There is a “clear structural story” taking place in Australian capital markets as regulatory pressures and a declining risk appetite prompt a retreat from banks in the commercial lending market, according to Citi.
This, in turn, has opened up an “attractive niche” for private credit, which stood at around $188 billion in Australia last year, according to recent projections from EY. BlackRock research puts the global private credit market at around US$1.6 trillion over the same period.
In his latest market note, Citi analyst Brendan Sproules labelled private credit a “hot topic” on the back of recent takeovers in the fund management space and a sharp rise in publicity.
Most recently, Regal Partners announced it entered into a share sale deed to acquire hard asset investment specialist Merricks Capital, citing “highly positive” outlook for private credit in Australia.
A month prior, HMC Capital said it had acquired Payton Capital, a leading commercial real estate (CRE) private debt fund manager.
“While some dismiss the rise of private credit in Australia as late cycle non-bank liquidity, we think that there is likely a structural shift emerging in the financial system,” Sproules stated.
This is backed by data, he said, pointing to a “strong uptick” in non-bank financial institution (NBFI) activity that is growing around 16 per cent year-on-year.
“The logical question is whether this hype is indicative of a structural trend, cyclical froth, or a combination of both? Certainly, we have seen through history huge swings in the availability of non-bank liquidity, which typically occurs late in the cycle as other liquidity tightens and some want to keep the music pumping,” he said.
In Australia, he noted an “inefficient” capital market has meant the “relatively narrow” financial system is dominated by the major banks and super funds.
“The industry funds are relatively nascent in building out their approach to direct lending in the Australian market, and the corporate bond market remains very small to an economy of Australia’s size,” said Sproules.
“Consequently, the major banks are responsible for the bulk of credit and credit intermediation in the Australian economy.”
However, with banks around the world facing funding constraints and higher capital requirements, there are “clear underlying drivers” which explain the structural emergence of private credit both in Australia and offshore.
“Heightened regulatory oversight of particular exposures has seen banks overcompensate in tightening credit,” he said, observing it is “unlikely” there will be a reversion in this behaviour that could see greater bank credit flow to some sectors.
“As a result, it is likely that private credit will continue to grow, particularly as higher base rates make gross returns more attractive.”
In particular, Sproules said higher-for-longer rates provide attractive returns and could see private credit achieve “equity-type” returns moving forward.
“While the returns over the past five years have been respectable from a risk-reward perspective, the prospect of higher for longer base rates is likely to continue to stimulate fund inflows into the sector,” he said.
“Since the GFC, the banks have increasingly de-risked, leaving the bottom of the investment grade credits and top end of the sub-investment grade market to new entrants. Around eight years ago, this was more likely a foreign branch, now it is more likely a private credit provider.”
Spreads in that bracket of the market are typically from 4–15 per cent over the base rate, and in the last five years, there has been a typical average annualised return of roughly 8 per cent for private credit.
“As base rates hold in a higher-for-longer scenario, this provides for [approximately] 10 per cent plus, or equity-type, gross returns for the sector with less volatility than other asset classes,” he pointed out.
Looking ahead, Sproules stated that a “peaceful co-existence” is possible between banks and private credit in many sectors of the markets. This, he explained, could mean banks potentially lend up to 65 per cent, and other providers step in for the residual on any given deal.
Previously, Metrics Credit Partners’ managing partner, Andrew Lockhart, highlighted how regulatory pressures on banks have limited their large-scale lending capabilities.
This will continue to see banks progressively cede market share, he said, thereby creating opportunities for private credit providers to fill the gap and cater to borrowers seeking alternative finance options.
“Whenever you hear a regulator say that they want the banking sector to be unquestionably strong, it means that the banks are going to hold additional capital, which means it becomes very difficult for a bank to be able to generate the required return on shareholders’ funds for lending for corporate and institutional purposes, and as a result of that, they’re ceding market share,” Lockhart told InvestorDaily.
“And let’s face it, Australia doesn’t have a corporate bond market where most borrowers can easily access alternative sources of financing, and most borrowers don’t have credit rating, so the ability to access financing away from the banks is of real value to borrowers.”
According to Lockhart, the market will continue to move towards private investors and private credit providers to meet broader financing demands, while banks move towards consumer home loan financing and lending for small and medium-sized businesses.
