SQM Research has placed the private credit sector on ‘watch’, in response to increased issues being identified by financial regulators, ASIC and APRA. Here’s why.
A ‘watch’ issued by SQM Research means they are increasing their active monitoring of the sector and have adjusted their ratings scoresheet to place a greater emphasis on governance.
The hugely popular private credit funds pool money from investors and then lend it directly to businesses or property developers, usually at higher interest rates than what the banks are offering.
Unlike traditional bank loans, private credit loans don’t come from deposits but from capital raised by the fund. It’s a structure that allows for much more flexibility for borrowers, while investors have the chance to earn much higher returns.
What’s great about private credit?
The appeal of private credit is simple: you’re lending your money at a higher interest rate, which means a higher return. While term deposits might have a fixed rate of 4 per cent, private credit is returning up to 10 per cent or more. That’s a big difference, especially when compounded over several years.
What’s the worry?
While SQM Research expects the bulk of its existing ratings to not be impacted by this watch, it is not ruling out downgrading or discontinuing to recommend some funds over the next 12 months. SQM Research has current ratings on approximately 70 private credit funds, covering both retail and wholesale funds, representing approximately $33 billion of funds under management.
The issues SQM Research is worried about include:
- Lack of transparency on who borrowers actually are.
- Questionable categorisation of asset holdings (illiquid/liquid/fixed income/convertible equity/equity).
- Lack of transparency on sub fund holdings.
- Lack of transparency on group financials.
- Highly leveraged balance sheets.
- Overall inadequate disclosure within information memorandums.
- Information memorandums that give too much latitude to the manager in terms of asset allocation weights.
- Elevated loan-to-value ratios, calculated on end of completion developments.
- Vertical and horizontal-related party structures that may give rise to a conflict of interest.
- Increased loan arrears and an increasing frequency of refinancing of existing loans that were scheduled to be exited.
- Sizeable interest rate margins not being passed onto investors.
- Lack of independence at board/investment committee level.
- Dubious marketing strategies involving advisers.
- An increasing number of products being offered with a mismatch between stated liquidity and the underlying liquidity of the loan assets.
SQM Research stresses these issues are not endemic within the sector but do appear with more frequency within wholesale funds and in particular, newer fund products offered to the market.
So, while returns from private credit funds look attractive, be careful about the fund you invest in.
