This article is sponsored by FC Capital
The size of Australia’s private debt market is still far smaller than that of countries such as the UK or the US. Would you expect this to change at all?
It is changing, but only slowly. The overall lending landscape in Australia has long been dominated by four major banks. Their core business model is mortgage lending, thereby rarely offloading mortgages or commercial loans into conduits, CLOs or other equivalent structures, as seen in the US and UK. Most Australian banks engage with offshore distressed investors when offloading troubled loans.
As a result, Australia lags the UK and US in terms of developing a sophisticated private debt market.
Banks do not typically look too deeply to understand a firm’s business model, instead focusing on ratios and secured collateral. There is limited analysis of how the business operates, cashflow structure or business performance. Lending on receivables, which is very common in the US banking system, is only rarely offered by Australian banks, or where this is possible it would only be offered for larger institutional clients with the right investment-grade rating. The business unit of a traditional bank might only be prepared to lend up to two times EBITDA (depending on industry) with additional property security. Borrowers, small and medium-size companies that require more leverage are basically lost in the process and increasingly without banking support.
Five years ago, changes were made in the banking landscape, following recommendations made by the banking Royal Commission on the financial services industry and tougher supervision from the Australian Prudential Regulation Authority, including capital adequacy requirements.
The consequence of this retrenchment is that firms are increasingly having to make private arrangements – perhaps by finding somebody who can lend them money on a personal account or going to non-bank lenders such as FC Capital.
There are a few asset managers, such as ourselves, who are starting to explore opportunities in the private debt market. But in general, things are very much in their infancy – the majority is subscale, not sophisticated in lending approach and not able to support capital requirements of $10 million and more.
To what extent is private debt making its way into the portfolios of Australian investors?
We need to divide the market into two. On one side are retail investors, accessing the market through one of only a few low-yielding products that are available, compared with underlying risk assumed.
On the other side, we have sophisticated institutional investors, such as large pension funds or family offices. They have become more aware of the sector over the last 10 years and have generated strong returns from private debt opportunities.
So, the appreciation of private debt as an asset class is steadily increasing and most institutional players will now have some form of it in their portfolio or build up teams to engage in this sector. The open question, though, is ‘what is the right percentage of private debt in a portfolio?’ Again, comparing Australia with other global markets, the weighting it should receive needs to be much higher within the overall portfolio. The market is growing, the returns are good and investments tend to be fairly stable, increasingly exceeding returns from listed equity or private equity products.
If structured correctly, private debt can offer returns significantly above what other fixed income products yield, while providing substantial capital protection. Another advantage is that, since private debt isn’t listed, the asset class doesn’t follow swings in the market, reducing volatility in investor portfolios. This is a win-win for the investor.
How should investors think about structuring private debt in order to achieve optimal returns and protection?
To maximise the opportunities within private debt, it is best if the private debt underwriter is in direct contact with the borrower, understands the business, runs a robust due diligence process and drives appropriate pricing. Fundamental to such underwriting process is a skilled investment team and established risk management processes.
The investment team should be able to run credit risk analytics in-house as part of their own DNA and rely less on arranged deals where the arranger has no continued engagement with the underlying assets and potentially has outsourced crucial due diligence and credit analysis.
If an investor is just a participant in a larger deal, then they are not able to optimise investments and the yields will almost certainly be suboptimal compared with the risk being taken.
What about the risk embedded in the asset class, particularly in terms of credit quality and the danger of underlying firms defaulting?
Again, the key to all of this is proper due diligence, understanding the true underlying risks and how a company may manage these or has managed these in the past.
Unlike in the US, firms in Australia do not require a banking charter/licence before they start lending money. This raises several questions that need to be addressed ahead of any investment. Is the lending arrangement enforceable? Has the credit been priced correctly? Has the appropriate due diligence been carried out?
