Private credit: Risks and rewards explained

Garreth Hanley:
This is INTHEBLACK, a leadership strategy and business podcast brought to you by CPA Australia.

Tahn Sharpe:
Welcome to INTHEBLACK. In today's episode, we're talking to Michael Block FCPA, about the rise of private credit and where it fits in the broader investment ecosystem. Only a decade ago, private credit was a little known and barely understood investment class and very much in the shadows of other private capital arms such as private equity and venture capitalism.

It has now become ubiquitous in investment portfolios, but its popularity has raised serious concerns about the inherent risks involved in non-bank lending and whether investors from mums and dads to large super funds are properly accounting for those risks. Here with me today is Michael Block, who is chief investment officer at boutique investment manager at Bellmont Securities and a former CIO at the then $11 billion Catholic Super as well as Mine Super and Nambawan Super.

He is a regular contributor to industry publications and is currently serving as industry professor at the University of Technology Sydney. Welcome to INTHEBLACK, Michael.

Michael Block:
Thanks very much for having me. Glad to be here.

Tahn Sharpe:
Good stuff. Can you broadly explain to kick off what private capital is and then maybe narrow that focus into private credit to show how it differs from those other investment strategies?

Michael Block:
As an investor, we like to think about splitting investments into two parts, public markets and private markets. Public markets pretty much means the share market because it's listed and essentially public markets are just shares and everything else is called private markets. And that can range from investing in bonds, just buying a term deposit or buying a government bond, and all the way down to private credit, private equity, and all the other niche strategies that are involved.

Historically, the difference between the two is as an investor you can either buy shares in a company or subscribe to equity capital or you can be a moneylender. And really at the end of the day, this is all about money lending. So whether or not you give your money to the government and buy government bond, that's a very, very secure investment grade, AAA rated investment, or you give your money to another borrower who's probably a small or medium enterprise, they're going to be unlisted, unrated, provide a much higher return, but be a little bit riskier than government bonds, term deposits and the like.

Tahn Sharpe:
So perhaps we could give some historical context. How have those sort of different arms of private capital fared in terms of the weight of investment over the years? We spoke about private equity and venture capitalism before. At what point did private credit really emerge and where is it now in terms of distribution across those retail, wholesale and institutional pools of capital?

Michael Block:
Well, historically, Australians have allocated very, very little to these niche strategies in private markets, and the main reason was because the Australian share market just did so incredibly well. If you ask my mother, would she like to invest in all these unusual strategies or would she rather just hold BHP and bank shares and earn 10 to 15% per annum? You know which one she chooses. So with the share market doing so well, there wasn't a lot of money allocated to alternatives, and that's just the way we categorise them in investment portfolio and the money that was allocated to alternatives was pretty much all going to private equity.

Why private equity you ask? Well, it provided a return of something around 17% and it was sexy and exciting, and if you only had a small amount of the portfolio to allocate, that's where you'd go. So venture capital, private equity, those sorts of things, the world's now changed. Equity prices are high. The Australian share market's making a number more like 10% per annum.

Houses are expensive. Everything's expensive. So in a world where the future is the returns are going to be more like eight to 12% than 17, then people are looking at other forms of investment. And so private credit has come to the fore because it promises something like that same eight to 12%, and it can compete with equities.

Tahn Sharpe:
It promises. That's the key word there. And I note that you touched on the classification of private credit, which we may come back to in a minute because I think that's really important in the asset allocation piece. But just to pull the thread on the institutional side, which you're very familiar with, of course, the incredible scale of super funds in Australia means asset allocation is critical.

Those huge tranches of capital, billions and billions of dollars need to be invested responsibly and with members' best interest in mind of course as a duty. And then you've also got the need for well-weighted levels of risk and return to meet your future, your super performance test. So seen through this lens with all those requirements for super funds, what does private credit provide to those institutional funds?

