Should regulators rein in private credit markets?

The financial system is experiencing a seismic shift. While public listings in countries like Australia are at a two-decade low, private capital markets have expanded as businesses seek alternative sources of funding and investors eye diversification and higher returns.

The world of private capital, where debt and equity are invested in privately owned companies, was valued at US$11.87 trillion (A$18.2 trillion) in 2023 and is projected to hit US$18 trillion (A$27.6 trillion) by 2027.

Private equity, which involves taking an ownership stake, accounts for nearly half of the market in Australia, although private capital fundraising in 2024 was at the lowest level in a decade.

While the venture capital arm of private markets gained muscle during the tech boom of the early 2000s, investor sentiment has been more cautious in recent years. The private market’s third arm, private credit, is a different story.

The global private credit market, which involves non-bank lenders raising money from investors to loan to businesses, has quadrupled over the past decade to reach US$2.1 trillion (A$3.2 trillion) in 2023. Growth was accelerated by the global financial crisis of 2007–09, when new regulations nudged banks towards more low-risk forms of lending.

Once the domain of wholesale and institutional investors like superannuation funds and insurers, the broader private capital market is seeing wider participation from retail investors, but the recent growth in private credit in particular has triggered concerns of elevated risk.

The International Monetary Fund has pointed to the global market’s limited regulatory oversight, while the Australian Securities and Investments Commission (ASIC) aims to test whether investment offers comply with existing domestic laws.

What does the growth in private capital mean for investors? And are the risk warnings warranted?

When supply meets demand

The US accounts for 54 per cent of all private capital fund assets under management, and Europe and Asia each represent about 20 per cent. The US also dominates private credit, accounting for around 70 per cent of global private credit raised since 2008.

The Asia Pacific region has seen remarkable growth in private credit, with data from Prequin showing assets under management rose from US$15.4 billion (A$23.6 billion) in 2014 to US$92.9 billion (A$142.5 billion) by September 2023.

In Australia, estimations vary depending on definitions and data sources. Reserve Bank of Australia data, for example, puts the private credit market at around A$40 billion. Research from KeyInvest suggests a much higher figure.

“Lending by banks has reduced since the global financial crisis and the size of private credit from our research has exceeded the A$220 billion mark in Australia, and that’s both commercial-oriented private lending and consumer-oriented private lending,” says Craig Brooke, CEO of KeyInvest.

On the borrowing side, mid-sized companies and commercial real estate represent the primary base. Joey Mouracadeh, senior investment director at Stanford Brown, says access to finance is a key benefit.

“There’s also been potential for banks to lend to more traditional borrowers, such as residential mortgage borrowers and more established businesses that might borrow with predictable cash flows, as opposed to startup businesses and growth businesses where there might be less to hold on to from a security perspective or a cash-flow perspective.”

Gordon Morrison, partner at McGrathNicol, says borrowers also value the flexibility of private credit.

“If a business is in growth mode and needs the proceeds for acquisition or to invest in their business, then the heavy amortisation of a bank loan takes cash away from growth,” he says.

“Private lenders are often more flexible on maturity and amortisation, they may say that you can have a three- to six-year loan with minimal amortisation until maturity, or in some circumstances even with capitalising interest.”

 

"Equity prices are high. The Australian share market is making a number more like 10 per cent per annum … and so private credit has come to the fore, because it promises something like eight to 12 per cent, and it can compete with equities."

 

On the investor side, institutional pools of capital such as superannuation funds are outgrowing equities and other conventional asset classes in Australia. Performance tests under the federal government’s Your Future, Your Super (YFYS) reforms, which came into effect on 1 July 2021, have also intensified their interest in private credit.

In a recent INTHEBLACK podcast episode on the rise of private credit, Michael Block FCPA, chief investment officer at boutique investment manager Bellmont Securities, says private credit “that might earn anywhere between 10 and 15 per cent per annum” is typically benchmarked against investment-grade credit.

“Therefore, an easy way for every superannuation fund to beat this benchmark is to allocate five to 10 per cent of its money to private credit.” Block notes that retail investors in Australia previously viewed private credit as too niche, with private equity the favoured sector in the alternative sleeve of portfolios.

