Our guest author today is Patrick William from Rixon Capital
The Australian private credit sector has seen substantial growth over the last 5 years, with a host of investment opportunities emerging for investors seeking exposure to this relatively nascent sector.
Funders offer prospective investors impressive headline target returns and apparently generous security cover. However investors should be aware of the underlying risks in this otherwise attractive asset class.
This article intends to act a primer for investors considering an allocation to this sector and is by no means a comprehensive guide.
Firstly, let us consider the most attractive by-line of any fund – its return targets.
Most of us understand the rule of thumb that the higher the return, the higher the risk. However, do we understand the different types of returns?
Simplistically, a fund that receives and pays cash interest regularly reflects a lower risk. The borrower is under constant pressure to ensure it can service its debt obligations and the lender is obliged to actively monitor borrower performance to ensure regular payments are forthcoming. As a bonus, investors benefit from a regular income stream.
A fund that permits the capitalisation of some or all interest is arguably a higher risk. Capitalising interest indicates a borrower without sufficient (or any) cashflow to pay cash interest. Therefore, the repayment of the loan and accrued interest is dependent upon the ratio of the future value of accrued debt to the future value of the underlying asset being lower than today. The risk underlying this lending is the quality of the valuer who assessed the potential future value of the project, and the possibility that changing variables over time reduce the end value of the underlying asset. These loans are common in the property development sector, and the risk of rising interest rates, scarcity of construction inputs, and lower immigration are beginning to put pressure in this niche. Investors should consider the profile and track record of the underlying lender to gain comfort they have strong debt underwriting policies.
Next, let us consider security. While the phrases below are attractive on their own, the reality is that each phrase in the order below reflects a worsening risk profile.
1st ranking senior secured over real assets > 1st ranking senior secured > senior secured > secured
The first is the best risk. It means investor capital has been lent against collateral with realisable value, and that the investor ranks first in line to monetise that collateral in the event of default.
The second may mean investor capital ranks first in line, however it may not be secured against collateral with an easily realisable value – perhaps secured over the equity of the business. Arguably in an event of default, the value of that equity would be substantially impaired, offering at best partial recovery of investor capital.
The third may imply that while investors funds are secured, they may rank behind another lender who will control the realisation process in the event of default, while other debtors wait in line for any residual assets.
The fourth provides very little information and without further detail does not instil confidence.
So there you have it - your primer to investing in debt. The authors advice to prospective investors is to ask questions and seek professional advice.