High yields or high risk? What investors need to consider before investing in private credit

"You then went through a stage where people thought all private credit was interchangeable; construction finance was the same as asset-backed securities, or lending to lenders was the same as non-investment-grade corporate lending," Manning said. 

"Fast-forward to today, everyone's talking about it, and there are lots of glossy brochures around the benefits of investing in it." 

In recent years in particular, we've seen an explosion in construction financing, at the same time as the Australian property market has continued on its path higher. 

"What that means is if you purchase a property and then you hold it for 12 months, typically, you're selling it for more than what you bought it for, and that covers up a lot of challenges in the fundamentals of that loan," Manning said. 

Going forward, Manning believes we are unlikely to see the same level of price appreciation - meaning the fundamentals are far more important. 

"At the same time, we're seeing this huge influx of capital and competition into that asset class. If there's one takeaway, I think investors really need to think about that - how strong these actual loan opportunities are and how clear is that exit," he said. 

Does private credit have a cycle? 

"At some stage, [we will see] a maturing of that cycle, and the characteristics of that maturing will be more institutionalisation of that asset class. This is not dissimilar to what we've seen in US and European markets," he added. 

"At that stage, there will be more divergence in those that prevail and those that don't succeed in that environment." 

That said, he doesn't believe the maturing or institutionalisation of the asset class will result in losses for investors. 

"I don't see there being this cataclysmic cliff that we're going to drive off and huge losses," he said. 

"I think we're seeing a huge increase in competition in the asset class - a lot of new managers, a lot of new players bidding for transactions. That will bid down credit spreads, that will bid down expected returns, and not everyone will be able to endure."

For instance, those that relied on wide spreads to survive, with big upfront fees to propel their businesses, will likely face challenges going forward as spreads tighten. 

And while more managers are likely to enter the space as investor interest skyrockets, fewer managers are likely to prevail. Although those that do will likely become more sophisticated in the face of tougher regulation, Manning said. 

Red flags to spot the fakers from the true private credit winners

Whether we like it or not, there's fraud in every asset class, Manning said, so investors need to think about this when assessing lenders and managers that they want to invest in. 

3. Highly leveraged exposures

Highly subordinated or very leveraged exposures are another area that investors should be aware of. There's a lot more risk, Manning said, and you may not be getting as rewarded for taking on this risk as you used to. 

4. Arrogance

If investors get a "whiff of arrogance" from managers they are dealing with, that's an important telltale warning sign and red flag, Manning said. The big banks, who are fantastic underwriters, are very careful and realise they can get bitten if they make the wrong decision. Private credit managers are also not immune to mistakes. 

The big lies lenders are telling managers 

As a specialist in asset-backed lending, Manning Asset Management looks at all the lenders across the Australian market and assesses whether or not they should be providing wholesale funding to them. 

"We speak to probably 15 or 20 lenders a month. And there's a mix of people that give us the bare bones, "This is what's happening. These are the things in our book." And there are others that put a marketing spin over it," Manning said. 

1. "We don't have any problems in our book"

While this would be ideal, it's probably a furphy, Manning said - noting that even if lenders make the best possible underwriting decision, facts can change and the borrower may not be able to make their repayments. 

"That's no fault of the lender. That's a reality, and you need to just work with those borrowers and find a way to get your capital back," he said. 

If a lender is saying they "don't have any problems" it either means they haven't been lending for long enough, they're not thinking about the risks, or they're not being completely transparent. 

2. "We've never had a loss"

Holding up the concept of zero losses as a holy grail is also fraught with risk, Manning said, as losses from lending and credit have been "very lumpy" throughout history. 

"There'll be periods where there are heightened losses. It's not this beautiful smooth line through time that oscillates marginally," he said. 

Just because a lender hasn't faced a loss so far, doesn't mean they are immune from losses in the future - and the arrogance that they won't is a red flag, Manning added. 

Why investors should consider the asset class

"I think, if you can really pull the complete understanding around that sophistication in the asset class and embed that in your business and how you run money, you can mitigate a lot of the risk," he said. 

Glossy marketing brochures, for all their issues, aren't completely wrong - the asset class provides investors with consistent inflation-adjusted returns and income. 

It doesn't mean the asset class is immune from risks, and investors need to be careful about which managers they align themselves with as competition increases, but there's still plenty of opportunity on offer - you just need to know where to look.  

And remember, if it sounds too good to be true, it probably is.