Has the Private Credit ship sailed?

For our investors, many will note my enthusiasm for private credit over the past 2-years. 

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As rates escalated aggressively in 2022, so did the opportunity set for private credit. Liquidity tightened. Growth assets declined rapidly. Those requiring non-traditional sources of credit had to start paying for it as floating rate instruments moved some 400-500bps higher. It made less sense to invest in equities, particularly in the US, which traded on relatively expensive multiples, and which historically had delivered long-run returns equal to or less than private credit, with a much greater level of volatility. 

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There were certainly still questions to ask. Not all credit managers were attractive – despite offering a similar return profile. Some of the largest groups in Australia, grew enormously prior to cash rates rising as aggressively as they did in 2022. The quality of their loan book was not as attractive in terms of the security and quality of covenants as others. Yielding 10% from a portfolio geared at 75-80% should not be viewed the same as a similar portfolio of assets still returning 10%, but only geared at 45%. Some Leveraged buy out (LBO) lenders were also too willing to support private equity transactions to maintain the relationship with the underlying sponsor, rather than protect investors. If lenders say no to a large private equity sponsors, they might not be involved or invited in future deals, and this may lead to conflict. After all, lenders get paid for lending, not for saying no to new loans.  So due diligence and discipline is key. 

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Yet, the environment we find ourselves in today is quite different. The volume of entrants into private credit has expanded rapidly. In Australia, fund managers, distribution groups and private banks have quickly moved to establish local feeder vehicles to their foreign credit funds or purchased private credit groups to then rollout across their respective network. This higher volume has resulted in increased competition, tighter credit spreads, and more generous flexibility with covenants (e.g. covenant-lite loans) to deploy capital. Compared to liquid credit, the illiquidity premium is now less attractive than previously. Remember, the best loans are made in the worst of times. When capital is scarce, not when there are ample lenders competing to lend money. 

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I have been fortunate enough to see Howard Marks present during his last two trips to Australia. For those who don’t know who he is – he founded Oaktree Capital and is probably the most reputable distressed debt investor in the world. While he has (with bias) emphasised the relative appeal of private credit vs. equities over the last several years; he has also emphasised a reality that with higher rates, come higher defaults. 

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While we haven’t necessarily seen evidence of this, lenders can extend loans, capitalise outstanding interest, and choose not to report what would otherwise be a default. Some refer to this as ‘extend and pretend’ – kicking the can down the road in hope that it’s not a problem, and the counterparty will find themselves in better shape. So, without adequate safeguards, independent, third-party valuations of the book of loans, and disclosure to investors of the number of capitalising loans, many would remain unaware of underlying problems. In Australia, we have also seen some credit managers launch new funds that commingle their role. For example, credit managers in the non-bank residential lending space deciding they are also going to become equity owners or co-investors of real estate opportunities they are lending to. How likely is a credit manager with co-ownership of a property asset, or a development interest in the property they lend to, likely to let the loan default? Are they going to be strict on terms, or relaxed? 

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The potential for conflicts is enormous. While it’s early days, this could be a discrete way to shift delinquent, or soon to be delinquent loans into portfolios and hide them as an equity asset, rather than reveal losses or defaults. Especially if credit funds and real estate equity funds are stapled together and offered to investors under a single vehicle. 

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What may give comfort to some investors, but particularly borrowers, is that we have seen the first sign of a turn in the interest rate cycle as the US Federal Reserve cut rates by 50bps in September (to 4.75-5.00%). In Australia the RBA remains on hold at 4.35%, but there are signs of weakening economic growth, and suggestions it will cut in 2025. 

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Lower growth, potential recessions, hard or soft landings – terms you have probably read about or heard in the media, all refer to a slowing economy. People consuming less, spending less, and businesses hiring less or cutting costs. For private credit, if this translates to lower income for the underlying companies in which loans are made, this poses a greater risk to investors. And yes, given most private credit funds issue ‘floating rate’ debt, rates should come down...eventually. However, most lenders – at least better-quality operators – have inbuilt loan floors within their loan book. 

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Meaning that if rates fall, they put a minimum floor in place for those borrowers, where irrespective of cash rates moving further beneath them, rates remain above that threshold. For example, if a private debt manager in Australia has a loan book paying RBA cash rate + 5%, this works out to be 9.35%. But they may have an interest floor set at 4.00%. So even if the cash rate falls back to 2.50 – 3.00%, borrowers are still paying 9.00% (not 7.50%). Borrowers can of course refinance, but some might not be able to. Especially if their incomes or fundamentals have deteriorated in a slowing environment.

