Private credit funds raise money from investors and lend it directly to medium to large-sized companies in a similar manner to banks. Investors in private credit and regular income generated from the interest and fees paid by those borrowers on their loans, less fund costs.

Private credit is booming. A recent Australian Financial Review article explained why investors are going nuts over private credit. They said ' the opportunity of earning double-digit returns by lending money to small businesses, large companies, and real estate developers that have been left hanging by the banks is what's making investors go crazy for private credit. And it describes lending money as reliable, stable, and thanks to higher interest rates, a compelling investment.'

This Investing Compass episode explores the asset class in further detail, and a pitch that sounds too good to be true. 

You're able to find Joseph's article here.

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You can find the transcript for the episode below:

Mark LaMonica: Investing Compass is a podcast we started to explore the fundamentals of investing and help you with achieving your financial goals, whatever they may be.

Shani Jayamanne: ANZ's 5 in 5 have sponsored this episode of Investing Compass. We also listen to 5 in 5 ourselves to keep up to date with the latest economic, markets, and business news each weekday. One of the things that we like about the podcast is that it has a similar approach to us. They leverage the insightful experts that they have across their global network to provide a rounded and level-headed analysis of news and insights each weekday.

LaMonica: You can find them in your preferred podcast player or click the link in the episode description to follow them and have a listen after us.

Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

LaMonica: We were talking earlier that I do these webinars. And there's a survey after the webinars. And most people are very nice in that survey. So, it comes up immediately after the webinars. But one person commented that they should find a native English speaker to do the webinars.

Jayamanne: I'm not on these webinars. It's just Mark.

LaMonica: Right. And as far as I can tell, I'm a native English speaker.

Jayamanne: But you were born in Taiwan.

LaMonica: I was born in Taiwan. But…

Jayamanne: You spoke English.

LaMonica: Yes, and still do, I think. So, I think what the person was saying is they don't like my accent. So, yeah, it's hard to know what to do with that information. Like you sit around all the time, and you talk about like abuse being heaped on immigrants. And now it's being heaped on me.

Jayamanne: This has gotten really political really quickly.

LaMonica: Not really. I'm just recounting conversations that you have. So, yeah, it's hard. It's made my transition to Australia, which has been 10 years now, really difficult. It seems like we should move on from the look on your face.

Jayamanne: What are we going to talk about today, Mark?

LaMonica: Wow. So, we'll get into today's episode. So, we're going to talk about an asset class that has been in the news a lot for both good and bad reasons. But it is certainly something that's drawn a lot of interest from professional investors, including the giant super funds, from retail investors looking for high yields, and increasingly the regulators who are assessing systemic risk. And that asset class, Shani, is private credit.

Jayamanne: For investors that may not be familiar with private credit, let's start with the definition. And we're pulling the definition from a great article that our colleague Joseph, who just started on the team, we did mention him a few podcasts ago, he wrote on private credit. And I'll quote the article, which defined private credit in the following way. So private credit funds raise money from investors and lend it directly to medium to large-sized companies in a similar manner to banks. Investors in private credit and regular income generated from the interest and fees paid by those borrowers on their loans, less fund costs.

LaMonica: Okay. And I'm going to quote another article from a less reputable source that is the AFR. And it was an article that explains…

Jayamanne: Can I just say, if compliance is listening, we did do the disclaimer. We didn't mean to offend anybody. We like the AFR.

LaMonica: We do.

Jayamanne: Those are the three points. You can continue on now, Mark.

LaMonica: Yeah, it was sarcasm, Shani. Anyway. The AFR article was explaining why investors are going nuts over private credit. And this was an article from June 7th, and it was titled, Fortunes to be Made as Private Credit Boom is Going Public. And the quote is, the opportunity of earning double-digit returns by lending money to small businesses, large companies, and real estate developers that have been left hanging by the banks is what's making investors go crazy for private credit. And it describes lending money as reliable, stable, and thanks to higher interest rates, a compelling investment.

Jayamanne: So those are two very different quotes, Mark. What did you think about them?

LaMonica: Yeah, well, that's the point of the episode. So, we are going to explore this in further detail. But I will say this pitch sounds a little too good to be true. So, let's start with the simple question of how did this market evolve where formerly companies that banks lent money to had to go somewhere else to borrow money?

