Superannuation funds must be aware of the risks associated with private credit, particularly as many increase their exposure to the asset class, Bellmont Securities chief investment officer Michael Block has warned.
Speaking in a recent podcast, Block said that while super funds have traditionally focused on shares and bonds, the introduction of the performance test has prompted a shift towards alternative investments like private credit.
Block said super funds are increasingly relying on private credit investments as a way of ensuring they meet the benchmark set under the performance test, particularly as private credit tends to generate returns of 10 to 15 per cent per annum but is benchmarked against investment grade credit.
This raises important questions around what assets super funds are pulling money from to make these new allocations in private credit, he said in a recent INTHEBLACK podcast.
“Do you take it from debt and fixed interest investments or do you take it from equities? I can say I’m in the minority and believe that it should be seen as an equity substitute as it’s much more risky than investment grade credit,” Block said.
Block outlined there were varying opinions and noted that the Your Future Your Super test measures private credit against an investment grade bond benchmark.
“I don’t agree with this because private credit has a lot of similarities and some of the same attributes as private equity,” he said.
Private credit should instead be seen as a type of hybrid asset class that’s roughly 60 per cent equity and 40 per cent debt, according to Block.
He explained that the businesses that private credit funds lend to predominantly fall into two categories. The first category is businesses who can’t get a loan from the bank and the second group is businesses that are unable to meet the much stricter selection criteria imposed by the banks following the Global Financial Crisis and the pandemic.
“Banks are now much more careful in terms of who they lend to and sometimes it can be a really good business but because of their size or profitability, the banks don’t want to lend to them because of the stricter regulations,” he said.
This means that private credit funds are generally lending to smaller companies, which means private credit could be classed as a high-risk, high-return, unrated, illiquid investment that should command a higher return.
“Unfortunately, a lot of people who are selling are saying things like private credit is an asset class where you can get equity like returns for bond like risk which is a misstatement,” Block said.
“While it’s true that a lot of private credit is first lien, senior secured debt, investing in first lien, senior secured debt for a very small company might be a much greater risk than highly subordinated debt of a regulated company like a bank. I don’t think people understand that this is the case.”
Investment manager and non-bank lender Woodbridge Capital recently raised similar concerns about some private credit funds making misleading representations about the level of risk associated with private credit investments.
Woodbridge Capital co-founder, managing director and chief investment officer Andrew Torrington told InvestorDaily there was currently a lack of rules for private credit funds relating to valuations, the disclosure of fees and leverage, a lack of standardisation across monthly reporting and the management of operational risk.
“It’s all very grey so bad funds take advantage of it. They’re hiding risks and hiding fees and investors can’t see that,” he said.
ASIC has previously indicated that it is conducting surveillance on the private credit market and also examining how super funds are investing in the asset class.
The corporate regulator plans to publish a progress report on private credit next month following its comprehensive review of the market.
Despite the risks associated with the asset class, Block said he still views it as a valuable tool in an investment portfolio but stressed that investors must be discerning about which funds they invest in.
“I invest in it both personally and professionally and I think it’s fine to invest in but only if you get the right one,” he said.
“How do you make sure that happens? Well, it’s very important to invest with managers that have got a long-term track record, where they’ve been able to manage money in good times and the bad times.
“I say this because in the last 20 or 30 years, we’ve been in a Goldilocks environment where it’s been a really wonderful environment to invest. We’ve seen interest rates come down. We’ve seen very negligible levels of defaults and we haven’t really had a default cycle.”
Block said investors should also look carefully at the collateral or the security for the loans and ensure there’s a strong change that they’ll get their money back or get paid a return that’s commensurate with the risk that they’re taking.