“The money that was allocated to alternatives was pretty much all going to private equity,” he says. “It provided a return of around 17 per cent and it was exciting. If you only had a small amount of the portfolio to allocate, that is where you’d go.” But the finance system has changed. 

“Equity prices are high,” Block says. “The Australian share market is making a number more like 10 per cent per annum … and so private credit has come to the fore, because it promises something like eight to 12 per cent, and it can compete with equities.”

Risk versus reward

Like any investment asset class, private credit comes with risk. In a recent discussion paper on the dynamics between public and private markets, ASIC notes that while private credit “is not yet systemically important to the Australian economy, it is at historically high levels” and is subject to less regulatory oversight than other sectors.

Julia Lee, head of Pacific client coverage, index investments group at FTSE Russell, says concern about elevated risk is largely due to growth among retail investors.

“Institutional investors have dedicated teams to assess not just the underlying business, but also the deal structure, potential illiquidity and broader risks,” she says. “As private credit expands into the retail space, it’s critical that investors do their due diligence and understand where the credit risks lie and where we are in the economic cycle.

When conditions tighten we could see more defaults, especially among companies that are more exposed to a downturn in the economic cycle.”

Brooke says that while regulation is important, warnings of higher risk exposure in private credit can be “generally overblown”.

 

"As private credit expands into the retail space, it’s critical that investors do their due diligence and understand where the credit risks lie and where we are in the economic cycle. When conditions tighten, we could see more defaults, especially among companies that are more exposed."

 

“The majority of private credit in Australia is investing in an Australian first-registered mortgage so, as an investor, you’re investing in the top of a capital structure of a company and you’ve got the security of some form of first mortgage over real property. That means that if something goes wrong with that company and situation, you’re the first to get paid.”

However, Brooke adds that not all private credit is the same.

“You may be investing in a non-recourse loan between the private credit manager and the borrower, and not have direct rights to the mortgage, which means that you don’t really have any protection in place. This has to be properly understood by an investor.”

Morrison says that any further regulatory action is likely to focus on reporting requirements.

“I think the regulators should focus on how credit funds market themselves and report performance to their investors — information and statistics at a portfolio and loan level on loans in default or arrears, loans approaching default and the borrower leverage metrics, for example,” he says. “None of that is required to be reported at the moment. In fact, many do not report the list of loans that are made.”

The rapid growth of private credit has raised concerns about a potential bubble. David Bell, executive director at The Conexus Institute, says that the size of both market and yield shows that if a bubble exists, it has not popped yet.

“Yields are coming in a bit, but there still seem to be quite attractive returns available for investors, so I don’t feel like we have reached bubble status yet,” he says. “I also think that there is a new supply of corporates looking at these markets as a financing mechanism, so you’ve got supply matching up to demand to some degree.”

Brooke says that a bubble may not be due to lending or investing, but rather the spike in private credit managers.

“Out of the 308 we found operating in Australia, over 200 of them are operating less than A$50 to A$100 million in overall funds, and that’s small, whereas the top 20 in Australia are commanding about 90 per cent of overall volume.

“The heart of this discussion is that there are more Australians retiring or coming up to retirement than ever, yet there is less access to financial advice than there has ever been in decades that I remember,” adds Brooke.

What investors should look out for

Along with loan collateral, Brooke suggests that investors examine a private credit manager’s track record.

“Has the manager returned 100 per cent of the invested capital to their investors on all loans that have been exited since their inception? If you’re looking for some sort of safety and security outside of equities, then you want to know that these people and businesses have a proven track record of about 10 years or more and have preserved the capital of their investors.

“Also, it is important that there is no individual in an organisation who can approve a loan on their own,” Brooke says. “It should be approved unanimously, through an experienced credit committee, to avoid conflicts of interest.” 

Bell suggests focusing on expected investment outcomes.

“With private credit, you can observe the running yield of a portfolio, but it is much more important to factor in expected losses, default rates and some assumed recovery rates to come up with a total expected return,” he says.

“My rule of thumb for avoiding financial disasters is to avoid the combination of leverage and illiquidity, and look out for fraud,” adds Bell. “And once you’re clear on your return risk and liquidity profile, you have to ask yourself whether the returns on offer really stack up.”