The potential risks of private credit investments

By Tony Kaye, Senior Personal Finance Writer

Investing Strategy

Investors considering private credit income products should closely assess the risks.

It sounds like an investment opportunity that’s too good to miss.

Earn double-digit annualised return, with income paid monthly. At least that’s how some private credit providers are pitching their products to attract investors eager to capture high investment returns.

Private credit, also regularly referred to as private debt, and sometimes as shadow banking, is a booming sector, not just in Australia but around the world.

So, what exactly is private credit? In very simple terms, it’s capital that’s raised from non-traditional lenders and lent to borrowers.

The investors providing their capital receive interest payments via the credit providers in the same way that banks providing home mortgages receive regular interest payments from borrowers.

Accessing private credit as an investor is relatively easy. Many private credit providers have specific private credit funds, which are directly accessible through them. Some private credit providers also have funds listed on the stock exchange, which investors can buy and sell in the same way as shares.

Financial services group EY estimates the size of the market in Australia was $188 billion at the end of 2023. Globally, the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the financial system, has put the number at around $95 trillion.

 

Private credit risks

The main attraction of investing in private credit is the potentially higher investment yields on offer relative to higher quality, traditional fixed income funds.

But higher returns usually involve higher risk. In the case or private credit, the risk is often in the creditworthiness of the borrowers (their ability to meet interest and debt repayments when they are due). According to the International Monetary Fund in an April 2024 report, private credit borrowers are typically highly leveraged medium-size companies.

Some borrowers use private credit as a top-up measure to supplement loans already in place with banks or other financial institutions. However, in other cases, the borrowers using private credit providers are unable to access funding from mainstream lenders.

Due to the additional risk, the lending rates charged by private credit providers are generally substantially higher than bank lending rates.

So, a key risk for the investors in private credit funds is the increased possibility of a loan default, especially if a fund has loaned capital to a single company or a project, such as a commercial or residential property development.

In many cases the investors in private credit funds do not have a clear view of where the fund is lending their money. In fact, some private credit products are being marketed as income funds without even specifying to investors that they are providing private credit.

Private credit funds are also known for charging high fees, with many charging a loan origination fee to the borrower and ongoing portfolio management fees to investors.

As such, it’s important for investors in private credit funds to fully understand the fees they are being charged as well as the loan interest rates being charged to borrowers and the profit margin being received by the private credit provider.

A key risk for the investors in private credit funds is the increased possibility of a loan default, especially if a fund has loaned capital to a single company or a project.

Concerns by regulators

Private credit providers essentially offer loans in a similar way to banks. Yet they are not subject to the strict prudential regulations that are imposed on banks and other financial institutions.

Last week the chairman of the FSB, Klaas Knot, warned G20 officials that regulators had not done enough to tackle the dangers created by the growing shift by borrowers away from the supervised banking system to non-bank financial intermediation (NBFI).

“Recent incidents of market stress and liquidity strains have demonstrated that NBFI can create or amplify systemic risk,” Knot said.

Around the same time, Australian Securities and Investments Commission (ASIC) chairman, Joe Longo, expressed concern that the investors in private credit funds may not be adequately protected.

Indeed, he said that ASIC has set up three taskforces to look into the need for regulating the private credit sector.

“We have to come up with actionable policies or ideas as far as regulation is concerned,” Longo said. “The very nature of private markets is a lack of transparency … what we are worried about is protection of investors and integrity of the market.”

One of the key challenges for regulators is to devise rules and standards requiring private credit lenders to hold enough liquidity to cover key risks, such as when a borrower defaults or when investors seek to recoup their capital.

Raising the capital requirements of private credit providers could limit their capacity to expand into risky lending activities.