Much is written about the explosive growth in Australian private debt in recent years, albeit off a low base.
There are no official figures measuring this trajectory. However, the share of business lending held by finance companies is a useful proxy – and it has doubled to more than 10% since 2020.
It’s commonly said this growth is a result of tightened prudential regulation that prevent banks from lending to a range of companies. The inference is that private debt offers “bank like” risk at attractive high yield margins.
A closer look at the evidence suggests otherwise. The banking industry has withdrawn from select sectors only, such as auto lending. Otherwise, the claim that banks no longer lend to a broad range of companies is an over-used refrain that camouflages an increase in riskier lending by private debt managers.
A rule of thumb states that credit growth in an economy should roughly equate to nominal GDP through cycles. In Australia, bank business lending has exceeded nominal GDP in all years over the past two decades – so there appears to be little shortage of it.
This suggests private debt providers are not necessarily filling an unmet need for high quality lending as suggested by industry advocates. Instead, they appear to be providing a substitute for equity in more aggressive capital structures or providing loans to lower quality borrowers.
The upshot is that private debt performance will be tested in an environment in which “higher-
for-longer” interest rates are now set like cement. The cost of debt doubled as central banks
pushed rates higher and it is likely to be some time before corporate borrowers experience meaningful repayment relief.
Recent global experience points to the likely outcome of this scenario. US small caps with minimal market power are experiencing a margin crunch that is likely to impact their credit worthiness and lead to a spike in defaults.
A similar thematic could play out domestically. This is particularly true in sectors in which market oligopolies increase pressure on the cash flow generation of the small to medium sized enterprises at the core of many private debt portfolios. Such businesses generally cannot pass on higher costs to customers.
This is likely to result in more challenging conditions for private debt returns as evidence of impairments and constrained liquidity surface in the months ahead. In fact, insolvencies are already on the rise in Australia and accelerating well past pre-pandemic levels.
There is an incentive for asset owners to invest in private assets, including private debt, which are not marked to market to minimise portfolio volatility. This is well and good if capital is invested in assets that are unlikely to be impaired.
But history shows that turbo-charged growth in a market does not always deliver the most efficient outcomes. The US sub-prime crisis and original dot com boom are among the most infamous examples of this reality.
Local private debt may not present issues of the same magnitude but its rapid growth in a small market should make investors wary.
Asset owners need to be cautious they are investing in the right parts of the market, and in the right securities, to achieve the promised benefits of the asset class without taking undue risks.
Phil Strano, senior portfolio manager, Yarra Capital Management.
