Morningstar will take note of how private credit funds are marketed and distributed as part of its rating methodology into the controversial sector.
Morningstar director of manager research ratings Matt Olsen told a media briefing in Sydney that situations where there was distribution of a product with “misaligned incentives” would be present a “red flag”.
“Those types of things are things where you need to look at how it’s been marketed,” Olsen said.
“Is it properly represented to the market, is it being described to investors with appropriate target market determination?”
Olsen isn’t alone in this view – ASIC noted the role played by researchers and how funds rely on fund ratings to support marketing efforts in its latest report into private credit released earlier this month.
Morningstar launched its semi-liquid rating methodology earlier this year with a focus on private credit and private equity but will expand into other asset classes in the near future.
“We think about private infrastructure, private real estate also as areas we could apply that semi-liquid methodology too,” said Olsen who will be speaking at the Professional Planner Researcher Forum next week about the democratisation of private markets.
The asset class has come under scrutiny from the corporate regulator – which will also be appearing at Researcher Forum – which said private credit is good for the economy “if done well” but has also expressed serious concerns about retail distribution.
Another report is expected to be released soon that covers adviser distribution of private credit funds.
“The bigger picture is from the investor portfolio point of view, there’s obviously large amounts of equity exposure, there’s fixed interest exposure and that varies depending on the risk profile… the bigger picture is they’re offering an alternative to equities,” Olsen said.
“Private equity offers some advantages in terms of accessing potentially faster growing and different market cap exposures to the equity space and the ability to source opportunities potentially diversified from global equities markets.
“That may be very useful in environments like we’ve got now where valuations look quite stretched in the public markets.”
Olsen said private markets assets have found their way into portfolios due to their performance during market downturns and because the negative correlation between fixed income and equities has broken down as a result of rising inflation.
“In 2022 when we saw equity markets fall significantly, private equity did quite well – there was negative market [returns] on public but private equity was delivering between 13 per cent to 20 per cent positive absolute returns, so it offered some diversification benefits,” Olsen said.
“Fairly solid private credit managers are offering returns of seven per cent to eight per cent which I would call equity like… for long term returns in equities it’s around six per cent to eight per cent that you’re expecting. These types of funds are offering that type of return in a floating rate environment, they provide some flexibility in terms of the strategy and the protections they can build in.”
In terms of challenges, Olsen said liquidity is a legitimate concern along with the quality of the underlying manager.
“Transparency is an issue, at Morningstar historically there’s been a reticence to cover the space given managers’ unwillingness to provide full transparency on their holdings and that’s something that we really champion and would like to see,” Olsen said.
“That opacity, the quality of the underlying manager, their ability to do workouts and have enough people in place to work through those problematic situations when things go wrong.”
Governance is also a key concern with independence between the responsible entity and the underlying fund manager being sacrosanct.
“We want to see a level of independent directors on the board and that’s just as a high-level starting point,” Olsen said.
“We want to see managers with a good track record, a range of experience in the space.”
The use of quality auditors is also important as well as whether they’re using well-known, independent firms to value loans on a regular basis.
“Some operators in the market do a good job with that,” Olsen said.
“Metrics do monthly third-party of the valuation of their loans by KPMG, so that’s a type of best practice behaviour.”