Jayamanne: And we need to go back to the GFC to start this story. A simplistic narrative of the GFC is that banks, particularly American banks, lent a lot of money to people who did not pay it back and required huge bailouts to stay solvent. And like any crisis, the regulators and governments around the world responded to try and make banks safer.

LaMonica: And in the spirit of always fighting the last war, many of these sweeping regulations often have unintended consequences. So, in summary, Shani, what was the response from regulators?

Jayamanne: Well, one of the biggest responses was to make banks hold more capital. Banking capital is simply reserves that are held by banks that can be used to offset loan losses. The more capital that a bank holds, the more losses a bank can deal with before becoming insolvent. More capital makes a bank safer.

LaMonica: And the problem if you are a banker is that you don't want to hold capital. You want to lend money out because that's how you make money. So, in essence, the more money a bank lends, the more capital that must be held. And this makes it harder and more costly to grow a loan book. And while each bank is different, the end result was that banks can't lend to all the borrowers that want loans from banks.

Jayamanne: And this is a gap that non-bank lenders filled. And the amount of money that has been invested in private credit has exploded. Globally, in 2013, there was around US$500 million invested in private credit. In 2023, it was above US$1.6 trillion.

LaMonica: And among these investors is some of our largest super funds. So, Cbus and Hostplus, their default MySuper options, have allocated close to 7% of investor portfolios to private credit. Aussie Super has around 4.5% allocated. And there are also a lot of ways for investors to directly access private credit. For example, Metrics is one provider who offers direct-to-consumer products. And their Direct Income Fund targets returns that equal the RBA cash rate plus 3.25%, which currently means there's a target of 7.6%. So, you can see why this is compelling to investors.

Jayamanne: And anytime we talk about returns for any investment, we of course need to look at risk. And we'll spend a little bit of time on the specifics, but I've already been warned that Mark is going to go on a history rant. So, I'm warning all of you.

LaMonica: That's like a trigger warning, Shani?

Jayamanne: Something like that. But I have really been enjoying the sound effects that Will has been putting in these rants. So, I've come to enjoy them. So, let's go for it if you want to have your rant soon. But I think before we do that, we should go through the risks quickly so you can get started. And the risks are pretty straightforward and easy to understand. When you lend money to anyone, the biggest risk is that they can't pay you back.

LaMonica: Yeah, which is fairly obvious. But there are other things we want to do when assessing the risk of a loan book. The company can't pay you back. You want to look at potential recovery rates. Basically, what does a lender get if the bank or in this case, the non-bank lender isn't able to get those funds back? And we can use an example to illustrate this. You can't pay back your mortgage, the bank can, of course, take your house. Depending upon how much the loan was for and how much the house can be sold for, that will determine the recovery rate.

Jayamanne: And things work a little bit differently with private credit. These are loans to companies. And if a loan can't be paid back and if the borrower and lender can't agree to a plan, the company will then go bankrupt. In that case, you take everyone that is owed money, which can include lenders and vendors and investors, and you put them in order based on their priority in getting paid back. Then all the assets are sold off and you start paying them back.

LaMonica: Yeah. And just as an aside, so people should know, shareholders are the last priority. So, if you're a shareholder of a company that has gone bankrupt, you will only get anything back after everyone else is paid back. But for lenders, it's based on the position in the capital structure. Some debt is more senior to others, which means they will get paid back first.

Jayamanne: There's one last risk that we need to consider, and that is interest rate risk. Bonds are simply loans, and one of the biggest risks for bond investors is interest rates. Bond prices move inversely to interest rates. And this is one risk that we don't need to worry about with private credit, as interest rates on the loans are floating rate, which means they reset as rates change.

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LaMonica: Okay. So, let's quickly run through the risks of lending and how it relates to private credit. We've talked about the floating rate nature of the loans, and this, of course, is a good thing for investors and private debt. The problem is that the amount of interest paid on the loans goes up, and it becomes harder for companies to pay it back, especially if the increase in interest rates makes it a more challenging economic environment. But ultimately, it all comes down to how many of these borrowers will default.

