investors to risks that are not adequately disclosed.

ASIC has actively sourced feedback from the market over the last 6-months and published initial findings in early November about areas of concern. A more detailed report is expected prior to end of the calendar year. In this article we look into the crystal ball to assess 4 key areas we expect to see heightened ASIC interest.

1. Outsourced AFSLs

The Australian Financial Services Licence (AFSL) is designed to be a barrier to entry into funds management. It requires applicants to demonstrate both financial and organisational resources, as well as industry experience. ASIC has a formal vetting process to ensure only capable operators are licensed to manage investor capital.

However, today it is common for entrepreneurial fund managers to rent an AFSL from a corporate authorised representative (CAR) provider. For a fixed annual fee, a start-up manager can effectively operate under the licence of another entity, sidestepping the cost and scrutiny of applying for their own. What was once intended as a temporary arrangement to help small firms establish themselves before seeking their own AFSL has become, in some cases, a permanent business model.

This practice raises a critical question: is this the intention of the AFSL framework, and is it in the best interests of investors? If an AFSL is meant to signal credibility, how much comfort should an investor take when the responsible entity is, in reality, an outsourced shell? The risk is that the AFSL no longer functions as a meaningful safeguard but rather as a compliance badge available for rent.

2. Related Party Lending

A more troubling practice is related party lending. There are private credit funds in Australia whose primary purpose is to invest in the debt of their own related entities. On paper, investors may be told the fund is secured by first ranking security. In reality, that security may be over a subordinated note issued by a related company, rather than a commercial third-party.

In addition, a rational borrower will seek debt finance from the cheapest source of capital, from a funder that will permit the loosest debt covenants. If the borrower establishes a private credit fund to lend to its related parties, it implies you the fund investor are the cheapest and most permissive source of capital for the underlying risk.

In principle, there is nothing wrong these structures if they are flagged in bold on page one of disclosure documents. At minimum, investors deserve a clear explanation that their capital is not being lent to independent borrowers but is instead tied up in related party exposure. Without this transparency, investors are left with a misleading impression of the credit quality and independence of the fund’s loan book.

3. Zero Management Fee / 100% Performance Fee Structures

Performance fees are standard in funds management. Traditionally, a fund charges a base management fee (say 1–2% of assets under management) plus a performance fee (typically 10–20% of outperformance above a benchmark). This model is intended to align the interests of investors and managers by rewarding genuine outperformance.

Yet in parts of the Australian private credit market, managers are adopting fee structures where all performance above the target return is retained by the manager. Illustratively, if the target return is 8% and the fund generates 12%, investors get 8% while the manager retains the 4% excess.

This structure creates two serious problems. First, it incentivises risk-taking by the manager, as any incremental outperformance accrues solely to the manager fee wallet – for no capital at risk. Second, it leaves investors exposed to 100% of the downside while receiving none of the upside. In effect, investors are underwriting the risk but handing away the rewards.

This fixed return profile is normal in traditional credit note structures in which the investor receives a fixed coupon and is protected by a clearly defined subordinated first-loss buffer. But in a fund structure, investors are offered a target return which can vary up or down. Therefore a 100% Performance Fee regime in credit fund misaligns incentives and undermines the basic principle of shared risk and reward.

4. Related Party Trustees

Finally, there is the issue of related party trustees. In Australia, managed investment scheme must have a trustee. The trustee has a fiduciary duty to hold the assets of the fund and act in the best interests of investors. The fund manager is appointed by the trustee via an arms-length investment management agreement. This structure ensures the fund manager does not have direct access or control over fund cash or assets and maintains a separation of investment management and asset holding duties.

However, in practice, some private credit fund managers also act as trustee.

This arrangement weakens the checks and balances that the fund trustee model was designed to create. If the trustee is not genuinely independent, who is protecting investors from conflicts of interest in areas such as related party lending, valuation, and fee setting? In theory such an arrangement would allow an unscrupulous fund manager to access investor funds for non-compliant use. 

Exhibit A is the investment manager involved in a recent high profile fund  collapse who had acquired a luxury Italian sports SUV using investor funds. This transaction would have been impossible if the fund had a third-party trustee.

Conclusion

The Australian private credit sector has strong fundamentals. This is particularly so in the SME and emerging corporate lending space which continues to underbanked. The opportunity to finance growing SMEs and corporates outside the banking system is real and attractive. The nascency of the domestic private credit sector means there is more demand for private credit than supply, allowing excess returns to accrue to good manager. However the sector’s credibility depends on high standards of governance and transparency.

The issues flagged above erode investor protections and are likely to be on ASIC’s radar. If left unchecked, these practices risk undermining confidence in the broader private credit asset class.

We expect ASIC is already scrutinising these practices closely. For investors, the key is to look beyond headline returns and interrogate the structure, governance, and incentives behind each fund.

Ultimately, sustainable growth in private credit requires not just attractive returns but also trust.