Wary of sharemarket volatility? This asset class offers resilience and diversification

Asset manager Pengana Capital Group’s listed Pengana Global Private Credit Fund (ASX: PCX) offers investors unprecedented access to some of the best global private credit investments. 

The underlying investments are managed together with leading global investment specialist Mercer, providing investors exposure to a highly-diversified portfolio of more than 2,000 loans from 20+ quality private credit funds.

Pengana Credit’s CEO, Nehemiah Richardson, said global private credit provides investors with attractive risk-adjusted returns and diversification away from volatile public equity and bond markets. Recently, he sat down with Livewire to talk through the fund's unique structure, targeted minimum yield of 7% p.a., and how he sees the investment shift from public to private markets.

Richardson also explains how much of the change is related to shifting dynamics in banking regulations, investor demand, interest rates, and credit quality are shaping investment strategies within the sector.

"If you go back 25 years, very few had significant international equity exposure," he says. 

"They mainly had domestic equities. We believe all investors should have a core allocation to global private credit in their portfolios given its attractive characteristics and I hope it's as ubiquitous in five years as international equities are in diversified equity portfolios."

Major themes driving the boom in private credit

Demand for global private credit has continued to build post-GFC, with investors drawn to the asset class’s unique blend of attractive risk-adjusted returns, capital preservation, and low volatility.

While demand has been traditionally been driven by institutional investors, including Australia’s Future Fund and the large superannuation funds, retail investors now have access to global private credit via investment vehicles such as PCX, according to Richardson.

“Changing demographics across the developed world are creating more demand for income-producing investments with defensive characteristics.

“We are seeing greater demand for income-producing investments as more people exit accumulation and transition to retirement when protecting capital is a key concern.”

Richardson added that global private credit shows lower levels of volatility when compared to other, more liquid income securities. 

The Pengana Global Private Credit Trust is unique in providing investors access to a diversified portfolio of illiquid investments via a liquid, listed structure.

“Accessing global private credit via a liquid investment vehicle such as PCX is a game-changer for retail Australian investors”, Richardson said.

The other big theme driving investment opportunity in global private credit is the structural changes which have occurred in banking in the USA and Europe post-GFC.

"This is a regulatory shift influenced by frameworks such as Basel III and the upcoming Basel IV regulation, thus creating a supply gap in the lending market which is being filled by private credit managers," he said. 

Private credit also now plays an important role in the US and European economies, with ~85% of mid-market corporate lending done by private credit managers and the balance by banks. By contrast, in Australia the banks provide around 90% of corporate credit lending.

"The first thing to note is this continuing retrenchment of the banks from certain segments of lending, including the mid-market corporate lending space," Richardson said.

"Mid-market companies are looking for money to borrow where bank funding has been withdrawn and so professional private credit managers have filled that gap and they're even starting now to work in cooperation with banks rather than in competition with them."

He added that a growing number of managers and products increases the complexity of choice for investors. “As an investor you've got to be clear about your investments' objective, e.g., what role do you want global private credit to play in your portfolio and what you're buying, so manager selection becomes really important."

Other reasons why we're seeing this shift from public to private markets

Richardson also outlines how increased regulation and costs are deterring many companies from going public, which means they seek funding from private investors such as those invested in by Pengana Credit.

"The burden of being a listed company has increased and can be less appealing than remaining private. Also, companies can find it difficult to balance the need to make value-accretive strategic investment decisions with the short-term focus of markets, particularly in a quarterly reporting regime as in the US," he says.

"If you're a private company looking to list, there are a number of important trade-offs you need to consider and with the longer term focus and growing availability of private capital, both debt and equity, remaining private can be a more attractive option, particularly when in a growth and expansion period."

Private credit resilient amid lower interest rates

According to the CME's US Federal Reserve market watch tool, investors placed more than a one-in-two chance that the central bank will cut interest rates at its May meeting as of March 10.