Jayamanne: And one thing the industry does argue is that default rates have become lower over time. One piece of data that we saw from KBRA DLD indicated that private credits default rates during 2023 was 1.7% for direct lending. And that is really low. Standard & Poor's estimates that global high yield, which are the companies that are judged to have the highest credit risk, had a default rate of 3.5% in 2023. And that's really strong. It's also a bit curious since these loans do seem to be the same companies. The IMF came up with a report looking at the amount of debt and the size of the companies that we were tapping private credit, and it fit the profile of the same types of companies that issued high yield debt.

LaMonica: And so, it's fairly curious the default rate would be meaningfully lower. And I'll get into this in a bit during this rant that Shani warned you about. But one thing to note is that there's always the possibility of renegotiating the loans if the borrower gets in trouble. And a paper by the Federal Reserve said that private credit borrowers do have more scope to negotiate if they get trouble.

Jayamanne: And this is where things get interesting with the KBRA DLD data. We mentioned that the default rate for private credit was 1.7% for direct lending. This is where the negotiations are between two parties, the borrower and the lender. The same data showed the default rate for syndicated loans where multiple lenders were involved, and that was 5.8%. That is a lot higher than the high yield default rate and certainly a lot higher than the direct lending rate.

LaMonica: The simple explanation is that it is harder to negotiate with multiple parties and come to an agreement. And fair enough. But an argument could be made that for direct lending, the lenders are doing whatever is possible to keep that default rate as low as possible. And this isn't necessarily wrong. It's going to be in the best interest of the lenders to keep that default rate as low as possible because they of course are selling the low default rate and the higher yields to investors. Essentially, the argument is that you are getting higher returns with lower risk. And that is a combination that should not be happening in investing. So, it raises a couple of questions.

Jayamanne: At the end of the day, this is all about the underwriting standards or how good each private credit lender is at evaluating which borrowers will pay them back and who they won't lend to. You're putting a lot of trust in the private credit without a lot of data about who is borrowing the money.

LaMonica: And that is a big question mark.

Jayamanne: Okay. I can feel you gearing up for your rant. I can feel it from across the room, Mark.

LaMonica: Well, there you go. Okay. So, I think it's time. It's not really a rant. It's just I get very worried when we see lots of investor money flowing into either a particular asset class or a certain subsector of the market. And in the late 1990s, investors went nuts over anything internet related. People realized that investors would buy anything associated with the internet. So, what did they do? They started lots of internet-related companies. They got lots of funding and they got very rich. And what happened? Well, it turned out a lot of these companies did not have a viable business model, investors got burned and a lot of these companies went out of business.

Jayamanne: And the dotcom boom and bust was only one example. We've also seen this happen throughout history. And it could be happening now with AI. It doesn't mean that the internet didn't transform the world in business. And it doesn't mean that AI won't do the same. It just means that investors have to be careful about where they invest.

LaMonica: And since we're talking about loans here, I want to point to some similar things that have happened with debt. And the first is a GFC. Investment banks created a market for securitized home loans. They looked at history and saw that people typically didn't default on home loans. They sold this story to investors. And there was lots of demand for bonds that held these loans. And Shani, what happened?

Jayamanne: Well, the problem was that to sell more securities, they needed more loans to package up. And to get more loans, they had to drop standards. All of a sudden, anyone could get a loan and the protections in those loans that led to the low default rates started to become compromised. All of a sudden, you had loans being given to people who wanted to buy a house with no down payments. You got what became known as liar loans when people were in some cases encouraged by mortgage brokers to exaggerate their income on their loan applications. You had loans where they didn't even bother to ask about income.

LaMonica: And the next example is star bond trader turned convict, turned philanthropist, Michael Milken. And he's obviously tainted by his criminal history. But I wanted to talk about junk bonds. And they're also called high yield bonds. As a young investment banker, Milken discovered that junk bonds had a fairly low default rate and that the higher interest rates that investors could get more than made up for the risk. He saw that they were mispriced.

Jayamanne: And he went out and sold investors on this notion. But there was one problem and that was that nobody would issue junk bonds. The only junk bonds that existed were companies with good credit that had fallen on bad times, and they were called fallen angels.

