Here comes private credit and it’s worth a look

Predictions come thick and fast at this time of year, so rely on them as you might dental floss for security when rock climbing. Picture: Jamie Hanson

As we kick off another year of investing, I thought I would offer a couple of predictions. They come thick and fast at this time of year, so rely on them as you might dental floss for security when rock climbing.

My first prediction is that you are going to hear a lot more this year about private credit. It will gain traction as an important new asset and will be added to an increasing number of client port­folios, especially for those who want to reduce their exposure to the volatility of public market ­assets such as shares, and those who want attractive returns and regular income.

My second forecast, and the one at greater risk of being premature, is that provided the backdrop of disinflation and positive economic growth remains in place, small-cap companies will have a good, if not stellar, year.

Baby boomers were born during an 18-year period of elevated births after WWII between 1946 and 1964. Last year, boomers celebrated birthdays between the ages of 59 and 77, and they make up a sizeable portion of the population of 4.1 million retirees. In 2020, according to the Australian Bureau of Statistics, 140,000 people retired, at an average age of 64.3, and across all industries most intend to retire between 64 and 66.

You might be familiar with some of those statistics because it’s the baby boomers who seem to dominate discussing retirement incomes and post-retirement investing, but there is a cohort of investors who have already been quietly investing and supporting themselves and their families for many years. Known as the Silent Generation (or The Builders), they were born between 1928 and 1945, preceded the boomers and are now aged between 78 and 95.

What has been startling about this generation – apart from the realisation that they are the great upholders of many of the values our society relies on to operate – is how many are completely over the volatility of the stockmarket.

Selling out entirely and throwing it all into a term deposit is not uncommon amid the desire to “simplify one’s affairs”.

It seems that once investors reach their late 70s and early 80s, there’s a strong desire to invest in something that can be relied on to produce more stable and regular cash returns, enabling the support of grandchildren’s school fees or even the payment of a mortgage for the older grandchildren.

Enter private credit. In Australia, a $200bn gap exists between what small to medium-sized corporates in Australia would like to borrow for growth and what the banks are willing to finance.

And that gap has nothing to do with the quality of the borrowers, many of whom are able to provide directors guarantees, general ­security agreements, first mort­gages and other high levels of ­security and collateral.

The gap exists because after the Global Financial Crisis regulatory changes made lending to small and medium-sized businesses more challenging for the big banks.

Fifteen years ago, had you asked me to lend money to small and medium-sized businesses, I would have thought it was too risky. The lending was to businesses the banks didn’t want to touch.

Today, the businesses looking for funding haven’t been rejected by the big banks at all. Instead, the big banks, due to regulation, have completely shut their doors to that type of lending.

My second prediction – that small-cap share prices might “catch up” to, or close the gap between, mega-cap company share price performances – is reliant on a precondition. That is, we continue to experience disinflation as well as positive economic growth. If those two circumstances persist, I believe investors will gain confidence taking on risk again and will begin to search for innovative growth companies further down the market-cap spectrum.

And last year, we were all ­afforded an insight into how quickly the narrative can shift for smaller companies.

In just a week to November 3, the S&P 600 Small Cap index rallied 7.4 per cent. It also jumped 5.47 per cent on November 14 and rose another 6.36 per cent over two days between December 12 and 14.

Big moves can occur quickly in small caps, reflecting the very real risk that investors could miss out on strong returns by waiting for all the signs to appear positive.

If the US Federal Reserve and Reserve Bank decide to cut rates, there’s a fundamental reason to anticipate rising share prices – lower interest rates result in a lift to the present value of future cash flows. If rates fall, they will fundamentally lift the intrinsic value of every asset. And that will be reflected in expanding PE ratios for equities – the reverse of what we saw in 2022, when rates shot up from near-zero levels.

Finally, a rate cut reduces the cost of borrowing, signals a more accommodative business environment, lubricates the funding of business operations or expansion, increases profitability, and frees up capital for investment in new projects, technology and labour expansion while also alleviating cost-of-living pressures for customers.

And with smaller companies often more nimble and more responsive to changing economic conditions, I reckon the stage could be set this year for small caps to benefit.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management