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What the private credit boom means for investors

Did you know 97% of all businesses in Australia are small and medium enterprises (SMEs)? And did you know the financial gap between what SMEs have and what they would like to spend and invest to grow is approaching $100 billion? More on that in a moment.

Hands: they're the telltale sign of hard work. From bakers to builders, tilers to teachers, and from jackaroos to jewellers, the lines, scars and colour of our nation’s hands tell the story of hard work. And it’s work that has supported families, founded partnerships and built a nation. Our land’s hostile climate, rugged landscape and vast distances ensured it would only yield to hard work. Those hard-working hands are the account of our modern history and the source of our global status.

There are investment managers backing and fueling hard-working Australian SMEs but they’re in an asset class you may not have previously had access to. Formerly the exclusive preserve of family offices, high net worth and ultra-high net worth investors, private credit is fast becoming an important inclusion in the portfolios of almost all Australians who want to support and back hard work.

Previously dominated by big banks

Private credit is one way businesses raise capital. Access to finance is essential for SME growth and unlike private equity, where investors contribute funds in exchange for a shareholding in the business, with private credit, investors provide loans and receive interest payments in return.

It’s an activity said to have been conducted in Mesopotamia, five thousand years ago. And up until recently, it was dominated by the big four banks.

If you ask the Australian Banking Association, they’ll tell you that in 2019 more than 80% of SME lending applications were accepted by banks. According to the ABA, most SMEs that seek access to finance also report they receive it.

According to that same body, in the three months to August 2021, new lending to small businesses jumped 26% from the same period in 2020 to $10 billion. Meanwhile, lending to medium businesses in the three months to August 2021, jumped 49% from the prior corresponding period to $19.3 billion.

Whether hard-working SMEs are being properly and fairly served depends on whom you ask.

Growing funding gap

According to a recent report released by fintech Judo Bank, the funding gap – which is the amount between what SMEs have and what they would like to spend – continues to grow, revealing credit and finance are not available to small businesses at the rate that they would like.

According to Judo Bank’s 2021 SME Insights Report, carried out by East and Partners after surveying 1750 SMEs, the funding gap for SMEs with turnover between $1 million and $20 million in 2021, widened by $4.6 billion, from 2019, to $94.3 billion - an increase of 5.1%. The annual increase in the funding gap prompted one Judo Bank spokesperson to say, “banks have retreated, leaving SMEs out in the cold”.

It certainly suggests there’s a limit to the big banks’ capacity and appetite to provide financing solutions, covering hundreds of customers, tailored to SMEs' individual needs.

Most recently, findings from an RFI Global survey of 4,700 owners and operators in Oceania, revealed 70% of SMEs in the Asia-Pacific were less than satisfied with access to credit provided by their main bank.

When choosing a loan provider or financial institution, the top driver cited by 45% of Australian SME respondents, was competitive interest rates. Perhaps more importantly, however, 77% cited access to funds and flexibility in repayment options.

Where banks might take six weeks to approve a small, short-term loan, many non-bank lenders have enabled technology to approve loans in 24-48 hours.

Think of a wheat farmer, with a record crop, who needs to take advantage of ideal harvesting conditions and a window of only a few weeks. Now imagine, in the middle of harvest, their header breaks down and needs $140,000 of clearly critical repairs. A six-week approval process is simply not going to cut it.

The RFI Global survey revealed Australian SMEs have made it clear, should they require financial support in 2022, they’re less optimistic about obtaining it from their main banks.

Private credit fills breach

Enter private credit, to fill the gap. Growth in this asset class was first driven by institutional investors before capturing the attention of family offices and high-net-worth investors. The continuing growth in the funding gap however has meant there’s more than sufficient demand from SMEs to permit wholesale and retail funds to be established.

And the growth should be welcome. U.S. journal Institutional Investor found private credit funds can lend capital when it’s otherwise unavailable, smoothing the credit cycle and stabilising the market. In anticipation of an economic downturn, banks decrease lending. But private credit funds, being already well-established, can offer credit that banks are unable to. This can keep businesses going, mitigating the severity of a downturn and helping a return to economic normality.

A growing number of private credit funds are being established in Australia. And the returns, even during the pandemic have been alluringly high, stable and regular. The Aura High Yield SME fund, which Montgomery distributes in Australia through a unique partnership, has returned a compounded 9.85%, and monthly income for over five years with no negative months, even during the Covid-19 pandemic when stock markets were collapsing.

What investors should look for

But as with any asset class, not all funds are created equal and there are risks. Investors need to dig deep to uncover how much diversification exists, whether any leverage is being used to boost returns and whether ‘lock-up’ periods exist, preventing investors from leaving.

Investors should first demand wide diversification. A fund with many thousands of small loans arguably offers diversification benefits that a fund with a handful of very large individual loans cannot offer. Similarly, investors need to look under the hood to ensure the loans are indeed to businesses and people they want to support. One fund may offer loans to cattle farmers and chickpea growers, but another may be lending for property development or a management buy-out.