Michael Block:
Well, let's start from the very top. You mentioned asset allocation. I'm a card carrying member of the club that says the most important determinant of how your investment portfolio goes is asset allocation. The best studies by one of my heroes, Gary Brinson, in the '80s and '90s suggest that more than 90% of the outcomes determined by asset allocation, namely how much you put in shares, how much you put in bonds, how much you put in alternatives, and how much you put in cash.

And with that in mind, it would say that you probably put the majority in equities because it's the most volatile and highest performing asset class. When you think about an institutional portfolio these days, you didn't use to allocate much to anything other than shares and bonds. In fact, historically most US portfolios were 60-40, 60% shares, 40% bonds. That's still the benchmark used today by most pension funds.

So what's happened to change all this? Well, probably the most important thing is that the government has brought in some regulations called Your Future, Your Super. It introduces a test so that if a super fund deviates more than half a percent per annum from a benchmark, it puts pressure under the fund. It maybe has got a right to its members and say that they're not performing or ultimately could lead to the fund having to be closed for new contributions. So a very large part of what a super fund now does, it's a little bit different from doing what's in the member's best interests. It's making sure they don't fail this performance assessment test.

Private credit is probably the best way of helping you pass that test. And the reason is the private credit that might earn anywhere between 10 and 15% per annum is benchmarked against investment grade credit. And therefore an easy way for every superannuation fund to beat this benchmark is to allocate five 10% of its money to private credit. You asked a little bit about the scale of things.

Private credit has limits, it's a niche strategy and there's a limit to how much money you can put in it. So big super funds like Aussie Super with 350, 400 billion are going to be challenged to make meaningful allocations to private credit because the market might not be able to sustain that. But all the smaller funds and certainly in retail investing, private credit is now the most popular thing.

Tahn Sharpe:
Is it generally even amongst the super funds, the terms of investment into private credit, are they all allocating around the same amount?

Michael Block:
Generally, yes. Remember that super funds want to achieve a few things and one important thing is to try and make the highest return. Well, we've all been to the same school or university. We've all got CFA's all advised by only two asset consultants. So pretty much once you know the outlook for various asset classes, this is called capital market assumptions, you come very close to getting the same answers.

So just to give you an example, nearly every single endowment fund growth strategy is 80% growth assets, 20% defensive. Most balanced funds are about 70-30 or about, and most conservative funds are about 50-50. And that's because you use a tool called mean-variance optimization. This is a fancy investment jargon for saying that you try and get the best mix of risk and return in a portfolio.

Tahn Sharpe:
So just to pull the thread on the asset allocation piece a little bit further, where is it coming from? If you're putting this new investment class into portfolios and you're putting a certain allocation towards private credit, are you taking that from a different bucket?

Michael Block:
So the $64 million question is if you're going to invest in private credit, where do you take the money from? Do you take it from debt and fixed interest investments or do you take it from equities? I can say that I'm in the minority and I believe you should see it as an equity substitute, and that's because it's so much more risky than investment grade credit, but opinion differs.

Certainly your future, your super test measures private credit against a investment grade bond benchmark, which I don't agree with. And by the way, the reason I don't agree with that is that I think private credit has a lot of similarities and has some of the same attributes as private equity. And in my way of thinking, it's a mix of roughly 60% equity, 40% debt. So I sort of think of it as a hybrid of sorts.

Tahn Sharpe:
Equity-like.

Michael Block:
Equity-like.

Tahn Sharpe:
Yes.

Michael Block:
Just as high yield credit and how do we know this is true is it's highly correlated with equities.

Tahn Sharpe:
Okay, so let's talk about the private credit providers behind all this. Who are they and how do they go about their business? I mean, why would businesses go to them for credit on one side, especially when that credit is more expensive and investors trust them with capital on the other side?

Michael Block:
So let's look at this from two viewpoints. Firstly, who are the private credit providers, the funds, and these range from solicitors lending money to people for bridging finance all the way up to some of the largest providers of private capital. These are the big businesses that you know both private equity and private credit providers like KKR, Blackstone, even BlackRock, has just bought into a private credit business.

