There is nothing new, or revolutionary, about investing in private debt. Direct lending is as old as civilisation and flourished in the late 18th, 19th and 20th centuries in the UK, Europe and the US. Back then, banking crises were frequent, and those with sufficient means and knowledge sought out opportunities to lend money to individuals and businesses they trusted and considered credit worthy.
The current expansion in private lending began in the 1990s when venture capitalists in the US recognised the potential of the internet. Most of these start-ups failed but many are still with us today, most notably Amazon and Google. But the increased banking regulation in the wake of the numerous markets crises throughout that decade also played a role. In the early 2000’s, the bursting of the dotcom bubble, the Enron and WorldCom scandals, and ultimately the Global Financial Crisis led to more banking regulation, driving the growth in private lending.
But another, often overlooked, factor also played a key role. In the decade and a half after the GFC, official interest rates were sustained at once unthinkable levels, and in some countries went negative. This extraordinary, unprecedented period of cheap money was much more responsible for the private debt boom than banking regulation or anything else.
The “chase for yield” was a global phenomenon in both public and private markets alike. And when borrowing costs are so low, lending money becomes less risky. Borrowers are less likely to default, and even if they do, debt recoveries will be higher.
But then inflation re-emerged. In a little over a year and half, cash rates went from near-zero to four percent plus in most countries. Absent global recession, the scope for rates to fall seems limited, with inflation likely to be structurally higher due to trade wars and climate change.
Higher rates have led to increased stress in both public and private credit markets. The big four private markets firms – Blackstone, KKR, Carlyle and Apollo – have been open and frank in their communications with investors in both equity and debt. Many private lenders have come up with an increasing range of short-term fixes to “kick the can down the road”, hoping that lower rates will in time reduce borrower stress or enable cheaper re-financing. All sorts of innovative solutions have been devised, like so-called “payments-in-kind” where interest due is funded by additional loans, or complex restructurings, where certain lenders in the capital structure undermine the claims of others. Such actions have even been given the colourful name of “creditor-on-creditor violence”.
Oddly, what is happening globally in private credit is rarely mentioned in the Australian context. It is as though private lending in Australia is immune to the risks of higher rates, weaker growth or the unfolding global trade wars. Yes, we have tougher insolvency rules, and conservative banks, and the last recession was a third of a century ago, in 1992. But surely it’s foolish to think that structurally higher interest rates globally do not matter to Australian credit markets, public or private.
ASIC chair Joe Longo’s expressed concerns about the “opacity, conflicts, valuation uncertainty, illiquidity and leverage” in private debt are not unreasonable in the global context. And all regulators should be wary of fads and hype, especially when there is money to made by those promoting them.
Australian super funds were foundational investors in infrastructure debt and equity. They have also followed the global trend of pension funds investing in corporate direct lending, commercial real estate (CRE) and venture capital. In other words, they should know what they are doing. One would hope they follow global best practice, with well-designed programs with diversification across managers, strategies and closed-end vintages.
But are retail investors and their advisers aware of what constitutes global best practice? Do they understand that investing in open-ended listed vehicles is not the same thing? Do they realise how difficult it is to measure the performance of even closed-end private debt portfolios, with cash flows in and out, side-pockets, not to mention the calculation of performance fees. I think not. In fact, even some large super funds might struggle from time to time with the sheer complexity of private market investing.
Hopefully, the consultation currently underway will result in measures to ensure that retail investors and their advisors are better informed on the risks, as well as the opportunities, in private debt investing.
Countering, or prohibiting, certain aspects of the marketing hype would be a good place to start.
First, the contention that traded market prices are subject to swings in sentiment or irrational behaviour and that “professional” valuations are more soundly based is self-serving nonsense. Like all accounting exercises, such valuations are prone to all sorts of conflicts. The tendency to imply that less “volatility” in unit prices for private debt investments make them less risky is disingenuous at best and at worst deceitful. When something goes wrong on a loan the mark downs are usually material. Something is only ever worth what someone else is prepared to pay. Transactions prices are the only truth.
Second, “internal credit ratings” of loans are not equivalent to ratings by professional agencies, whatever the methodology used. As we know, even the credit rating agencies are far from perfect. The publication of average credit ratings on private debt portfolios is extremely misleading. A portfolio in which 50 per cent of the loans are BBB and 50 per cent are BB is not an investment grade portfolio. The expected default and recovery rates are sub-investment grade.
Third, given the nature of the Australian economy, portfolio diversification is extremely challenging. Australian focussed private debt portfolios will invariably be less diversified than US or European portfolios. Best practice is to diversify by geography, industry and cyclical/non-cyclical exposures. Also, globally speaking, private debt investors recognise that lending for infrastructure and commercial real estate requires different skill sets, and poses different risks, to mainstream corporate lending. Few managers are equally capable at all forms of private lending.
Private debt investing in Australia should have a future. There is a role for it in portfolios, including for individual investors. But the market here is in its infancy. If the issues raised by ASIC are not properly addressed and embraced by the industry it might never reach maturity.
Wayne Fitzgibbon is founder and chief investment strategist for investment education firm Thinking Differently.
