Mark to market: How to interpret ASIC’s damning report on private credit
Mark talks with Morningstar Investment Management’s Asia Pacific CIO Matt Wacher about private credit.
Question:
I spent some time with the members of the Australian Shareholders Association inner-west Sydney chapter last week. It was day the ASIC report on private credit came out and I received several questions from members.
The summary is many investors have turned to private credit as a source of income given APRA’s ban on bank hybrids. These investors were concerned about ASIC’s findings and what that means for their portfolios.
Answer:
Private credit has been a frequent topic of conversation in the media over the last few months. US private credit funds First Brands and Tricolor both collapsed in October prompting JP Morgan CEO Jamie Dimon to state “when you see one cockroach, there’s probably more” in reference to US credit conditions.
These credit concerns are echoed in a recent report from Morningstar DBRS. Just under 30 percent of the approximate 400 middle market borrowers the credit rating agency rates are under financial stress.
In Australia ASIC released a long-awaited surveillance report on private credit identifying issues with hidden customer fees, misleading marketing and questionable valuation practices. ASIC chairman Joe Longo speaking to the National Press Club warned that industry practices were “rather unattractive and close to illegal.”
Understandably investors are scrutinising the asset class including the Australian Shareholder Association members. I’ve been vocal on my view of private credit but wanted to gain some additional perspective. I sat down with Matt Wacher the Chief Investment Officer, Asia Pacific for Morningstar Investment Management to get his view.
How investors should think about private credit
For context, Matt and his team run multi-asset portfolios for their clients which include investments in private credit. I asked Matt to provide some context on the asset class and the current conditions.
Matt stressed that private credit is among the riskiest types of credit available to investors. It is analogous to high-yield or junk bonds which distinguishes it from high quality government bonds or investment grade corporate bonds. Private credit is not equivalent to a hybrid from a credit risk perspective. Private credit resembles the risk profile of shares more than bonds.
As a multi-asset investor, Matt and his team are constantly comparing the relative attractiveness of a variety of asset classes. They do not see private credit as attractive currently. A key component of investing in any type of debt like private credit or bonds is the credit spread.
A spread refers to the differences in interest rates between different types of credit. The spreads represent how much an investor is getting compensated for taking on the higher risk of a borrower not paying back their loan. Currently the spreads on private credit are historically low which is why Matt and his team don’t view private credit as attractive at this time.
How to approach private credit
Matt stressed the importance of finding the right private credit managers. When investors are not being excessively compensated for the higher default risks of less credit worthy borrowers an investor needs to consider a manager’s ability to deal with downside risk.
In plain English this means a manager may have to seize the assets of a borrower and get the best possible outcome for investors. This could turn a private credit manager into a de-facto private equity manager for a portion of their loan book.
Despite the concerns raised in the ASIC report Matt is confident that his team’s due diligence process can identify strong managers. He isn’t as confident individual investors can assess the relative merits of different private credit investment opportunities.
To quote Matt, “Perhaps what this points to is not that Private Credit or investment managers in the space are all bad, but it is that it is probably a space for more sophisticated investors rather than retail.”
My conversation with Matt reminds me of one of the foundational tenants of investing that is too-often ignored – if you don’t understand something, don’t invest in it.
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