Have you been hearing more about private credit? You’re not alone. A flood of new investment products arrived in 2022 offering investors and businesses alike access to the $3 trillion private corporate lending market in Australia.

Private credit is the oldest market that’s rarely spoken about. Put simply it’s a loan from one party to another – and existed well before listed equities, hedge funds or bonds. The reason you haven’t heard about it is because the banks have cornered this market for the longest time.

There are two sides to the private credit story. For investors, a primary promise of private credit is its potentially attractive income at a time when returns from traditional shares are expected to be lower in coming years compared to recent years.

Borrowers range from small to larger companies with excellent rates of growth, seeking flexible credit to fund their business growth. The private corporate lending market provides a secure and convenient alternative to the traditional banks.

Sounds simple. But what else is there? And what are the traps to avoid?

Here are the seven things investors should understand about the Australian private credit market:

One: Know thy market: it’s bigger than you think!

You may not know it, but the Australian private credit market is bigger than the Australian share market which was worth $2.4 trillion as of 31 October 2022, down from $2.7 trillion in March, reflecting falling share prices.

The mid-market in corporate loans – which is where Epsilon focuses its activities – is a segment of the private credit market that is worth around $70 billion and it’s growing; it consists of loans to support the growth of companies that have annual revenues between $25 million and $500 million, of which there are an estimated 34,000 in Australia. So, the pool of companies is actually quite deep.

Two: Keep it simple

Mid-market corporate loans are predominantly bilateral in nature – that is, there is one borrower and one lender in a loan agreement. Hence the term ‘direct lending’.

There are no so-called ‘middle men’ involved such as brokers or banks who take their cut or commission, which can erode value for the people funding the loans. The lender is the only one to evaluate, structure and document a direct loan – and gain the full return of that loan in terms of the interest rate and fees it structures.

Three: Direct loans can provide an inflation hedge

Corporate loans deliver a regular income stream for lenders, and the return often comes with a hedge against inflation. That’s because most mid-market loans are floating rate loans. Loans are typically senior secured based on the ongoing, forecast cash flow and enterprise value of the borrower.

The floating interest rate is typically linked to the bank bill swap rate and resets regularly, usually every 90 days. The interest rates on loans can vary between 4 per cent through to 15 per cent depending on the borrowers’ risk profiles, which vary widely. Overall returns from mid-market direct lending typically average in the high single digits.

An increasing interest in direct lending globally suggests that borrowers are happy to pay slightly higher rates to borrow from direct lending fund managers than to work through the bureaucracy of borrowing from banks.

Four: Full transparency; no hiding behind opaque arrangements

As any lender would know, the quality of their loan portfolio all depends on the quality of the borrower and in particular the sustainability and predictability of the free cash flow the company generates month-to-month.

Direct lending demands thorough due diligence processes with borrowers; there is transparency in the loan selection process, and so this corporate debt can be high quality.

Lenders also enjoy protections through seniority in borrowers’ capital structures, and crucially, security over borrowers’ assets and other financial covenants which protects against instances of company’s facing headwinds. The loans are underpinned by transparent contracts.

Importantly, a company must repay senior debt first if it goes out of business whereas shareholders are last in line to get their money back.

Five: Fund manager selection is critical

Entering this space requires some homework on the part of the investor. The first thing to research is the experience of the manager behind the private credit offer: lenders need broad industry contacts to access the most compelling lending opportunities. Loan terms and pricing are often idiosyncratic and interest rates must be negotiated, so private credit managers with expertise and experience are best placed to lend to borrowers.

The loan is typically held until maturity. The asset selection process is key to creating a solution for borrowers that combines a good return with managed credit risks.

Six: Not all security is equal (the trap of comfort in the term “senior secured”)

While senior security means that lenders are repaid well ahead of unsecured creditors and equity holders, this doesn’t always mean senior secured loans offer strong downside protection.

Imagine providing a senior secured loan of $10m to a leading global business which generates $500m per annum in free cash flow. Prima facie that’s a safe loan.

Imagine providing the same $10m on a senior secured basis to a small business which generates $200,000 of free cash flow per annum. Two senior secured loans of the same size, but very different risk profiles.

Don’t be fooled by lenders spruiking the value of senior security without understand the underlying nature and quality of the businesses they’re lending to.

Seven: Corporate assets include intangible assets

A company’s tangible assets include the things you can see, touch, and feel – the buildings, people, plant and machinery or physical land. But it is the intangible asset component of a great company’s balance sheet (the stuff you can’t see or feel that famous share market investor Warren Buffett refers to as ‘moats’) that today can account for up to 90 per cent of a corporate’s value.

Many of these great companies boast valuable IP, in their design, patents, relationships, or just simply their brand, all of which are intangible assets. Global brands like Coca Cola, Apple, and Microsoft are worth trillions of dollars for their brand alone.

Lending to other companies with strong brands and valuable intellectual property can be reassuring to investors that they will get their money back when a direct loan matures.

A strong brand may mean strong sales and cash flows, so your investment in a direct loan is likely to result in a potentially attractive risk-adjusted return.

The views, information, or opinions expressed in the interviews in this article are solely those of the interviewees and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.