5 key lessons in private credit lending
In today’s dynamic financial landscape, private credit has emerged as a pivotal component of the investment ecosystem. As traditional banks retreat from certain lending markets, private credit funds have stepped in to fill the void, offering tailored financing solutions to a diverse range of borrowers. However, the success of these investments’ hinges on rigorous credit analysis and disciplined investment approaches.
‘Private credit’ encompasses a range of lending strategies provided by non-bank lenders via bilateral loans or small club deals. Borrowers are typically highly leveraged, have a higher risk of default and as a result, do not have access to more traditional forms of debt capital via bank debt or public bond markets. This broad classification includes various sub-asset classes, each with its own set of risk and return characteristics. Private credit is typically unlisted, illiquid, and unrated, introducing challenges for effective risk management and oversight. Information asymmetries abound, and instruments are mainly variable rate, in contrast to their fixed-income securities counterparts like bonds that provide a fixed coupon rate, are externally rated and can be traded in public markets.
Credit analysis is the cornerstone of private credit investing. It involves a thorough assessment of a borrower’s financial health, including their ability to repay the loan, the quality of their collateral, and the strength of the structures including lender protections. This process is critical in identifying potential risks and ensuring that the investment aligns with the fund’s risk and return objectives.
As non-bank lenders and superannuation funds expand their investments into private credit, in this latest article we look at the lessons learned by the banks when they expanded into higher risk credit lending. Private credit funds and Superannuation Trustees should examine their practices incorporating the lessons learned from previous periods of heightened lending defaults and losses in investment frameworks and practices.
1. Everyone apparently uses cashflow analysis techniques
A deep understanding of actual and forecast cashflows generated by the underlying operating business or assets is fundamental to determining the ability to service debt obligations. We have only seen this done well at a handful of lenders. The firms or teams that espouse philosophies of cash flow lending typically use earnings-based measures in their analysis rather than analysing the capacity of operating cash flows available for debt servicing.
The resilience of structures and the sizing of leverage is heavily dependent on thorough and well documented scenario testing. We often hear about the application of severe but plausible scenarios; however, this is subjective and has built-in biases of the team originating the transaction. The use of breakeven and worst-case scenarios represents better practice to identify and address sensitivities in the financial and operational models of borrowers. For example, a minor decline in profit margins can have a material impact on operating cashflow available to service its debt commitments. When performing a postmortem of problem loans, we often find that these loans relied on optimistic projections at origination including making a directional play with unpredictable timeframes, costs and rates of sales or price assumptions to maintain forecast profits.
2. Equity risks for debt returns
Many problem loans have characteristics with tenors that are longer term, higher risk however earning a relatively low return. Many private credit loans will often contain equity-like risks but provide investors with limited upside (i.e. with a loan the best you can do at its expiry is to be repaid in full).
Examples of equity-like risks in lending exposures, include:
- providing leverage against the value of personal and private corporate guarantees and these typically became worthless when defaults occurred;
- portfolio allocations and deal sizes grew significantly whilst underlying asset prices peaked or had already started to decline, with the underlying profitability of the new businesses and assets financed small relative to the risk in the portfolio. It is important to remember that when market competition heats up, risk increases and returns fall. It is only disciplined lenders who are not prepared to follow the market into inadequate returns for risk; and
- Structures that only worked with assumptions of sales growth, margin expansion, and/or underlying asset prices continuing to grow throughout the life of the exposure. We often find that the risks associated with these assumptions were not fully transparent and understood at origination in the credit assessment nor adequately considered and challenged in the decisioning process at the credit / investment committee.
3. The race to lend offshore
Many superannuation funds are undertaking lending offshore (distant from head office) and in new markets. The Australian Major Banks’ offshore lending experience has been poor. The banks failed in their multiple attempts to fully appreciate the expertise required and risk culture challenges when expanding portfolio sizes rapidly in new overseas markets. Examples include the experiences of ANZ and NAB in structured credit markets in the US and Europe, and Macquarie Bank’s real estate business in the US prior to the GFC. Australian banks expanded lending in these segments at the worst time, at the peak of the markets, often participating / taking risks from the local investment banks that were selling downing their exposures / taking risk off their books.
When these exposures got into trouble, it was only then that many Australian lenders learnt that they did not fully appreciate the relevant legal systems they were operating in despite having local on the ground experienced staff, did not identify that asset prices in underlying markets had peaked and were starting to get into trouble, and the idiosyncratic risks associated with particular industries that were different to similar industries in Australia.
