The emergence of Private Debt – what's fuelling Australia's lending landscape shift?

• Private debt is gathering pace in Australia as traditional lenders and big banks turn their attention to large-scale corporate entities, leaving smaller borrowers high and dry.

• The conditions that led to surging private debt in the US and Europe at the beginning of the millennium are all present in Australia now – high volumes of mergers and acquisitions, vast amounts of leveraged capital.

• The Royal Commission's report, APRA's change in lending guidelines, and spiking interest rates are coming together to accelerate the shift in the lending market.

• Banks are no longer able – and in some cases no longer willing – to service the needs of small-scale borrowers. This is leaving small businesses and homebuyers frozen out of the market, as traditional lending channels dry up. Instead, investors and private lenders are entering the frame, keen to plug the gap in the sector and to reap the potential rewards of consumer lending. As a result, Australia's private debt market is surging.

What Got Us Here

It's November 2021, more than two years after the banking royal commission submitted their report to the treasury with 76 recommendations to reform the sector, and little has changed. Earlier in the year, it was revealed that the majority of the report's recommendations had been either abandoned or delayed. And now, with the end of the year looming, spiralling debt-to-income ratios are still putting borrowers at risk. The Australian Prudential Regulatory Authority (APRA) decides to act, raising the mortgage stress test threshold from 2.5% to 3%, essentially raising the bar of entry for borrowers seeking loans.

Fast forward six months to May 2022, and inflation is soaring. The Reserve Bank of Australia (RBA) announces the first cash rate rise since 2020, and the end of a historic low of 0.1%. Skip ahead another six months to November 2022 and the cash rate moves up again, hitting 2.85% for the first time in over a decade.

This basically brings us up to date – a sort of perfect storm in which stricter regulation, higher stress testing requirements, and increasing interest rates combine to threaten traditional borrowing channels. To put it simply, banks and mainstream lending institutions are no longer equipped to provide loans and mortgages to many of their would-be clients, while many of these would-be clients can't meet the requirements anyway.

The Conditions Are Right for Private Lenders

The private debt sector could be about to step in and fill the gap, thanks to market conditions that feel very familiar indeed. Back in the early to mid-2000s, a shifting and tumultuous market led to a surge in non-bank lenders in the US and Europe. First, the 1990s and a shift of focus, as banks began to look to larger-scale corporate borrowers as their ideal clients. Then, the 2000s and the global financial crisis, along with tightening regulations and institutional caution. But, here in Australia, we didn't experience this – these conditions never really emerged.

At least, they didn't emerge until now. Leveraged buyouts, and mergers and acquisitions transactions, are on the up in Australia. Of the 10 biggest M&A deals in the last 10 years, half have taken place since 2021, with three of those involving a significant amount of borrowed capital. This mirrors the situation in the United States in the '90s, and is driving that shift in focus away from smaller borrowers to high-level corporate enterprises.

The groundwork is in place. The conditions are just right. But we're not there yet. Australia's private credit market still lags far behind the rest of the world. On average, 12% of the world's credit is provided by private investors and non-bank lenders. In Australia, it's 2%. The idea that Australia is becoming a private credit hotspot is not quite right, but we could be moving in that direction. According to the Australian Investment Council (AIC), the country's private debt market grew to $1.4 billion in 2021, an increase of more than 100% in only 12 months. Why is this? Because of what we've discussed above – banks are either turning away voluntarily, or they are being driven away from smaller-scale business owners and residential property buyers. Private lenders are stepping in to fill the gaps.

Private Credit and the Gap in the Market

What makes private lenders able to service the needs of borrowers when traditional banks can't? As well as the market conditions, there are a few other aspects that are fuelling the growth in private lending.

Looser Regulation

Any entity operating in Australia's financial services market is bound by regulation, and will need to toe the line when it comes to how they operate. However, private credit organisations and peer-to-peer lenders are not hampered by such strict controls as those imposed on banks, giving them a little more leeway when it comes to lending.

Better Connection with the Needs of Borrowers

Some of the more traditional lending options offered by banks are unsuitable for the needs of modern Australian homebuyers and business borrowers. In the past, borrowers essentially had to 'grin and bear it', taking on debt with a product not necessarily ideal for their situation. Private lenders tend to offer more flexibility, providing lending options that meet the diverse needs of Australia's borrowers.

Limited Lending Scope

We can also flip the situation on its head. Private lenders and investors are in fact precluded from high-level corporate lending simply because they do not have the means to provide this sort of capital. They can't follow banks into the world of leveraged buyouts and M&A, so they focus on small businesses and homebuyers instead.

Looking to the Future...

Interest rates won't rise forever – if the RBA's moves can help to bring inflation under control, we can expect to see the cash rate start to fall by Q2 of 2023 according to some projections. Nor will banks and traditional lenders wholly abandon small businesses and homebuyers, instead offering recalibrated home and business loans that meet the developing needs of these borrowers. It's also important to remember that traditional lending is still the dominant force in Australia, with the vast majority of smaller-scale borrowing still conducted via these channels.

In the short term, however, we can expect to see private credit continuing to strengthen against the banks, as investors seek to exploit the market gaps left behind by this perfect storm of market conditions, sector reform, and stricter regulation.