Private debt

We get approached by private assets firms hoping to offer new funds to our clients pretty much every week.* Almost all of these funds in Australia are doing the same thing: lending money to property developers. Because interest rates have increased a lot and credit spreads have widened, the running yields on these funds are very impressive. Some are as high as 10%. Because most of these loans are floating rate the increase in interest rates hasn’t affected them. And because most of them are unlisted funds that are not marked to market, the collapse of various builders around the country hasn’t caused the unit prices to fall. So on the surface, they look like great investments. You’re getting equity-like returns for something that appears to be fixed interest.

But this raises the question of why these funds pay such high rates. The answer is that by investing in these funds, you’re lending to the businesses that can’t get a better deal from a bank because they’re too risky. In recent years APRA, which regulates the banks, has relaxed its stance on real estate development. APRA requires the banks to hold capital to protect the banks in the case of an economy-wide downturn: there are provisions for loan losses, which is the expected loss on the loan book in each year, and an extra capital amount that reflects the additional losses that can occur in a downturn when many businesses are failing at once. This capital amount is ultimately based on historical losses using data from around the world, combined with judgement. It used to be that APRA wouldn’t trust the banks to calculate these losses for real estate and basically told them how much capital to allocate based on very simple qualitative criteria. Now APRA allows banks with good risk management to treat them as commercial loans, but with an extra 50% capital buffer because the loans are riskier.

Source: APRA

But that often makes the proposition unattractive for banks and developers. The banks need lots of information from the developer, take a long time to process it, and are inclined to say no because they can earn a much higher margin on the capital with mortgages or other loans. So, in steps the private debt fund. In many cases, these funds can turn around a loan in a matter of days and are willing to lend to developers that the banks wouldn’t touch.

The question everyone wants answered though is, are they a good investment? That’s a difficult question because these funds have not been through a downturn in Australia, and it’s hard to know how effective their risk management will be. In general, though, we can say that they’ll probably make money. There’s a significant premium to safer assets embedded in the interest rate, and the fund managers are well credentialed with what sound like rational processes. But the risks are high. If we say that the risk of a collapse in the property development sector is about 4% (that is, one year in 25 with conditions like this there’s a sector-wide issue – with the number of builders failing that we see at the moment, I’d argue that’s optimistic) and that the average loss in a default is about 75% (half-finished housing developments in outer suburbs are not usually saleable if the whole property market is down). That means you subtract a notional 3% expected loss from your return. That’s still better than you’d get on a safe asset. But if a downturn does happen, you won’t be able to sell out and your equities will be down as well, so from a portfolio construction and diversification standpoint, that extra yield comes at a cost. If a downturn doesn’t happen, you can collect your income and congratulate yourself on your skill or good fortune.

The fund managers themselves give some indication of the extra level of risk: they talk about risk mitigations like having direct access to the developer’s accounting and being able to see (and sometimes having to approve) every invoice. Regular lenders don’t have to do things like that because there are saleable assets securing the loan, or the borrower’s source of income is secure enough that you don’t have to audit their accounts constantly. For these funds, that’s not the case.

Overall we’d consider them a niche investment. They have the potential for good returns but are hard to fit into a diversified portfolio because of the negative skew and correlations with equities in a crisis. Do you reduce your equities to add private debt? Probably. Under what scenarios will that leave you better off? A muddle-through economy where nothing terrible happens but growth remains moribund for years. Add in the illiquidity of most of the funds, and we conclude that most investors don’t need to add these to their portfolios.

* I write note this with some trepidation, as usually a note like this triggers an extra flurry of fund BDMs attempting to contact us to position their products.

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