Another cause of failures from rapid offshore lending growth has been misalignment of risk cultures with the experienced local sales staff originating transactions offshore and head office in Australia with limited local experience and knowledge of the offshore markets or having relatively junior Australian risk staff located in offshore locations. This resulted in financial institutions not sufficiently questioning what they assumed, and what they didn’t know and needed to.
4. Who is best positioned to manage the exposure when it gets into trouble?
We have seen situations where teams that are geographically distant from head office withhold or obfuscate information with regards to problem credit, sometimes with the belief or mindset that they can manage through the problem.
We have also found that the mindset and expertise of a loan originator is different to an experienced workout professional, especially when shifting from a relationship mindset focused on new origination to a recovery mindset to minimise loss. This may result in asset valuations that do not reflect the underlying fundamentals of loans, biases built into the provisioning assumptions, and problem loans are not proactively identified and managed as early as possible to maximise recoveries.
Greater independence of managing problem loans away from those that originated the transaction reflects better practice. This is also recognised by APRA with the requirement for an independent workout function in APS 220 Credit Risk Management.
5. Conflicts of interest exist and appear in different forms
Private credit lending introduces several potential conflicts of interests. These appear in a number of different forms that all lenders should be aware of and manage. The key types of arrangements where conflicts arise include:
- partnership arrangements (such as joint ventures, separate funds, multitrack syndications, origination agreements) with investment banks / arrangers guaranteeing deal flow. In these situations, financial incentives are not aligned. Investment banks are in the transportation business (underwriting and selling exposures off their balance sheets) whereas superannuation funds and other private credit funds are in the storage business (the investment is held on balance sheet to maturity or repaid when a refinancing event occurs). How independent is the decision-making process of the fund to ensure that it does not become a “stuffie” vehicle of the originator?
- investing in different positions in the capital stack. The interests of debt investors and equity holders in the same company diverge significantly. Conflicts can arise as a result of the different rights that give them a degree of control over the borrower. Important decisions to provide additional debt vs additional equity capital, waivers or amendments to covenant breaches, capital expenditure investment decisions and taking enforcement action are but a few examples. Where a company is in financial distress, debt holders may end up having to take enforcement action at the detriment of equity being written off. How will these conflicts of interest be managed?
- Financial incentives of investment staff and the adequacy of structures to ensure alignment to the outcomes of investors. Conflicts in reward structures could include targets to grow funds under management targets vs measures that are based on the performance of the investments in the fund or risk-adjusted measures.
Better practice is to deploy structural measures in investment governance structures to address these risks. These can include mandate restrictions, committee and incentive structures. Experience and capability of credit investment and valuation committee members also plays an important role in identifying and managing these risks.
The case for independent credit assurance goes beyond your governance structures
Whilst lenders remain on alert, could alert fatigue set in and desensitise lending and risk staff, leading them to miss, ignore or rationalise signs that risks are building and not act at the worst point in the credit cycle? How confident are executives and boards that latent risks and blind spots are not growing in their portfolios?
Despite credit risk management being a well-established practice (compared to some of the newer risk types), there are often cases of lenders with high conviction and confidence in the quality of their lending practices and controls during periods of benign conditions (low default history) eventually being caught out when conditions deteriorate, and significant losses eventuate. In these instances, material weaknesses were identified when it was too late.
We often find that internal Line 2 credit portfolio reviews reflect built-in biases of the organisation or have approaches that require enhancement. Line 3 independent reviews often take an audit or process-compliance approach to credit risk management rather than identifying and challenging the underlying assumptions in the way credit risk strategy, appetite and portfolios are constructed and whether credit approval and exposure management are truly effective. The weaknesses are only identified and realised by leaders and boards after the losses start coming through the door. Lenders will need to continue to ask themselves whether they are being rigorously challenged about the quality of their credit risk management practices.
How Rhizome can help
Rhizome offers a comprehensive suite of risk management services designed to address the complexities and challenges of private credit investing. Rhizome helps financial institutions:
- Portfolio deep-dives: providing senior executives, investment committees and boards with portfolio insights and assessments of lending practices, identifying potential risks and areas requiring enhancements.
- Lending credit culture assessment: facilitate the alignment of risk cultures between local sales staff and head office management, ensuring cohesive risk management practices across geographies.
By partnering with Rhizome, financial institutions can navigate the complexities of private credit investing with confidence, ensuring disciplined practices and robust risk management strategies are in place to achieve sustainable returns.
In conclusion, private credit offers substantial opportunities, but it requires a sophisticated approach to risk management. By learning from past market dislocations, applying rigorous credit analysis, and maintaining disciplined investment strategies, risk officers and directors can navigate the complexities of private credit investing successfully.
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