Don't get burned: how to vet your fund manager

Private credit funds have emerged as a popular alternative investment option, offering attractive yields and diversification as the non-bank lending sector continues to thrive in Australia. However, their growing prominence has attracted both regulatory and media scrutiny as some fund managers compromise borrower creditworthiness and face loans in default.

Private credit funds are growing so quickly with some loaded up with cash and have had to deploy that capital in corporate loans they may have walked away from in the past. Recent media reports of poor lending practices by some private credit fund managers underscore the importance of investors conducting due diligence before they commit capital to a private credit fund. Only by carefully assessing the factors outlined below can investors ensure that their chosen private credit fund aligns with their financial objectives and their capital is invested diligently.

Look for a track record

First and foremost, investors must evaluate a private credit fund manager's track record, expertise and risk management capabilities. Look for a proven history of successful lending, experience in complex loans and credit industry knowledge. Review the total number of loans funded, and check that the manager has experience across different corporate transactions.

Investors should ask about the quality of loans funded and loan recovery on principal and interest, the number and percentage of bad loans or defaults in their lender’s portfolio, as this reflects the manager’s ability to manage risk effectively and resolve problem loans. Additionally, assess whether their performance spans various market cycles to ensure resilience in different economic conditions.

Fund structure

Consider the fund structure and approach to investments. Evaluate whether a fund is closed-end or open-ended and which one aligns better with your needs. A pooled fund accepts new investments on an ongoing basis and investors can redeem their investment at any time, unlike closed-ended funds which have a specific term.

Pooled funds must continually deploy cash, so there is pressure to lend money. This can lead to investing in riskier loans to meet deployment targets as the need to invest large sums may result in less rigorous vetting of individual loans, potentially compromising the overall quality of the lender’s portfolio. Many managers do not disclose the underlying loans in a pooled fund portfolio, so the investor may not have a true sense of the risk in the portfolio.

In contrast, investing in a single loan or contributory deal can offers several advantages, including a greater focus on due diligence. With only one transaction to evaluate, investors can conduct thorough risk assessment and proper vetting of the loan. Investors also have a clearer view of where their capital is being deployed, overcoming concerns about opacity in some private credit funds. The ability to carefully select and structure a single deal also allows for more precise risk management.

Also, assess the manager's approach to borrower relationships, whether the manager adopts hands-on management of the loan after it is granted or if the manager is more passive, which may increase risk of default.

It is also important to understand that where the fund invests in distressed debt or mezzanine financing, with the latter, the loan is subordinated in position to another lender.

Conduct due diligence

Conducting thorough due diligence on private credit fund managers and their loan practices is crucial for investors to mitigate risks. As the private credit market continues to grow, it's essential to scrutinise a fund manager's track record, investment strategy, and risk management practices.

Key factors to focus on include the manager's experience across full credit cycles, their approach to loan structuring and covenant monitoring, and their valuation methodologies, which must be rigorous to avoid the overvaluation of any assets which secure the underlying loans.

Investors should also examine the fund's transparency in reporting, fee structures, potential conflicts of interest (see more on this below) and loan arrears, especially in a time when the global and Australian economy could be slowing.

Check for conflicts of interest

Always scrutinise the fund manager’s background, affiliations and check for any related party transactions to ensure the manager is acting solely in the best interests of the fund and its investors. If the fund manager is lending to related parties, that raises the risk of loans being structured to benefit the manager or related party at the expense of investors.

Be especially wary of fund managers with dual roles as commercial property developers. This dual position creates a significant conflict of interest that can compromise the integrity of investment decisions. Such private credit managers may be tempted to use the fund's capital to support their own development projects, potentially prioritising their interests over those of investors. This conflict can lead to biased lending decisions, unfavourable loan terms for the lender, or the fund being used to bail out troubled development projects.

The important point for any investor is to do your homework. Selecting a reliable private credit fund manager requires due diligence to ensure alignment with your investment goals and risk tolerance. If a fund manager doesn’t want to disclose or answer your questions in detail, take this as a red flag. By checking their track record, loan quality, potential conflicts of interest, and risk management practices, investors can invest their money more wisely and yield a favourable return.