Private debt is an attractive asset class - some funds are spoiling it for everyone

Medium-term forecasts paint a picture of an Australian investment landscape ridden with high inflation and equity market volatility. Private debt funds are an attractive proposition in these circumstances. But some fund managers are giving them all a bad name.

The RBA is expected to implement up to two additional cash rate hikes this year, with some easing of rates anticipated in 2024. Broader economic uncertainty is compounding investors' concerns.

Investment in private debt is emerging as a popular strategy in this environment. Investors are attracted to private debt's stable returns, high degree of capital protection, and ability to yield income that exceeds inflation.

However, as this nascent sector grows, investors have reason to be cautious.

Negative sentiment about the asset class is brewing, particularly as economic pressures begin to bear down on what seemed until now to be an unendingly reliable source of returns. This is largely thanks to some private debt fund managers who have allowed themselves to become opportunistic, instead of prioritising the interests of their investors.

Why is private debt attractive?

Loans - especially to well-run businesses with clear growth opportunities - are a compelling opportunity to escape the volatility of the listed asset market.

They can also offer real returns above inflation, with floating interest rates structured as a fixed margin above a benchmark for the cash rate.

Of course, no investment worth its salt is without risk. Particularly, corporate loans carry the inherent risk of the borrower's business becoming unable to meet its financial obligations or even facing insolvency.

Some loans are riskier and thus more expensive for the borrower, offering a higher risk-adjusted return for the debt investor.

One would expect that the risk appetites of individual investors would be an important consideration for private debt fund managers when they offer these investments. Therein lies the rub - some fund managers are less clear about the risks to which investors are exposed, and some are benefitting from this opacity.

Risk in private debt

The risk of a debt instrument broadly depends on two things: the lender's priority as a creditor in the event of default and the quality of the assets over which the loan is secured.

The least risky loans are those that hold "senior" creditor status should a borrower become insolvent. In the event of the borrower's assets being liquidated, senior creditors are the first to receive repayment. As we descend the creditor hierarchy, the risk associated with the loans increases: second-ranking creditors are paid second, and so on. The lower the ranking, the greater the probability that the proceeds from the liquidation of the borrower's assets will not cover the debt owed to the lower-ranking creditor.

The least risky loans are also those secured over a borrower's real assets, such as immovable property, equipment, and receivables - assets that retain value even if the underlying borrower business is in decline. Loans can also be secured over intangible assets - like the business's IP or underlying equity - but this is a riskier scenario as they are unlikely to offer a meaningful realisable value in a default scenario. The riskiest loans are unsecured.

What's wrong with Aussie private debt funds?

A select few funds in the Australian market are mandated to only write loans within a strict prescribed framework - e.g. only loans that are senior-ranking and secured over real assets. This practice is far from ubiquitous, however. The more common strategy is to have a broad mandate that permits the manager to lend across the different creditor-ranking levels and security types.

This could be deemed a legitimate strategy. The problem arises when private debt funds are opaque in their messaging such that uninformed investors believe they are taking on a lower degree of risk than in reality. An even greater problem arises when fund managers pocket a part of the proceeds of their investors' higher-than-expected risk exposure instead of passing these benefits back to the investor.

Private debt fund mandates disclose an absolute, fixed target return for the fund. While some mandates may disclose a preference for senior-ranking and secured debt, they often permit some degree of leeway in funding loans across the risk spectrum.

This is problematic as it may allow a fund manager to deliver a fixed target return by taking risk across the credit risk spectrum.

Consider an example in which a fund is mandated to deliver a target return of 10% p.a. They could choose only to invest in low-risk loans that deliver 8-10% p.a., or they could skew toward higher-risk loans and deliver a net return of 15% p.a.

These private debt managers are incentivised to pursue the latter strategy because it permits them to meet their target return and generate a "performance fee". Hardly in the best interests of their investors, these few managers do not disclose sufficient information on their underlying loan book to permit investors to determine if they are receiving an adequate return for the underlying risk.

This is not where issues with opacity in mandates end. While most investors are aware of the disclosed "management fee", the small print of some mandates permits fund managers to share directly in the income generated from borrowers in the form of upfront "arranging" or "establishment" fees.

Consider this example. A private fund manager, who has a 1% management fee, finds a borrower for her fund that seeks to pay 14% p.a. for a 1-year loan. The manager structures the loan to have a 3% arranging fee and an 11% p.a. interest rate. She then discloses to investors that she has structured a loan paying an 11% p.a. in interest rate. The hapless investor earns a net return of 10% (14% less 1%) while the fund manager earns 4% (3% arranging fee + 1% management fee). While this is technically in line with the mandate, it risks investors receiving a materially lower return for the level of risk exposure.

Finally, investors are increasingly frustrated about the lack of transparency in private debt fund managers' investor reporting. Portfolio data is often only reported at a group level. This prevents investors from seeing the impact of the practices outlined above, and the underlying risks accruing to them.

What is to be done?

For private debt to become a credible long-term investment option, fund managers need to be committed to the levels of transparency that have become industry standard with mature asset classes like listed equity funds.

Funds could also elect to constrain themselves with straight-jacketed mandates that restrict them to certain types of loans - senior-ranking, real-asset secured loans, for example. This would offer investors confidence that the target return pursued by the fund is generated from a specific risk profile - one that is appropriate to the size of the target return.

Finally, investors should always demand to know as much as possible about their investments - as is their right. If the funds they have chosen put up resistance when this information is sought, it is fair to ask - why?