Is the private credit boom a little too hot to handle? Not always, but keep your eyes on the road ahead

The sale is complete. You’ve picked up the keys and are smiling ear to ear as you drive your new wheels home for the first time. Several months later you book your pride and joy in for a service and — uh oh. What lurks under the hood starts to emerge. Faulty water pump, oil leaks, cracked head — the list goes on. A seasoned mechanic could have spotted these issues and helped determine if the risks were manageable, but instead you’re now left with an asset that may chew through cash and be difficult to dispose of. The same goes for private credit. Private credit is a type of non-bank lending where a fund manager raises money from a range of private investors for lending to specific projects, as well as to private and public companies. We regularly see a variety of new investment groups popping up, but what we have noticed is a rapid increase in the number and variety of private credit investments available. There are several factors that have created conditions for its accelerated growth, with the private credit market almost doubling in the past five years. That is creating increased caution among some investor commentators about the quality of some of the underlying loans and some of the managers that have entered the market to cash in on the boom. So what has created this investment environment? The private credit market boom has been driven by traditional lenders, such as banks, altering their lending practices. This shift in lending philosophy saw many banks exit property development lending and tighten up on loans to small to medium enterprises. It left the door open for private investors to step in and fill the gap, through pooled funds operated by private credit managers. Historically low interest rates from late 2020 through to mid-2022 further fuelled the attraction to private credit as investors armed with piles of money were desperately searching for yield on their assets. Internationally, growth has been even more pronounced, thanks partly to the more aggressive approach of funds using leverage to boost funds’ size, and hence their fees. This layering of leverage is akin to carrying out major engine performance modifications to your car. Yes, it can turbocharge returns, but equally it can blow up the engine if pushed too far. That is why internationally, such financial engineering has started to raise regulators’ eyebrows. While default rates on the loans within these funds have been subdued, there is a risk that if the economic conditions become tough, some credit funds may be reluctant to call out their bad loans. Instead, they may prefer to renegotiate terms with their borrowers to avoid a crisis in confidence among investors, which would be more damaging to the fund’s reputation. And when it comes to valuing their loans, though private credit funds generally follow accepted accounting principles, the rules for asset valuations are complex and can be inconsistently applied. Therefore, valuations could become even more precarious if a macroeconomic shock prompts widespread reassessment of asset values. The real issue here is the opaqueness in the private credit funds’ operations, which increases potential risks. As demonstrated by last week’s interest rate announcement, the Reserve Bank has stated it is not in a hurry to cut interest rates aggressively which, together with stagnating growth in many sectors, could lead some of the more marginal credit providers start to misfire. Don’t get me wrong, the right private credit fund, like a great performance car, can be a worthwhile purchase. Potential advantages of private credit include the generation of a strong income stream, improved diversification, and offering protection from rising rates, given their typically floating rate nature. It can have a place in a well-diversified portfolio where the investments are made through high-quality, experienced and disciplined private credit fund managers, which is why it requires a sound pre-investment inspection to ensure you understand what you are getting yourself into. Christian Golding is a strategic wealth adviser at Pitcher Partners Wealth WA