Many smaller firms often engage in these types of lending activities without the necessary experience or expertise to originate and structure the loan in the first place, or in the event of a default without know-how to enforce and recover the investment, if necessary.
Investing in private debt requires the rights skills and the right credit analytics. It’s not simply about applying a multiplier to an EBITDA ratio. It’s about understanding the underlying credit or valuation basis and concepts deployed. If the manager is not able to do this, or demonstrate these kinds of skills, then private debt investment becomes a bit of a wildcard. The investor might think double-digit returns is great, but they might not be if the manager doesn’t understand the risk the investor has been signed up to.
US pension funds are showing a lot of interest in private debt investment at the moment. Is a similar trend being seen within Australia’s superannuation sector?
We are seeing a shift in focus of Australian superannuation funds, as previously there wasn’t a strong focus on private credit. Most funds are in an accumulation phase with an emphasis on growth managed through engineered low volatility listed equities. This is where funds may want to shift focus towards private debt with specialised managers.
The majority of Australia’s superannuation engagement in private debt is focusing on larger investment-grade or infrastructure debt transactions, with fairly low risk-adjusted returns.
Another observation is the state of our superannuation industry, with most funds in Australia and the majority of their member base focused on the accumulation phase, therefore not paying out a lot to their member base. Traditionally, these funds have larger allocation on riskier and high-growth asset classes.
When this changes – and it will change over the next 10 to 20 years – these funds will have to start providing retirement income streams to the underlying member base. At this time, the private credit book will play a very significant role because of the stable income and capital protection it offers. In the long term, I can see a fundamental shift in Australian superannuation fund portfolios away from equities towards private credit with better capital protection and consistent income streams.
Did covid-19 impact the market for private debt?
Interest in private debt investments slowed during the pandemic, but this was more the result of a general standstill in the capital markets in 2020. There were only a few distressed opportunities in Australia and most existing lenders, non-bank or bank, worked with borrowers throughout these unprecedented times.
What the covid-19 experience did show is that private debt is an asset class that has an important role to play within the overall investment portfolio – because of low losses, persistent returns and opportunities emerging from various pipelines, which are persuading the unconvinced. Fundamental to achieve a stable book even during times of high volatility or so-called black swan events is a well-diversified book across multiple industries and borrowers. If you look at any private debt or fixed income portfolio, well diversified, it outperforms volatility swings in the equity markets as seen in 2020, assuming constant investment.
Private debt and direct lending has further benefits, allowing non-bank lenders/credit managers to work directly with the borrower to secure the best results. In the listed markets or with volume products that are highly structured, the investor becomes a passenger with no active involvement, often limited to a simple wait and hope that things turn around. If available, managers can use credit derivatives, but such strategies can be costly and hard to manage if the underlying risk or volatility, as seen in 2020, have fundamental shifts.
As a direct lender in a private debt investment, you can go in and work with the borrower to upskill them, or help them through a crisis, but also rely on their expertise of the immediate business needs and subsequent impacts on financial performance.
What is the outlook for private debt investment in Australia?
The outlook in Australia is fairly positive, with positive GDP growth and one of the lowest unemployment rates in the world, while retaining a triple-A credit rating, for more than two decades. Even if there are signs of a recession or slowdown in economic activity, a well-structured private debt portfolio investment should continue to provide superior risk-adjusted returns. Similar to the US and UK, I expect to see a strong growth in the developing Australian private debt market and increasing interest and focus in the asset class from wholesale and institutional investors in Australia, and offshore with new products and structures.
Looking further ahead – and I’m talking 10 or more years – the market may adjust, and credit spreads between the UK, US and Australia will become aligned, for deals with similar leverage. However, I am hopeful that further growth and interest won’t impact on the current financing documentation, which is lender friendly, covenant driven and robust compared with many offshore markets.
Private debt investments in Australia still offer superior risk-adjusted returns, with better covenant regimes and a better set of underlying lender provisions, than you might see in the more established and fairly competitive markets in Europe and the US.