What investors need to know as ASIC targets private credit sector
ASIC has the private credit industry in its sights. Here’s what investors should ask themselves before parting with their money.
ASIC has made its position clear on private credit – more needs to be done to improve both industry practices and investor disclosures.
Although now removed, the regulator’s recent stop order on La Trobe’s flagship 12-month and two-year term account products as well as its US private credit fund show that ASIC has had enough.
Although private credit is a growth sector in Australia, the average person probably does not know how it works. Also known as private debt, it is essentially when money is lent from a private company, rather than a bank. The loaned money is then used for things such as funding business expansion plans or for funding a property development project.
Firms such as La Trobe that lend in this sector obtain their capital from investors such as superannuation funds, family offices and wealthy individuals in exchange for providing them with a return, usually in the form of a monthly interest distribution.
Due to the lending constraints of the major banks, the private credit sector has grown from about $40bn a decade ago to $200bn today, a fivefold increase over the past 10 years. As a result, dozens of new private credit companies have set up shop, all looking for capital from investors to then onlend to corporate and property borrowers.
One of the major issues identified by ASIC is the way that private credit providers promote their retail and wholesale fund products. With the high level of industry competition, private credit funds need to be careful not to overstate the returns and understate the risks when promoting the benefits of their products.
In the case of La Trobe’s US private credit fund, ASIC had concerns over an investor disclosure document called the Target Market Determination (TMD), which is meant to guide consumers as to who is suitable for the investment.
Reviewing the pre-ASIC intervention TMD versus the updated one, the key differences were a tightening of the target market and a clearer recognition of risk.
The revised TMD upgraded the risk from “low to medium” to “medium to high” and recommended a maximum of 10 per cent portfolio allocation to the fund, down from 35 per cent previously.
Stronger warnings regarding potential loss of capital were added as well as stronger wording on the nature of returns not being guaranteed.
The new TMD also clarifies that redemptions are limited to a quarterly window and capped at 5 per cent of total units, meaning investors might not be able to fully redeem their investment in one quarter if there is a rush of investors also wishing to exit the investment.
One of the first things you see on La Trobe’s website on their US private credit fund is the fund overview. It says: “The US Private Credit Fund indirectly invests into a defensive portfolio comprising a majority of directly originated senior secured loans issued to US middle market companies.”
For many investors, phrases such as ‘defensive portfolio’ and ‘senior secured loans’ are associated with lower-risk investments offering stable, regular income and some degree of capital protection.
But reading pages 58 and 59 of the 194-page Product Disclosure Statement paints a more complex picture on the risk taken when investing in a fund that lends to US middle market companies:
“The middle market loans in which we generally expect to invest are typically not rated by any rating agency, but we believe that if they were rated, they would be below investment grade (rated lower than “Baa3” by Moody’s Investors Service, lower than “BBB-” by Fitch Ratings or lower than “BBB-” by Standard & Poor’s Ratings Services), which under the guidelines established by these rating agencies is an indication of having predominantly speculative characteristics with respect to the issuer’s capacity to pay interest and repay principal. Debt instruments that are rated below investment grade are sometimes referred to as ‘high yield bonds’ or ‘junk bonds’.”
The contrast between the short description on the website and the fuller technical description of risk buried deep in the PDS that fewer investors would read illustrates how crucial it is that investors do their research when it comes to private credit investments.
A ‘defensive portfolio’ is not usually associated with ‘junk bonds’.
The problem for the average investor is that on the surface, private credit investments can appear to be very attractive. They pay regular income. They pay double, sometimes triple, the rate of the RBA cash rate, and they appear to be backed by strong assets.
And with economic conditions being strong over the past 10 years, we have not seen major defaults and losses in the private credit market.
But investors need to understand the risk they are taking when it comes to private credit and ask themselves the following each and every time they are about to invest:
– Do I fully understand what exactly I am investing in? In other words, can I explain how my money is being used by the private credit fund and the fees being charged?
– If I took away the private credit company and assuming I had the expertise, would I lend my own money in the same way to property construction projects and corporate lending deals or would I find the risk too high?
– Am I comfortable with the risks when it comes to potential capital loss, limited investment redemptions and disruptions to income payments?
– Is it really worth the extra risk when I can invest $250,00 per bank and benefit from the Australian government guarantee on bank deposits?
James Gerrard is principal and director of financial planning firm www.financialadvisor.com.au
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