Private credit, commonly referred to as private debt or non-bank lending, is a growing asset class garnering increasing attention from investors.
Historically, this was space dominated by the big banks. However recent regulatory changes in addition to the Royal Banking Commission have led to traditional lenders exiting the space and limiting their lending activities to big corporates and residential mortgages.
This has led to the emergence of the non-bank lender market, where borrowers left behind by the big banks, including small and medium enterprises (SMEs), can obtain financing for their business activities. The private debt market has more than tripled over the past three years to currently stand at $2.1 billion.
Despite the rapid growth, private credit represents just a fraction of the total capital invested in Australia. The asset class still remains relatively unknown to most investors.
Our goal is to help bridge that gap but answering five common questions we receive from investors. As always, don’t hesitate to contact us directly should you like to discuss private credit in further detail.
1. What is Private Credit?
Private credit is the provision of business loans by non-bank lenders such as investors, credit managers, family offices and superannuation funds. The loans are written to companies across a broad spectrum of size and sector, with an emphasis on SMEs.
Unlike government or corporate bonds, private credit is not traded on a public exchange and therefore is an illiquid asset. Investors are subsequently compensated with a higher return, with the long-term returns from credit outpacing that of traditional fixed income.
There are various forms of debt issued to corporations including:
Credit largely consists of floating-rate loans, meaning the interest rate payable corresponds with movement in the cash rate. This makes the asset class negatively correlated against other asset classes such as equities or bonds that are typically negatively impacted by higher interest rates.
2. What is the Capital Stack?
When a business decides it needs external capital, it has two primary options: equity or debt. Most businesses will use a combination of both, and this is called the capital stack.
In simple terms, the further down the capital stack the more risk the investors are prepared to take. For that extra risk, the returns, and importantly the downside, are higher.
The key to the capital stack is there is no right or wrong. An investor may be willing to take on more risk and invest in the equity. Another investor may want regular income with downside protection and therefore opt for a senior secured loan backed by property.
Private credit funds invest in the first three tiers of the capital stack. The TAMIM Credit Fund is invested primarily in senior secured loans and has no unsecured lending exposure and only 5% in the Mezzanine segment.
3. Why Invest in Private Credit?
Private credit plays both offence and defence for your portfolio via four key benefits:
Private credit provides reliable and regular income to support your lifestyle needs. Instead of investing in a single company or government bond, capital is deployed across a diversified portfolio of loans that have each been independently evaluated and approved by an investment team.
Distributions are paid quarterly and are more reliable than ASX dividend shares, where distributions are often halted in times of turbulence. To illustrate, the popular ASX dividend share Commonwealth Bank (ASX: CBA) cut its dividend in half when the pandemic hit in 2020. Conversely, the TAMIM Credit Fund maintained its quarterly distribution, providing income when investors needed it most.
The offence component centers on returns. Over the past five years, the benchmark S&P/ASX 200 has returned 7.64% while the TAMIM Credit Fund has returned 7.11%. With the recent rise in interest rates, private credit returns may soon to be on par and exceed the returns available from equities, while offering considerably less risk.
4. What are the Risks of Private Credit?
Like all asset classes, private credit has risks investors need to be cognisant of – foremost being a borrower unable to continue servicing a loan. Businesses do go through periods of turbulence, and this can impair income distributions and investor capital.
Fortunately, this is mitigated by the contractual obligation borrowers have with the credit fund to make repayments. In the unlikely event of default, the creditor can reclaim the assets and business operations from the borrower. This provides investors assurance that their capital is protected subject to their underlying security. Moreover, a good credit fund is well diversified, meaning the failure of one loan should not materially impact ongoing income distributions or the fund’s capital.
Higher interest rates also need to be considered. As loans are floating rate, increasing repayments can place stress on borrower’s cash flows. Again, this is mitigated by writing loans to resilient borrowers and investing further up the capital stack.
5. How Does Private Credit fit in my Portfolio?
Private credit is appropriate for a range of portfolios, from investors who are prioritising growth to those needing regular income with downside protection. Determining the suitable allocation can however be more art than science. The best allocation will come down to your return expectations, risk profile and investment objectives. Adding private credit may reduce portfolio correlation, which may reduce the impact of drawdowns. Big investors are taking note, with Australian superfunds nearly doubling their exposure to private debt over the past five years, with an average allocation of 3.9%.
If you’re interested in further understanding the role of private credit in your portfolio, don’t hesitate to reach out.
At TAMIM we are committed to educating investors on how best to manage their retirement futures.
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.