Before we over-regulate private credit, let’s understand it

Critics of private credit – including traditional lenders protecting their patch – paint a picture of an unregulated free-for-all that leaves Australian investors and borrowers exposed.

This is far from the truth. The reality is that private credit providers and facilities in this country are, rightly, already subject to multiple layers of regulation – all designed to enhance transparency and protect both investors and borrowers.

Private credit is certainly growing rapidly in Australia and shows no sign of slowing.

Around the world, there are enormous reserves of global capital in our superannuation and sovereign wealth systems looking for a home – and a decent risk-adjusted return. And there is the recognition that private credit is a highly credible source of capital, particularly for borrowers or projects with specialised needs.

Private credit can provide product solutions that are more difficult for traditional lenders to deliver. Because providers typically invest capital sourced from equity, they can allow for more flexibility in the underlying terms as the capital does not have the tension you get with highly leveraged balance sheet structures.

Today, private credit is an important part of our financial system, providing another source of capital into the economy that supports growth, drives competition and innovation, and adds overall liquidity and stability. One of the causes of the 1990s liquidity squeeze was the lack of alternative credit providers beyond the banks and government. If we had another squeeze like the 1990s, borrowers would have a range of alternative capital providers available, beyond the traditional banking system.

Naturally, such an important and growing part of our financial system needs to be well-regulated – and it is.

Private credit funds involve a third-party manager securing capital from investors, ranging from retail and wholesale investors, all the way through to superannuation and sovereign wealth investors. These funds provide the investors’ capital to borrowers in the form of a loan. In the traditional funds model, investors contribute their capital to the manager not by way of a loan, but in the form of an equity investment.

Fund managers that raise capital from investors in this way are already subject to strict, multi-layered regulatory requirements.

A manager must have an Australian Financial Services Licence (AFSL) and requisite management skills and expertise, which is a regime supervised by the Australian Securities and Investments Commission (ASIC).

They need to register with the Australian Prudential Reporting Authority (APRA) and undertake periodic reporting under the Financial Sector (Collection of Data) Act 2001 (Cth) (FSCODA). The threshold for reporting is typically a debt of $50 million.

They must also comply and undertake ‘know your customer’ procedures as part of exhaustive anti-money laundering and counter-terrorism financing obligations overseen by AUSTRAC in respect of both their investors and the borrowers that are lent money.

On top of that, there are additional safeguards in place for retail investors, which require fund managers to have a product disclosure statement registered with ASIC, target market determinations and design and distribution obligations.

If the fund is listed on the Australian Securities Exchange (ASX), continuous disclosure arrangements apply alongside all other companies, and the fund must adhere to the ASX Listing Rules. Additionally, it is the norm for institutional fund managers, like Qualitas, to have robust group-wide enterprise risk and compliance systems overseen by a board comprising independent directors.

That just covers investors. What about borrowers?

If the borrowers are for residential mortgages, the manager must hold an Australian credit licence and the borrowers will have the benefit of the National Consumer Credit Code protections. These are the same rules that apply to authorised deposit-taking institutions – the banks. In the commercial property sector where Qualitas specialises, the borrowers are large, sophisticated groups with legal and financial advisors.

What about capital adequacy requirements? Private credit funds are not authorised to take deposits (like banks) and do not have the benefit of the Federal government deposit guarantee scheme.

Banks provide a systemically critical function in the Australian (and global) economy but they are highly leveraged institutions that are in the business of facilitating borrowings for others. For every $1 of deposits, banks generally provide $9 of loans into the economy and are generally required to hold $1 of reserves.

This extreme liquidity mismatch is why APRA regulates banks and why Australia has adopted the Basel rules of capital adequacy.

APRA’s responsibility is to protect the financial interests of Australians and ensure the financial system is stable, competitive and efficient – and a highly leveraged bank without adequate Tier 1 capital protections presents a risk to all.

Compare the above to investment funds which in Australia are mostly 100% equity funded (no debt) and not a ‘loan-on-loan’ type structure. Such structures are robust due to the absence of debt and do not amplify profits or losses.

One area that I have espoused for a long time is educating wholesale borrowers that not all lenders – outside the trading banks – are alike. Borrowers need to ask their lender some basic questions such as their capital source, longevity, and who is in control in the event of decisions being required. Such disclosure would allow borrowers to differentiate between lenders and more fully understand the relative risks of dealing with different lenders. Such risks differ between lender liquidity risk and ensuring the borrower understands who controls the relationship is paramount.

Increasingly, I am seeing private market funds, including private credit funds take on leverage in their funds (similar to a mortgage over the fund assets). Both borrowers and investors need to understand the risks that these types of loans carry for their investment.

We already operate in a highly regulated financial system, with laws in place to protect investors and society – so before we over-regulate private credit, education for borrowers on the capital nuances of varying alternative lenders is a good place to begin.

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