So these are some of the biggest fund managers in the world are also private credit providers. The way I'd like you to think about them is non-bank lenders. So private credit is really lending to borrowers who aren't getting their money from banks, non-bank financial institutions of sorts. So the first question is why would a borrower borrow money from a private credit provider and not from a bank? And the very short answer is that there are only two real reasons.

The first one is that the bank won't lend to them, and that's by far the main one because who would borrow a 10% from a private credit provider when they can get bank finance at 6 or 7%? And the second one is that there are some changes to regulations ever since the GFC, COVID, et cetera, which have tightened up bank lending and made it so that banks have to be much more careful in terms of who they lend to. So sometimes there were really good businesses might be because of their size, might because of their profitability, who banks are unable to lend to because of stricter credit regulations.

Tahn Sharpe:
Okay. So this picture of private credit begs one clear question, I think. Are people judging the risk of loss adequately? We've heard everyone from the IMF to Treasury, regulators and central bankers here and abroad express concern about private credit. So what can go wrong, Michael? And is the risk underestimated, overstated or properly rated?

Michael Block:
Sounds like Goldilocks and the Three Bears, doesn't it? Is the risk too heavy, too light, or just right?

Tahn Sharpe:
Indeed.

Michael Block:
I'm going to suggest that people are not properly understanding the risks of private credit. I've just explained that private credit has a lot of the attributes of equity. It's generally lending to smaller companies. So we could class private credit as high risk, high return, unrated, illiquid in investing and it should command a much higher return. And commensurate with that high return is a higher risk.

Unfortunately, a lot of the people who are selling private credit are saying things like private credit is a place where you can get equity-like returns for bond-like risk. This is a misstatement. It's absolutely true that a lot of private credit is first lien, senior secured debt, but first lien, senior secured debt of a very small company might be a much greater risk than highly subordinated debt of a regulated company like a bank.

o I don't think people understand that this is the case. By the way, this is exactly the same as most people think of banks as blue-chip companies when a bank is really a highly levered financial organisation and by no means a safe blue-chip company.

Tahn Sharpe:
Your mum probably takes a different view on that. But I'm just asking, I just want to ask about the nature of that debt. And you touched on another moment ago, can you explain the difference between first lien debt and secured debt?

Michael Block:
Absolutely. It's just like the difference between a first mortgage and a second mortgage. If you borrow a house, the bank has the first mortgage, which means if anything goes wrong with your borrowings, they get the house as collateral. If you want to borrow some more money and the bank's already got the first mortgage, you take out a second mortgage. And the term we use in finance is that the second mortgage is subordinated or stands behind in the pecking order in the line to get paid behind the first mortgage, namely the bank.

Tahn Sharpe:
Okay. So that really speaks to the risks involved.

Michael Block:
Absolutely.

Tahn Sharpe:
Very good. So looking forward, what should investors across the spectrum or all those pools of capital be thinking in terms of due diligence when they assess private credit as an alternative asset?

Michael Block:
So I think the most important thing is just to be discerning. I'm clearly in favour of using private credit as a tool in an investment portfolio. I've helped seed a number of Australians private credit strategies. I invest in it both personally and professionally. So I think as a rule it's an okay thing to do, but only if you get the right one. So how do you make sure that happens? Well, I think it's very important to invest with managers that have got a long-term track record and where they've been able to manage money in the good times and the bad times.

And I say this because the last 20 or 30 years, and I use the term Goldilocks again, it's been a really wonderful environment to invest. We've seen interest rates come down, we've seen virtually very, very negligible levels of defaults. So this all looks like investing risky credit all just goes swimmingly. We haven't really had a default cycle. And then the other thing I'd suggest you do is you very carefully look at the collateral or the security for the loans and make sure there's a very strong chance that you get your money back or you get paid a return that's commensurate with the risk you're taking. So as an example, if you're a bank and you only lend up to 60% of the value of property, you're pretty safe in knowing that the money you've lent you get back.

