Why this investment space challenges the risk-return equation

In a world where investors are searching for alternative ways to generate alpha, private markets are increasingly attractive. Within that, private credit is projected to grow from $US1.5 trillion to $US2.8 trillion in the period between 2022 and 2028.

Mark Power, Head of Income Credit for Qualitas, believes the increased interest from all investor types comes down to the risk-return equation available in this space, particularly for those in real estate on the commercial scale.

“Because you’re attached to the debt part of the capital stack rather than the equity part, you’ve always got first claims on cashflows coming out of the asset,” he says, highlighting the ability to generate regular monthly income from investments in this space.

Once viewed as niche and the domain of institutions and the ultra-wealthy, the industry has matured and become increasingly accessible all investor types, including retail investors.

In this episode of The Pitch, Power explores the outlook for private credit and the risk-return profile for the industry. He also shares his tips for selecting managers in this space.

This interview was filmed 21 February 2024.

Edited transcript:

What is the outlook for private credit globally?

Power: Private credit is actually forecast to grow strongly over the course of the next few years. If you look at common market consensus, the view is that globally, the market will increase in size from $US1.5 trillion to $US2.8 trillion in the period between 2022 and 2028. While that is really strong growth, it’s interesting to note that in the past 12 months, the number of funds being launched has actually decreased by 40%. That seems counter to the strong growth in the sector, but what we’re finding is that while the number of funds has reduced, the size of those funds has increased significantly by more than 28% in terms of the amount investors are contributing to new funds.

Those global investors are aligning themselves to a fewer number of managers but committing more capital to those managers. They’ve identified that as the sector has matured, those managers with a really sound track record are outperforming over a long period of time and they want to attach themselves to that.

What is driving this increased interest from investors towards private credit?

Power: I think it is a function of the risk-return equation in the asset class. You are almost cheating the risk-return curve here because you are getting equity-style returns, but in the debt stack. Institutional investors coming into the market can see Australia is a great place to invest. They can see the structural gap that has occurred in terms of the traditional financiers and it is still an emerging market in Australia with strong return characteristics associated with it.

Essentially, those global investors can get the same returns in Australia as in an unlevered fund with no back leverage – as compared to other parts of the globe where they’re getting similar returns, but are doing that with a whole lot of financial engineering in behind them.

Is there anything you think the market hasn’t fully appreciated about the potential of private credit?

Power: I think so, as it is still quite a new asset class here in Australia. Certainly, one part of the equation I don’t think people have properly appreciated is the extent to which real estate private credit can provide through-the-cycle consistent returns. If you look at the market as a whole, we should be able to generate returns somewhere between 400 and 600 basis points over the 60-day swap rate. Because you’re attached to the debt part of the capital stack rather than the equity part of the stack, you’ve always got first claims on cashflows coming out of the asset, you’ve always got first claims on funds coming out from the realisation of the asset as well. It is very defensive.

For investors that are after that regular monthly distribution from an asset class which has got strong fundamentals supporting it and you’re in the debt stack – I don’t know that investors fully appreciate it, they are starting to get it now compared to 12 months ago. There is a better appreciation of that characteristic but the market is still on a learning curve as far as that is concerned.

Is there anything that investors need to be mindful of when they're choosing to invest in this space?

Power: I think it is really important for investors to attach themselves to a local manager. Real estate is, from a geographic point of view, a very local investment thesis. You want to make sure the manager has strong connections and relationships with the counterparties that they’re involved with so the borrowers essentially. It is very critical.

The other piece is around the risk process of the manager. Real estate private credit is not a set and forget strategy – it has got to be dynamically managed and that’s at the time of underwrite. For an investor looking at a particular manager and looking at investing in this sector, they should thoroughly unpick the risk underwriting process of any manager they’re looking at to ensure they are going through a really thorough due diligence process. What I mean by that is at Qualitas, we consider ourselves to be unapologetically intrusive in terms of the amount of due diligence we do on our borrowers because we want to make sure if we bring a loan into any of our funds, we are very comfortable with the risk exposure at the time of underwrite.

That’s one point from a risk mitigation side of things. The other side is once you bring that loan and underwrite that loan, it’s not a set and forget, that loan needs to be dynamically managed. For instance, we review every single one of our loans on a monthly basis to see if there’s been any shift in the risk profile of that loan. If there has been deterioration in that loan, we then look to put risk mitigation strategies around that to ensure that it either improves, is restructured or ultimately re-financed.

The third piece I’ll talk to as important is the attraction of being able to invest alongside institutional investors. For example, the vast majority of Qualitas’ funds are institutional capital, and those investors are incredibly sophisticated, they do an enormous amount of due diligence on us as a business before placing funds for us to invest. If other investors can invest in funds sitting alongside institutional investors, it can provide comfort that they’re investing alongside very sophisticated capital.