Private Credit: An Australian Perspective

The Australian private debt market reached $133 billion at the end of 2021, up by $100 billion over five years. While private credit is growing, the asset class is not widely understood by investors. Simply put, private credit is non-bank lending provided to private, sponsored and public companies; the debt is not issued or traded on public markets and as such benefits from an illiquidity risk premium, which can help

Quarterly Insights: Q3, 2022

Private markets globally are at an all-time high, with US$10 trillion in assets now invested in the sector, representing a five-fold increase since 2007.1

Within private markets, private credit has shown considerable growth over recent years. The Australian private debt market reached $133 billion at the end of 2021, up by $100 billion over five years.

The expansion of private credit markets has been fuelled by a harsher regulatory environment for banks, both locally and globally, in the years following the global financial crisis. As banks tightened their lending criteria in response to tougher regulations, business borrowers sought alternative sources of funding. This created opportunities for private investors to offer financing options tailored to borrowers’ needs, with terms and conditions favourable to delivering attractive risk-adjusted return to the investor.

Now, with inflation and interest rates rising – to the detriment of returns on traditional fixed income securities, but to the benefit of segments of the private credit market – investors are likely to increasingly seek out opportunities in private credit.

Even following its recent expansion, the Australian private credit market is still in its infancy. Trends overseas suggest the market here in Australia has the potential for ongoing growth in the short to medium term.

Why private credit?

While private credit is growing, the asset class is not widely understood by investors. Simply put, private credit is non-bank lending provided to private, sponsored and public companies; the debt is not issued or traded on public markets and as such benefits from an illiquidity risk premium, which can help to drive investor returns.

Private credit offers several potential advantages. For instance, it can:

  1. Generate a consistent income stream underpinned by the contractual obligation of interest payments between borrower and lender;
  2. Provide exposure to a market that has historically been difficult to access;
  3. Deliver a low correlation with equities and related asset classes;
  4. Provide access to the lowest risk part of the capital structure, where – as a senior secured lender – the investor can benefit from terms and conditions such as security and covenants;
  5. Offer defensive protection from inflation if cash rates are increased, given their typically floating rate nature.

 

Another feature of private credit investment that may benefit investors is that it is possible to be highly selective in investment decision making, with the ability to select assets from a wide funnel of private transactions and choose the best ones for their fund. For example, the Roc Private Credit Fund was established specifically to identify and take up private credit opportunities in businesses in Australia and New Zealand that have a proven track record in delivering consistent returns and are considered to have strong risk-adjusted investment prospects.

Transactions are negotiated between the borrower and lender and include numerous protections to the lender such as security, covenants and other terms and conditions that make private credit more defensive than other forms of investments.

An inflationary environment

After more than a decade of low inflation, the major global trend in 2022 to date has the been the return of inflation. The cash rate, which increased to 2.35 per cent in September, is now at its highest level since December 2014 and is poised to increase further as the Reserve Bank of Australia (RBA) seeks to lower inflation, which is forecast to hit 7.8 per cent by the end of 2022.2

Rising cash rates are pushing up the Bank Bill Swap Rate (BBSW), which is the benchmark rate for pricing much of the Australian dollar debt market, including corporate debt.

The three-month BBSW is now at its highest level since 2015 – above 2.6 per cent – having increased from below 0.1 per cent at the start of 2022. Markets are pricing in the high likelihood of continued rate rises into 2023 as illustrated by the rising yield curve for long-dated swaps, which reflect the market’s anticipation of BBSW at certain points in the future. The current one-year BBSW swap rate – which is essentially the market’s expectation of where BBSW will be in one year’s time – is at 3.3 per cent, having been near zero 12 months ago.3

As the below chart shows, interest rates are not anticipated to come down anytime soon.