SQM Research has placed the private credit sector on “watch” in response to the heightened scrutiny of the asset class.
In a media statement on Thursday, SQM said the sector watch issued means the researcher are increasing their active monitoring of the sector on existing ratings and have adjusted their ratings scoresheets to place more emphasis on governance.
It comes just a day after it was revealed leading licensee Count had recommended selling holdings in Metrics Private Credit funds as part of a broader review of the approved product lists in licensees it acquired during the Diverger acquisition.
ASIC has raised concerns over private credit last month and said it believed “failures are on the horizon” and is undertaking work to examine the sector and risks to retail investors.
Additionally, APRA, the RBA and the International Monetary Fund have raised concerns about potential “liquidity mismatches” from private market investments, particularly private credit.
Lonsec revealed yesterday it will be commencing a review into alternative asset classes, as part of their regular review cycles. Lonsec, who was Count’s research partner, had given at least a “recommended” ratings to several Metrics funds.
Zenith Investment Partners had declined to reveal if it was pursuing any similar type of review, while Morningstar was unable to respond by time of publication.
SQM managing director Louis Christopher said the researcher is acting due to recent announcements by the regulators.
“This action doesn’t necessarily mean that a fund rated by SQM will be automatically downgraded or placed on hold,” Christopher said.
“However, it is viewed as a necessary step to ensure appropriate oversight of an asset class that has been growing in relevance and size over recent years.”
Additionally, SQM’s initial due diligence screening, which occurs prior to a formal review, will also be increased.
However, the researcher expects the bulk of its existing ratings not to be impacted but “cannot rule out some funds to being downgraded or discontinued over the next 12 months”.
SQM has ratings on approximately 70 private credit funds, covering both retail and wholesale funds, which represents approximately $33 billion of funds under management.
The researcher has claimed it had screened out approximately 20 private credit funds, the majority of which were in the wholesale sector.
SQM has been covering the private credit sector since 2007 but began to observe issues with “increasing frequency” including lack of transparency on who the borrowers are as well as over holdings and financials.
Additionally, the researcher cited concerns over highly leveraged balance sheets, inadequate disclosure, too much flexibility given to the manager over asset allocation weights, elevated loan to value ratios, and increased loan arrears and an increasing frequency of refinancing of existing loans that were scheduled to be exited.
Also flagged were concerns over conflicts of interest – “vertical and horizontal” related party structures, and a lack of independence at board/investment committee level.
There were also concerns about “dubious” marketing strategies involving advisers, as well as an increasing number of products being offered with a mismatch between stated liquidity and the underlying liquidity of the loan assets.
Christopher said there is still an expectation wholesale funds provide the same transparency as retail funds, noting the “rapid increase” on wholesale offerings which the researcher believes is driven by the increase of investors who qualify as wholesale.
During the ‘Review of the regulatory framework for managed investment schemes’, Treasury cited research from Australian National University that estimated by 2021, 16 per cent of Australian adults met the individual wealth thresholds to be classified as a wholesale client versus 2 per cent in 2002.
However, the researcher believes the issues are not endemic within the sector but are more frequent with wholesale funds, and some of the issues have been observed beyond the private credit sector.
While SQM has raised an alarm with this review, Christopher said he expects the sector to “weather current challenges”.
“The private markets sector has a positive future in front of it as there are genuine opportunities for investors,” Christopher said.
“What we are observing to date is nothing like what was experienced back in 2008 when a large number of mortgage trusts were forced into redemption suspensions. However, I think the risks within the sector have increased in recent times and so increased diligence is required.”
Yesterday, several advisers detailed concerns they had to Professional Planner about the private credit sector.
Evalesco CEO and adviser Jeff Thurecht said the firm has never allocated client money to private credit because they have “always” had concerns with illiquidity risk being the leading factor.
“Consider that many of the Australian offerings are real estate focused, including development and mezzanine finance, and as such the underlying security assets are inherently less liquid and higher risk than perhaps their label suggests,” Thurecht said.
Arch Capital financial adviser Nigel Baker said his concern is “it should never have been in the retail space”.
Moran Partners Financial Planning principal Paul Moran said he has concerns about others attempting to gain a foothold in the sector when they don’t have the expertise.
