Private credit offers diversification, prospect of higher returns to investors

Private credit – a burgeoning form of investment – offers myriad advantages to those chasing asset diversification and healthy returns, writes Tim Boreham.

Private credit can put money to work, as well as offering portfolio diversification.

Like an elite private club, the term “private credit” implies something that is out of reach to retail investors and shrouded in mystique.

In reality, private credit offers myriad advantages for investors seeking higher returns and asset diversification.

Also known as private debt, private credit refers to lending to businesses outside of the realms of the banks and the publicly-traded bond market.

Investors usually have a long-term outlook and include superannuation funds, insurers and family offices.

Private debt borrowers include large ASX-listed companies such as Woolworths and Origin Energy, or mid-to-large sized private entities.

Private credit users also include the real estate sector, private-equity acquirers and special purpose vehicles facilitating projects such as toll roads.

Private credit is burgeoning: investment data analyst Preqin forecasts private credit assets to grow to $US2.3 trillion ($3.5 trillion) globally by 2027, compared with $US1.2 trillion ($1.8 trillion) in 2021.

Consulting firm EY estimates the size of the local private credit market at $188bn as of the end of 2023, 7 per cent higher year-on-year and consisting of $112bn of “business related” loans and $76bn of commercial real estate exposures.

Private credit emerged after the global financial crisis, when stiffer capital adequacy and prudential rules resulted in the banks retreating from business and commercial property lending, in favour of home mortgages.

Filling a void

“We have seen a steady increase in terms of both the demand for non-bank capital, as banks withdraw lending capacity,” says Andrew Lockhart, managing partner of private credit specialist Metrics Credit Partners, which pioneered ASX-listed access to the sector in 2017.

“But equally, private credit has become a relevant asset class for investors.”

Private loans are far from a case of “one size fits all”, as they range from investment grade unsecured senior debt to secured, sub-investment grade junior debt.

Current returns vary from 8-9 per cent for a conservative fund, to 11-13 per cent for a higher-risk fund. In comparison, a government-guaranteed bank term deposit currently yields 4-5 per cent.

Much depends on the financial strength of the borrower and – as with all investing – a weaker credit profile means higher risk.

While the loans come in many flavours, they share key common characteristics, including a “floating” (variable) interest rate.

The floating rate is tied to a benchmark, typically the bank bill swap bid rate (BBSY), plus a margin. As the base rate rises or falls, the total returns are adjusted accordingly, thus providing an inflation hedge.

In contrast, the “coupon” (interest) on bonds is usually fixed. Because they are not publicly traded like bonds, private loans are usually held to maturity.

Prudent diversification tool

A lingering misconception is that equities are safer than private debt in the event of corporate failures, which can – and do – happen.

In reality, private lenders rank ahead of equity holders, who risk losing all their money, if things go sour. The exact ranking in the debtors’ queue depends on how the loans are structured, but most have restrictive financial covenants to control the borrower’s debt levels and debt servicing ability.

Private loans tend to have a low correlation with “growth” assets such as shares, property and even bonds (fixed income).

Given that, they can be a prudent diversification tool for a conservative portfolio usually skewed to blue chip shares.

But how do investors join the “club”?

Both listed and unlisted private credit funds provide a one-stop exposure to many loans with different characteristics and across diverse industries, thus ameliorating the risk of a single loan exposure.

“A well-diversified portfolio of well-constructed and managed private debt provides an investment portfolio with greater diversification and downside protection,” Lockhart says.

This content was produced in partnership with Metrics Credit Partners.

Originally published as Private credit offers diversification, prospect of higher returns to investors