Australian private debt shows broadening appeal, says Metrics Credit Partners

This article is sponsored by Metrics Credit Partners

How would you describe the current appetite for private debt among large Australian institutional investors, and what is driving that appetite?

Australia’s institutional investors have an increasing appetite for private debt. They would largely all be underweight in Australian private debt, with a lot of the superannuation funds and others having tended to look at offshore assets to reduce home-market bias.

Australia is a market dominated by four major domestic banks, and we don’t have a corporate bond market of any size or scale; plus most Australian companies are unrated, so their ability to access finance away from those banks is fairly limited. That makes private debt an attractive alternative – over time the market will continue to move towards providing more private debt to finance companies and projects, which will drive interest from both Australian and offshore institutional investors.

We are also seeing growth in demand from retail investors. We operate two Australian stock exchange-listed funds to give those investors access to private debt in a liquid tradable investment vehicle. What is driving that demand is the volatility we have witnessed in public markets. Traditional asset classes have not delivered great returns for investors and so they are looking for more stability of capital and more predictability of income, which private debt delivers, so we expect that demand and interest to continue to grow.

How does private debt tend to fit into the portfolios of large super funds, and how are external managers tailoring investments to meet the needs of those LPs?

Private debt really plays two roles in client portfolios, recognising the spectrum of private debt investments can range from very high investment grade borrowers through to sub-investment grade. We, at Metrics, have capacity to invest through the capital structure, so we see ourselves as very much private market origination and risk management specialists that are able to deliver the appropriate risk and return for an investor.

At one end of the spectrum, you can have low risk positions with lower yielding returns, playing a defensive role in the portfolio as an alternative to traditional fixed income. Where bonds have traditionally played that role, in a rising rate environment investors have experienced negative returns in traditional fixed-income bonds and don’t have as much liquidity as they would like.

At the other end, with mezzanine finance and subordinated debt, you are entering into the world of quasi equity investment and starting to move towards being an equity market replacement. We believe private debt can be an equity market replacement in that you can get an equity-like income from debt, but because it might be debt that is subordinated or high yielding, it will be less risk in terms of where you sit in the capital structure, compared with an investment in equities. Our clients are a bit sick of volatility or deteriorating returns as interest rates rise and economic conditions start to slow, so they are looking for more predictable returns and moving into lower risk positions.

At the moment, we see demand at both ends of the spectrum. When we started doing this a decade ago, domestic Australian investors’ exposure to the asset class was limited, so they tended to go for the more conservative strategies. Now, those that understand the market better and understand our skillset tend to move into high-yielding strategies as well.

What should LPs be focused on when it comes to manager selection in private debt?

LPs should be looking at prior track record, the skillset of the team, the capacity to originate transactions directly and the capacity to structure terms and conditions that are acceptable to both borrowers and investors. They should also be looking at the depth of the team and the level of diversification across the portfolio.

One thing that is very important for investors in private credit, which is unlike some other asset classes, is that rather than wanting any concentration of investment, in debt you want a low level of counterparty risk against any individual borrower, in order to protect investor capital.

Fees are also important, so LPs should look at the costs and the risks associated with the liquidity features of the fund. Often, managers will quote a target return that appeals to investors but in fact that manager might have a track record of failing to deliver against that target. As such, investors should look at a period of time and see if the fund has been true to label in terms of creditworthiness and tenor and delivered on the expected target returns.

It is very easy in credit to take on more credit risk and use leverage to drive a return for an investor, but that increases the risks too. Our view is it is far better not to adjust the levers of credit worthiness, leverage or tenor.

Finally, when we deal with borrowers, investors and employees, we believe the reputation of the business is critical. If you are not performing well for your people, they will speak out about that, so organisational business culture and the success of the team is key. Delivering a good service to borrowers and being responsive to their requirements is also the principal mechanism for achieving a good outcome for investors. By investing in that borrower-client relationship, we deliver for everyone.

What kinds of opportunities are on offer in Australian private debt versus global private debt?

Australia is a unique market because it is so bank-dominated, with limited alternatives to the four major domestic banks. This is actually a very good market for an investor, with lower risk because deal structures tend to be more bank-like, and have premium pricing in comparison with the offshore market. This is because access to alternative funding is limited. It is also good for Australian investors because there is no foreign currency risk and the tax position is straightforward – it becomes slightly more complex for offshore investors but still offers excellent opportunities.

We are seeing more offshore investors coming in and considering an allocation to our strategies so they can access the Australian market. Previously, investors may have said they wanted an Asian exposure and that tended to mean China or developed parts of Asia. However, the returns you can generate in those markets are quite different to the returns in Australia, which we believe can be at a premium to elsewhere.

The real attraction of Australia is its very stable legal and regulatory systems, and its corporate insolvency framework – which means the interests of secured creditors are well protected, unlike in many other offshore jurisdictions. That is why more offshore investors are starting to see the Australian market as attractive, and they are looking for a manager of scale with a strong track record, with origination and risk management capability in the country.

We are the dominant private debt player in the Australian market, so this is a positive for us. We have been successful with quite a number of offshore investors, particularly out of Japan, where we started raising capital a year ago and see a growing pipeline of investors. We are now looking to attract capital from European and North American investors, from other Asian investors and from the Middle East. Most North American investors are still heavily overweight in the US and the opportunity for that to change over time is quite significant.

What are the attractions of private debt as an asset class in the current macro environment, compared with other income alternatives?

Our loans are directly originated and negotiated with the borrower. We structure the terms and conditions, and we set and negotiate the price. We like to mitigate risk through covenants, controls and taking security, so as a result, we have an asset class that is done properly with a skilled manager who can directly originate and negotiate the transaction.

The other element is that the majority of the loans we make are short-dated floating rate loans, so as interest rates have risen, the capital has been preserved and total income has increased for investors. In an environment where people are nervous about economic conditions, these protections are valued by investors when other asset classes have proven to be more volatile.

Furthermore, through the pandemic the government supported the market with the Reserve Bank of Australia funding facilities, but now the banks are looking to repay those facilities, which is creating a withdrawal of market liquidity. With banks restricted, that leads to further opportunities for private debt.

How does private debt, and something like the recently exit-gated Blackstone REIT, differ from other asset classes when it comes to liquidity considerations?

Liquidity is always an issue for investors in any asset class, so it is up to the manager to have an appropriately structured investment product that caters to those demands. We offer varied funds to investors, with different risk and return targets and different liquidity terms, recognising the mix of assets that make up our funds.

As our funds have become larger, we increasingly lend for shorter periods of time because we believe that reduces credit risk and market risk for investors and gives us the ability to recycle capital, making the portfolio more liquid and creating opportunities to generate additional fee income for investors.

We operate open-end fund structures where investors can redeem or receive distributions as the portfolios mature and go into run-off. Those are becoming more common in Europe now, recognising the problem with closed-end fund structures in creating an unknown refinancing risk for borrowers. The open-end structure means companies can have confidence around our ability to continue to finance their operations without a fixed date to return investor capital, and the investor has more flexibility to decide when they want their money back.