Private credit - separating noise from reality

As conditions normalise, we expect to see a divergence in outcomes across managers, with some portfolios likely to experience stress as loans fail to perform as originally expected.

What to look for in private credit managers?

This is where the rubber hits the road. In private markets, including private credit, the dispersion of returns between the best and the worst managers is significantly larger than in public markets. As a result, manager selection is critical. Key considerations when assessing managers include:

• Workout experience is non-negotiable
  It’s one thing to write a loan; it’s another to recover capital when things go wrong. The ability to manage stressed or underperforming loans is a core part of the private credit skill set. This experience is relatively scarce in Australia, given the benign credit cycle of the past three decades, meaning very few managers have been tested through a period of elevated defaults and stress. In our view, only those with genuine insolvency, workout and restructuring expertise will be well positioned if stress emerges in the system. We strongly favour managers with these capabilities, such as the two managers we partner with in WAM Alternative Assets (ASX: WMA), Longreach Credit Investors (Longreach) and Intermediate Capital Group (ICG).
• Valuation discipline
  Portfolios where all loans are consistently marked at par should be treated with caution. Some level of borrower stress is inevitable in any sufficiently large and diversified loan portfolio, particularly given borrowers are often accessing private credit because traditional bank funding is unavailable. Businesses will underperform, covenants will be breached and interest payments may be delayed; this should be reflected in valuations. Disciplined and consistent impairment practices should be standard across the industry, however, unfortunately this is not the case.
• Diversification isn’t optional
  Private credit is characterised by left-tail risk; the best outcome is the return of capital plus interest, while the downside can be a permanent loss of capital. Unlike equities, there is no meaningful upside (right tail) to offset this risk. As a result, diversification across a broad portfolio of loans is critical. Each additional loan helps reduce the impact of any single borrower underperforming, making diversification one of the most important tools in managing risk within this asset class.
• Fee transparency
  Understanding how managers are compensated, particularly in relation to origination fees, is critical. Borrowers will typically pay upfront fees which can be up to 3-4%, and in many cases some, or all, of these fees are retained by the private credit manager. This can create misaligned incentives if managers favour higher upfront fees over ongoing loan economics. Transparency and alignment are key here.
Conflicts can and do matter
Situations where managers provide both debt and equity capital to the same borrower across different funds or investor groups can create meaningful conflicts, particularly in downside scenarios. In these situations, managers can effectively be enforcing against themselves, with investors potentially caught in the middle. While not widespread, this is an area that warrants careful consideration, particularly if we begin to see increased stress emerge in the sector.  

We think this is the right way to access the asset class: targeted, selective, and risk-aware.

The bottom line

Private credit remains a structurally important component of global capital markets and is likely to continue to grow over time. It fills a genuine gap in the market and provides investors with access to income that is difficult to source elsewhere.

However, the rapid growth in the sector means a shakeout is likely. And that’s not a bad thing; in fact, it’s healthy. The stronger, more experienced managers with the right disciplines and skill sets should come through that period in a stronger position. Others won’t.

For investors, the takeaway is simple - private credit can provide attractive income and diversification benefits, but should be approached with a focus on manager quality and appropriate portfolio sizing.