One must also uncover whether lockups prevent an early redemption, which of course might be required when one’s needs and circumstances change. With some, you may not be able to retrieve your money within twelve months or even longer. Look at least for monthly liquidity and no lockups.

Investors should also find out what the average duration of the loan book is. If the average duration is four months, your returns are more likely to follow interest rates as they rise. If the average duration is a year or two, you may find your returns lag any increases in rates.

And finally, be sure to understand the structure. What I want to see, and what you should demand, is alignment between your money and the capital of the lenders who are the businesses originating the loans, processing applications, and providing the finance directly to the borrower. Good alignment sees the originators put their capital and returns at risk first. That way, if there are some defaults and the security that was provided cannot be retrieved and therefore a loss occurs, it is the originator’s returns and capital that are impacted first, offering some initial protection to returns and capital of fund investors.

Private credit is a growing asset class, but it isn’t new. Your bank has been lending to SMEs for a century and now they’re pulling back, opening the opportunity for others. Previously you had to own bank shares to see some of the returns from SME lending. Private credit funds now provide direct access to this income stream and growing asset class. As always be sure to seek and take personal professional advice.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

4 Comments
Paul Rider
November 25, 2022

Roger and Warren, thank you both for the in-depth responses. Most appreciated.

Paul Rider
November 23, 2022

Would the trade-off of higher returns be more risk of loans gong bad? I assume SME loans have a higher % of loans going bad than normal commercial loans? Be interesting to see the bank data on this.

Roger Montgomery
November 24, 2022

Hi Paul, Of course. There is a profound link between returns and risk. It's an immutable investment law. A few years ago I purchased units in an unlisted property trust that owned hospitals leased to the likes of big operators like Ramsay. Healthcare properties have extremely low volatility with very long-term leases. And your tenant tends not to go broke nor move very often. And yet the yield on offer was over ten per cent per annum. I also saw the valuations of the properties were based on higher cap rates than other funds were adopting. I figured there were revaluations coming as well as a great yield. That investment turned out to be a cracker generating total returns of almost 15% for the next four years. If I had ruled it out because the yield was too high and assumed it was too risky, I would have missed out. It is vital to understand the underlying risks and assess them appropriately, and to seek personal professional advice.

Warren Bird
November 24, 2022

I agree with Roger's response to your question, Paul.
However, a couple of things to add.

First, SME loans per se don't have worse credit risk than commercial loans. If an SME is well funded by its proprietor's equity contribution, is well managed, in a good industry, etc and, as a result, has a credit risk rating equivalent to, say, BBB then its probability of default is that same as a commercial loan rated BBB.

One thing that SME loans do have in a risk sense that could make them different is that the information on which the lender bases their credit risk assessment may be less reliable than for commercial transaction. They probably don't use a sophisticated auditor, for example, and may not have the same standard of book-keeping as a more corporate enterprise. Having a part-time external accountant isn't the same as having an in-house finance officer.

That in turn could mean that, if they do go into default, you will find that the loss you realise is larger than for a corporate entity that defaults. EG there may be fewer buyers willing to take over the SME's business than with a corporate entity, reducing the sale value you could realise if you need to pursue that avenue of capital recovery.

These sorts of considerations could mean that, even though you assign the same credit risk rating to the SME loan, you might want to charge them a higher interest rate to cover the risk that there's been more mistakes made in the information they've given you.

That's one of the reasons that one of the longest standing private debt fund types - commercial mortgages - relies so much on having security over a saleable property behind the transaction. Those funds - and I've overssen the teams that have managed some of the largest non-bank commercial mortgage portfolios in the country in my time - do as much work as they can on the quality of the borrower and their tenants, but at the end of the day property security is vital because you are dealing with entities that don't always keep great records!

Even more important in response to your question is my oft-repeated mantra about the importance of diversification. One SME loan on its own is many times more risky than a hundred SME loans to businesses in different industries and locations. That one loan might pay you an interest rate that's, say, 4% higher than a term deposit, but if it goes sour then you may earn nothing. But a portfolio that pays 4% more than a TD will at least still pay 3% more if one loan goes bad.

This is why it's important to use an investment vehicle that can diversify properly and has the resources to keep an eye on all the different SME's to which loans have been made, pulling them into line in their business if necessary. I've personally known too many people who lose a big chunk of their life savings because they try to do it on their own, through their solicitor or accountant, or whoever, and they just haven't managed concentration risk at all well.

A diversified portfolio paying the same yield as the individual loans in the portfolio is still paying that same yield, but it's a much less risky investment. The old saying that diversification is the only free lunch left has some truth to it.

There are other risk factors to look at, but hopefully this gives you the gist of how to think about this kind of investment.

 

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