Australian private debt: Risk is in the manager, not the market

The Australian Private Debt Market has exploded onto the scene of the domestic fixed income universe and now accounts for almost 15% of all corporate lending. Amplified by rising interest rates, investor demand has been robust with up to double-digit returns akin to the ASX200 but with greater capital stability.

This has provided significant benefits for investor portfolios in terms of both income and diversification, particularly in an asset class dominated by bank and government-related issuers. However, we argue the risk profile of private debt can be often misunderstood, reflecting the lack of leveraged borrowers in the Australian fixed income universe historically.

The Australian private debt market has now revolutionised this opportunity set, providing access to leveraged borrowers that have been previously locked up on the balance sheets of Australian banks. This has widened the credit spectrum to riskier borrowers and defaults will be ultimately a normal feature of the market. However, the historical performance of Major Bank corporate lending suggests that for defaulted exposures, impairments are relatively low, and recovery rates are relatively high.

We therefore argue that the real risk for investors is determined by the quality of the asset manager rather than the market itself, with robust processes around risk management and governance as key determinants. BondAdviser’s Alternative Investment Fund Research Methodology encapsulates this due diligence process and aims to provide investors with a transparent and in-depth understanding of product risks.

Loan valuation policies, co-investment and risk transparency all remain at the forefront of global regulatory agendas to improve the oversight and quality of managers. We view this as a positive evolutionary step and will be necessary for the Australian private debt market to reach its full potential.

Defaults are a normal part of leveraged borrower markets

Defaults have been a long-standing characteristic of leveraged borrowers. While the Australian private debt market is still arguably in its infancy, historical global data in Figure 2 illustrates this credit risk. This shows the average transition in credit quality (defined by credit rating in this instance) over a 3-year period (a typical term for a private loan). We note this includes the global universe of S&P-rated borrowers over 1981-2023.

Leveraged borrowers within the Australian private debt market typically have sub-investment grade credit quality. This corresponds to an implied credit rating equivalent of BB, B or CCC/C, of which there was a default over a 3-year period, 4.3%, 15.8% and 59.0% of the time, respectively, according to the data. 

In contrast, higher-rated borrowers (typically constituting Australia’s public bond market) had a negligible experience of default over this time period. In other words, managing default risk historically has been relatively simple task in the domestic fixed income market. 

Loans to Australian leveraged borrowers have exhibited high recovery rates 

One way or another, Figure 2 shows the Australian private debt market is going to experience defaults. While this exposure can be cut in public markets through standardised secondary trading, risk mitigation for a private lender is put in place at the start of the loan through explicit and customised documentation outlining conditions regarding control, restrictions and security. This means that if a borrower does default, then the lender can have various avenues to either recoup capital or continue the agreement at even more attractive terms.

There has been a lack of data from Australian private debt participants to validate this process. However, our analysis of extensive regulatory filings from the Big Four Major Banks exhibits a high recovery rate for corporate loans. We are specifically referring to the non-performing exposure (NPE) and actual losses from corporate lending:

• Non-performing corporate loans have been a small minority: The leveraged corporate lending book of the Major Bank is approximately $417 billion, and heavily weighted to higher-quality BB borrowers (~88%). As a result, non-performing corporate loans have been a small minority over the past decade, accounting for approximately 3% on average of the Major Banks’ total exposure to leveraging borrowings.
• Non-performing corporate loans are not always impaired: Non-performing exposure (NPE) represents loans that are overdue (by 90 days) but are only impaired (below par) when the bank considers it is unlikely to receive full repayment. While this can be volatile, between 25-75% of the Major Banks’ corporate NPE is not impaired. This implies a high rate of capital recovery for many defaulted corporate loans (NPE).
• Realised losses have been limited in a worse-case scenario: For loans that have been impaired, actual losses are usually limited by the underlying security and/or other work-out scenarios (cross securitisation, trade sale etc). There is a lack of granular data here, but we utilise the ratio of realised losses to average NPE as a proxy. For the Major Banks, this has been less than 10% recently but we view 15-25% (2014-18 levels) as a more relevant measure given it was prior to the rapid expansion of the private debt market. 

It all comes down to the Manager 

The successful management of leveraged borrower default risk by the Major Banks comes down to two main factors, 1) diversification, and 2) robust processes. For the Australian private debt market, diversification is a function of fund design and/or maturity while process is a function of manager skill, expertise and governance. This is particularly important in the context of the private debt market’s early stage of development, which is yet to be faced with a material credit cycle downturn.

Relative to other asset classes, we argue downside protection is even more important in the case of private loans due to, 1) zero capital upside (a typical loan cannot be greater than par value), 2) illiquidity, and 3) complex valuations (impairments can be applied suddenly rather than progressively). Importantly, investors are being paid for said risks given the attractive returns relative to other high-beta alternatives. However, manager selection is ultimately crucial and requires extensive due diligence, particularly given the evolving nature of the Australian private debt market.

BondAdviser’s Alternative Investment Fund Research Methodology encapsulates this due diligence process, analysing five core pillars: Strategy & Performance, Processes & Policies, Risk Management, Governance and Quantitative Analysis. Importantly, the latter overlays qualitative aspects of the fund rating process with an extensive simulation of the Fund’s underlying portfolio assets in a range of operating environments. This analysis drives our objective Risk Score, with the same standardised steps taken across all funds to ensure comparability.

Oversight and transparency needed for the market to reach its full potential 

The rapid expansion of private debt markets has been a global phenomenon and garnered significant attention from regulators due to the uncertain impacts to financial stability. We believe this comes down to the fundamental question of whether private debt funds are de-risking bank balance sheets (therefore purely taking market share of current risk) or providing loans to borrowers that have historically been unable to qualify for financing from the regulated banking system (therefore increasing the risk profile of the system).

In this context, domestic regulation will likely come in over time, especially given rising capital allocation from the superannuation sector. Overall capital allocation to private debt was 0.8% as at June 2024. That said, there is scope for this to rise in line with global trends with capital allocation from pension funds and insurance firms rising from 0.8% to 3.6% between 2016 and 2023 according to the IMF. As shown in Figure 5, capital allocation has been even higher in the case of smaller funds.

In this context, we highlight ASIC is positively expanding its supervision of private credit funds by establishing a dedicated private markets unit to reinforce and test the expectations around governance, reporting and managing conflicts of interest.

While there has been limited detail thus far, European regulation could provide a blueprint of what is to come. One such example is the Alternative Investment Fund Managers Directive (AIFMD 2) that applies to loan originating alternative investment funds in Europe. It came into force in April 2024 and outlines restrictions on borrower concentration (<20%) and leverage while setting up requirements for risk retention (5% for each loan), effective policies and investor disclosures (among others).

We view this as a positive evolutionary step of a growing and important market, both for the banking system and end-investors. While there will be some level of opaqueness for the foreseeable future, we believe transparency will improve and will ultimately be needed for the private debt market to reach its full potential, both in Australia and globally.