Australia’s private credit market is estimated at A$200 billion. However, it can be challenging to navigate like most markets. In this article, we provide a list of key elements that you must consider in order to better understand and navigate the Australian private credit market. While it is not an exhaustive list, it provides a starting point for novices.
1. Attractive Risk-Adjusted Returns
One of the primary attractions of private credit investing is the potential for attractive risk-adjusted returns. Private credit transactions can provide enhanced returns above those of public markets, with yields typically ranging from 8% to 12%. This yield premium compensates investors for the increased risks associated with lending to borrowers who may have lower credit ratings or less stable financial profiles. Moreover, private credit has historically delivered annualised returns of around 8% to 10% since the global financial crisis, outperforming traditional fixed-income assets such as high-yield bonds and leveraged loans. This performance highlights the potential of private credit as a stable income-generating asset, even during economic downturns.
2. Diversification Benefits
Incorporating private credit into an investment portfolio can provide significant diversification benefits. Private credit typically exhibits a low correlation with traditional equity and bond markets, which can help reduce overall portfolio volatility. For instance, the correlation of private credit returns with Australian equities is approximately 0.3, suggesting that private credit can act as a stabilising force during market fluctuations. Additionally, private credit investments can be tailored to meet specific risk-return profiles, allowing investors to create customised portfolios. This flexibility enables investors to blend various private credit strategies, such as direct lending, mezzanine financing, and distressed debt, to achieve their desired investment outcomes.
3. Illiquidity and Leverage
Investing in private credit comes with inherent risks, primarily related to illiquidity and leverage. Private credit investments are typically illiquid, meaning they cannot be easily sold or exchanged for cash. Investors should be prepared for a long-term commitment, often locking up capital for several years. Leverage is another critical component of private credit investing. Investors often use borrowed funds to amplify their returns, allowing them to control larger investments than they could with their capital alone. While leverage can significantly enhance returns, it also increases the risk of losses in the event of default.
4. Manager Selection and Due Diligence
The success of private credit investments often hinges on the expertise of the fund manager. Investors should conduct thorough due diligence to identify experienced managers with a strong track record, as the performance variance among managers can be substantial. A manager’s ability to navigate economic cycles, including in workouts of impaired loans, is an important indicator of their competency. Additionally, investors should be aware of potential conflicts of interest, such as the treatment of origination fees and the valuation process. Transparency and good governance are crucial when assessing a private credit manager.
5. Market Growth and Opportunities
The Australian private credit market has grown considerably in recent years, driven by several factors including changes to bank lending practices and regulations, as well as increased borrower awareness of the opportunity in private lending. The market is still in its early stages of development compared to other regions such as the United States and Europe, presenting significant growth potential. While the current environment presents a compelling opportunity, investors should be mindful of the potential risks associated with the asset class. Appropriate manager selection is critical to protect investors in the event of an economic downturn, when performance will likely diverge between managers.
Private credit investing offers Australian investors a compelling opportunity to enhance portfolio returns, diversify holdings, and reduce exposure to traditional markets. However, it is crucial to recognise the inherent risks, such as illiquidity and leverage, and to select skilled managers with proven track records. As the private credit market grows, staying informed about market conditions, borrower profiles, and investment strategies is key to maximising potential returns while managing risks effectively. With the right approach, investors can position themselves to benefit from the evolving landscape of private credit in Australia.