LaMonica: And as Milken convinced more investors that buying junk bonds made sense, he needed more supply. So, his company Drexel Burnham started letting companies that had low credit ratings issue junk bonds.

Jayamanne: And he sold those bonds to investors, and they wanted more. So, he needed to find more junk bonds. And over the time, the standards were just lowered and lowered. Eventually, this blew up and the desire to buy more junk bonds lowered standards to the point where the original investment thesis didn't exist anymore.

LaMonica: And he tried everything possible to hold this together and prevent defaults that would spook investors. The fees were too lucrative. So, he just kept going. And eventually the standards were so low, the company started default and the whole thing fell apart.

Jayamanne: So, Mark?

LaMonica: Yes, Shani.

Jayamanne: Is this what you're saying will happen to private credit?

LaMonica: Well, I have no idea. I'm just saying that it makes me nervous. That tremendous increase in the amount of money flowing into private credit just worries me. It worries me that of that US$1.6 trillion that has flowed into private credit US$506 billion still hasn't been lent. It's called dry powder. And there's every incentive in the world for this money to be lent, because lending the money is how the private credit investors make money. That is going to put a lot of pressure on lending standards. Not saying that those standards will be lowered. But historically, when similar situations have occurred, guess what's happened? Standards have been relaxed.

Jayamanne: And I think this gets back to our original point. And that is that underwriting standards are extremely important. And I think it's very hard to judge those standards because there's no transparency into who is getting that money. And there's little transparency into how these loans are priced, which is something that ASIC recently formed a task force to explore.

LaMonica: And there's also systemic risk to think about. On the surface, this whole situation seems ridiculous. Governments around the world have decided that banks present systemic risk. If a bank collapses, it creates huge problems. Credit in the economy dries up, which leads to all sorts of economic issues. That is why banks are so regulated. That is why capital reserves are raised after the GFC. Does it seem odd to anyone else that we have these heavily regulated banks that represent a systemic risk to the economy and then allow private credit funds with no regulation to do all the same things as banks without any of the oversight? It just seems strange.

Jayamanne: So, I take it you're not going to be rushing out to buy private credit?

LaMonica: I mean, I personally wouldn't. But to be fair, I have my super as do you, Shani, with Aussie Super, who has invested in private credit. And if there are huge problems with private credit, which impact the economy, I would certainly be impacted. I also avoid investing in things I don't understand. And while I understand what private credit is and how it works, I don't understand who is being lent money. I don't understand how these loans are priced. I have no view of the standards of different private credit providers. And to date, there are no regulators that seem to be taking a hard look at what is being done. And the thing that makes me nervous is that not knowing all of that makes it really hard for me to understand what is going to happen if we have a combination of higher interest rates and slowing economic activity.

Jayamanne: And I think that is a good place to end this episode. So, if you get one thing out of this podcast, it is for each of us to understand what's in our portfolio and be at least a little bit skeptical of things that we hear about investments. Higher returns and lower risk is a red flag. At the very least, it is a good jumping off point for more research.

LaMonica: All right, Shani, we did it. Once again, we would love everybody to fill out that survey and enter into a chance of winning that $250 gift certificate – or gift card, sorry. So, thank you very much.

Jayamanne: We can issue a certificate as well. Investing Compass' Best Listener or something like that.

LaMonica: It's like the thing you get your parents when you forget about their birthday, like four free hugs.

Jayamanne: Yes.

LaMonica: Anyway. Thank you very much for listening. We appreciate it.

Mark LaMonica: Investing Compass is a podcast we started to explore the fundamentals of investing and help you with achieving your financial goals, whatever they may be.

Shani Jayamanne: ANZ's 5 in 5 have sponsored this episode of Investing Compass. We also listen to 5 in 5 ourselves to keep up to date with the latest economic, markets, and business news each weekday. One of the things that we like about the podcast is that it has a similar approach to us. They leverage the insightful experts that they have across their global network to provide a rounded and level-headed analysis of news and insights each weekday.

LaMonica: You can find them in your preferred podcast player or click the link in the episode description to follow them and have a listen after us.

 

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)