But global private credit returns tend to be resilient during interest rate fluctuations because global private credit securities typically have floating rates. “Demand for global private credit remained strong during COVID-19 when interest rates were at zero”, Richardson said.

"Lower rates are good for companies and private equity and credit investors. A lower cost of capital means more capacity to invest in growth opportunities.

"Lower rates also improve the credit quality of companies who have floating rate debt, as their interest burden reduces in line with lower rates."

Credit quality of borrowers

Pengana's underlying managers research and screen thousands of mid-market companies seeking credit. This means there's less chance of default on the loans, and greater certainty of income.

"A high quality private credit manager will always be underwriting with the downside in mind," he says. "And where you have a supply and demand imbalance between companies looking for capital and banks retrenching, so you're able to be more selective about where you deploy capital."

Richardson adds the fund targets non-cyclical companies that earn defensive, often recurring revenues, and deliver consistent profits.

He describes middle market companies as the ‘sweet spot’ for quality and opportunity. “US-based mid-market companies are a good size, often having a market cap of US$1 billion-plus.”

Many of the best opportunities are built around bilateral loans – a loan between a borrower and an investor.

“Well underwritten bilateral loans have strong structural protections and information rights, and modest LVRs, which result in low risk of default and loss.

“These investments are relatively resilient as the loans are individually negotiated and structured. The lender generally has seniority and security over a borrower’s cash flows and assets, and the right to force a borrower to take corrective actions to protect the value of the lender’s capital if necessary.”

But the ultimate key to quality is engaging with the best private credit managers, Richardson said. 

“The best managers have long track records of attractive returns and low net losses, through many cycles. They have longstanding relationships and differentiated origination where they get first look at deals.”

Managing risks in the current environment

Another advantage of private credit funds is that they're less volatile than stock markets as they're not subject to sharp changes in sentiment unrelated to intrinsic valuations, according to Richardson. 

"The world's always a risky place. It's always volatile. Something's always going on, right? So it's important to identify the things that you can do to mitigate that in the investment process," he said.

"With us that process is really about manager selection and diversification, so we have our top quality managers, they rely on robust origination, and are very good at underwriting credit and looking at all the downside scenarios they're managing.

"They run downside cash flow scenarios to assess a company’s capacity to pay interest and repay principal, and assess the value of security carefully and conservatively given security is there to recover capital if a company is unable to do so out of cash flows. The transactions' structures and protections are negotiated with this in mind.”

Richardson adds that the risk of insufficient diversification should also be considered for investors who are largely allocated to Australian private credit.

"We really seek to mitigate concentration risk and idiosyncratic risk and we do that through our wide diversification, we don't want single manager business or performance risk," he says.

"In the fund now, we've created a vehicle that allows any investor to access a diversified global private credit exposure, where you have day-to-day liquidity in the market."

Day-to-day liquidity in global private credit

For investors, the fund is traded on the Australian Stock Exchange, which means anyone can buy or sell units during market hours. To help support the fund's net asset value (NAV), Pengana also allows investors to make redemptions at NAV via a quarterly off-market buyback offer worth up to 5% of the fund.

"The quarterly buyback helps protect the price in the market, and means as an investor you can choose when and how you want liquidity," Richardson said.

"So, you don't have to sell in the market if you don't want to. You could take advantage of that quarterly buyback window. And we've seen it operating well. Not only does it support the unit price, but also it provides investors with options to exit."

Holdings and target yield

In total the fund now has around $168 million in investors' funds under management and uses 20 underlying funds that have invested in more than 2,000 loans.

"We have a minimum target distribution of 7% p.a. which we've paid since we listed," Richardson says. 

"But we also have net asset value accumulation potential because some of our strategies will accumulate and recycle capital. The predominance of these strategies pay contractual income in cash which we distribute, but some of them will accumulate over time."

The fund also has a hurdle return of the Reserve Bank's cash rate plus 6%, with a minimum of 7.5% per annum. A performance fee of 20% of any increase in the fund's NAV above the hurdle return is also calculated.