And why is this so important? And this is because investing in fixed interest or credit is asymmetric. If things go well, the absolute best that can happen is you just get paid your interest and you get your capital back. There's no upside like equities. But if you screw it up and just to get a couple of extra percent, you lose big chunks of your capital. This is a really poor outcome and one you want to avoid.

Tahn Sharpe:
Yeah, that asymmetry doesn't get spoken of a lot, but it's an important feature of private credit that needs to be made clear I think.

Michael Block:
And absolutely. And an easy way of thinking about it is there's equity investors who are all optimistic and all they think about is the future and nobody really gets too upset if you invest in 10 different shares and one does badly or go broke. On the other hand, there are boring old dour people like me who are fixed interest investors and we are very, very scared of the asymmetry of bond investing because if you invest in a bond and it goes south, there is a lot of words to be spoken and it's not a good look.

Tahn Sharpe:
So the downside is unlimited but the upside is capped.

Michael Block:
Exactly right. There is very limited upside. All there is your interest payments, but you could lose all your capital.

Tahn Sharpe:
Yes. Final question, Michael. Do you think that we'll ultimately have a government or some kind of regulatory intervention into private credit in Australia? Is it a case of having some kind of disclosure requirement or perhaps a rating system? I mean we have prudential requirements for banks to have reserve capital. Is that under consideration for non-bank credit providers?

Michael Block:
I wish it were, but it weren't. It will not happen. Just have a look at something like Afterpay. It's always been able to skirt all the credit regulations by not falling under them. This is just my personal opinion, but I think you can bet your life that there's going to be further regulation on private credit for no other reason than it's hugely popular. And as we spoke about before, I don't think people really understand that it's different from a government bond. It's different from a term deposit. There are real risks in getting your money back.

And the reason I say this is that the government has sought to phase out hybrids, which are banks using subordinated debt to get money and they're still pretty much banked in. They're only just below investment grade at BBB- or sometimes even BBB. So they're much safer than private credit and the bank's phasing them out because of a concern that investors might mistake them For term deposits.

It's almost a bit of nanny state by the government. So if you use that lens to look at things, I'm absolutely certain that the government would be aware that people are selling private credit as equity-like returns with bond-like risk. And I think they're going to want to at the very least, make it absolutely clear that you can't say that. You have to make it clear to people that this is unrated illiquid higher risk, higher returning debt. And I think they might make some restrictions on that, but certainly some regulation.

Tahn Sharpe:
So at the very least, perhaps some parameters around how private credit is marketed, especially to retail investors.

Michael Block:
I really hope so. I mean, let's go back to the hybrids. We have to stop selling hybrids which are really very safe in the big scheme of things because of the fear that little old ladies might buy them thinking they're return deposit. But those same little old ladies can buy equities and crypto and gold. So certainly if that's the case then maybe the regulations sort of already exist.

Under the know your client and best financial interest duty, I think there are reasons that you've always got to tell the truth to potential investors, but I expect to see this codified in some way in the future for no other reason than private credit right now is the most popular investment. And the reason is, as I explained before, if you're really going to try and get a return of eight to 12% per annum, private credit is probably one of your best chances.

Tahn Sharpe:
Michael, it has been a fascinating discussion about what is a red-hot topic in financial services and investment circles. Thank you for joining us today.

Michael Block:
Thank you so very much for having me.

Tahn Sharpe:
And thank you for listening to INTHEBLACK. Make sure to check out the show notes for links to Treasury and the IMF's reports into private credit, and other resources mentioned in today's episode.

If you found this episode insightful, please subscribe to INTHEBLACK and share this episode with your network or colleagues. Your support helps us bring you more valuable discussions like this and we really appreciate you being with us. Until next time, thanks for listening.

Garreth Hanley:
To find out more about our other podcasts, check out the show notes for this episode, and we hope you can join us again next time for another episode of INTHEBLACK.