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When I think about where the best ‘risk-adjusted’ return in now across assets, I can’t help but focus on commercial property. Not mum and dad retail purchases, but institutional quality property assets. This could be indirectly by investing in listed REITs who own them. Or it could be directly by buying the assets they and their investors need liquidity in the funds/trusts that they operate. You see, many REITs, while they do have some degree of balance sheet investment, are also fund managers. They set up property trusts, buy direct properties, provide investors with indicative terms – including an expected fund life and liquidity horizon. That liquidity horizon is generally 5-years with optional extensions. Those funds who purchased assets 5-6 years ago, are now expecting their capital to be returned – and liquidity is scarce. Sellers don’t want to sell at today’s market where rates are elevated, and cap rates remain 2-3% above trend. The higher the cap rate, the lower the property value. To enable liquidity, large REITs and institutional investors have been selling at 20-50% discounts to earlier purchases. 

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Without naming specific property assets, below are examples of what I have seen: 

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1) Investors were able to purchase a Brisbane CBD asset in 2023 on 10% yield, and a very similar price to what a Swiss Bank acquired it for 10-years earlier. The asset was anchored by the Australian Tax Office and a lack of new supply meant that it would either renew the lease or backfill the tenancy with another government department. The building traded at what would be a circa 50% discount to today’s replacement cost. 

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2) Similarly, a high quality, smaller format Brisbane Tower, leased to a diverse mix of corporate tenants was sold by a German Bank. It sold for ~$50M less than what it owed the bank (inc capex) and from their purchase of it in 2017. Again, this was paying a c. 9% yield. It was almost fully occupied and there were good signs of rental growth. 

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3) An aging 10,000 SQM+ office asset sitting on 2,800sqm has been on the market with an expected sale price 60% below replacement value. The site has DA approved plans for a second tower, which can’t be built because it’s too uneconomical to do so.  The manager who owns the asset, has the property held in a fund with one other asset – a Chinese shopping mall. Investors want out. The fund that owns the asset has no ability to raise additional capital, so there is no ability for capex or incentives to motivate new tenants to occupy the office (given incentives elsewhere). It’s 30% vacant.  

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4) Numerous managers have expressed a need to secure additional liquidity. Banks have removed lines of credit intended to fund capex or incentives for operators, which has especially impacted those who took on higher LVRs than otherwise. Incentivised by the idea that rates would remain low for longer – something the RBA governor at the time alluded to. Without a capital injection, they will be unable to offer incentives that generally run 30-40% in the current market to tenants and could see vacancy rise. If this happens, the ICR and the LVR of the property will shift, because asset income will fall. If covenants are breached with the bank, there may some forced redemptions. 

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We have seen examples of managers accepting capital injections via unsecured debt at elevated levels’ (15-20%), preferred equity with the same; or equity unit purchases at 40-60% discounts to last reported NAV, diluting investors. In every opportunity above, there is an ability for investors to buy below replacement and add value with capital. 

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This mismatch in liquidity needs between the fund manager, who would likely prefer to hang onto the asset and sell as the cycle shifts, and private investors who want their liquidity at the end of the expected term, ultimately results in forced redemptions; review of structuring and capital options; or ultimately, asset sales at large discounts. 

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Investors that can provide a source of liquidity in these scenarios, in the right structure, are uniquely placed to benefit.  Especially if investment occurs immediately as the interest rate cycle appears to be turning; and when replacement and construction costs make new supply uneconomical, reducing debt costs and driving higher rents as vacancy tightens. In Brisbane, we are seeing this occur – our state has the highest rental growth rates nationally. Additionally, CBD office should benefit from significant new infrastructure leading into the 2032 Olympic games; and ‘return to office’ mandates. 

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So relative to private credit, we are now at a point in the cycle where: 

1. Private credit yields will start turning lower as loans mature, and new floating rate loans move alongside cuts to cash rates. 
2. In comparison to private credit, commercial office and some other types of property assets are yielding as much as 9-11.00%. Subject to tenant quality, these yields don’t decline but increase over the lease term with CPI. 
3. In a slowing economy, with rising unemployment, employees are unlikely enjoy the same flexibility as recent years. If employers see greater productivity in the office – they will demand greater office attendance. This is occurring in the US. 
4. We are seeing strong rental growth due to supply constraints such as elevated construction costs and skilled labour shortages. 
5. Office incentives provided by landlords is starting to compress due to the above. 
6. Lower cash rates reduce borrowing costs, increasing margins on debt-funded property purchases. 

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For the right property types and locations, this could be the most opportune time in the current cycle to purchase institutional commercial real estate, enjoying attractive yields as well as capital appreciation as yields revert to longer-term averages. So, has the private credit ship sailed? 

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Maybe, maybe not…but commercial real estate is looking like a better boat. 

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