Introduction

Over the last decade, and particularly the last 5 years, there has been a proliferation of private debt strategies issued by fund managers in Australia. The segment has evolved into a distinct asset class, with private debt fund managers now offering Australian investors access to a multiplicity of underlying loan exposures. These include Australian commercial real estate (CRE) loans with property development, residual stock and land sub-division purposes; SME loans secured by assets such as mortgages (property-backed cashflow loans); invoices (invoice lending); property, plant and equipment loans (largely business auto loans); legal disbursement lending; livestock lending (feedlot lends); and direct lending to mid-size or non-listed corporates (mid-market corporate lending).

To fund the increased loans, the sector has attracted considerable capital across the spectrum of investor types, including superannuation funds, institutional investors, family offices, high-net-wealth (HNW) individuals and wholesale and retail investors. Most importantly, it has delivered on its stated investment benefits, which include strong capital preservation, relative income stability, attractive risk-adjusted returns, and low or negligible correlation to listed asset classes, including publicly-listed debt (bonds/floating-rate notes).

Foresight expects the Australian private debt sector to continue growing, driven by these 2 key tailwinds: fund managers delivering on stated performance objectives and investors continuing to be drawn to the sector.

Background

This piece focuses on the Australian private debt verticals that the banks continue to retreat from, specifically CRE lending, SME financing, specialty financing, and low-to-mid-market corporate direct lending. It does not cover the non-bank residential mortgage and consumer credit verticals – where banks remain heavily focused – which display quite different market dynamics. In the non-bank lending market, the consumer credit vertical is a paper in itself. Suffice to say, Foresight would strongly recommend eschewing the sector during this stage of the economic cycle.

In Australia, the private debt sector is dominated by CRE lending and then significantly less by SME lending and corporate direct lending. That said, we believe SME lending, particularly the warehouse and securitised note structures (the only vehicle structures we would recommend in the SME lending sub-segment), will likely exhibit the highest growth rate over the foreseeable future.

Foresight maintains a cautious outlook on the corporate direct lending segment in Australia, in contrast to the U.S. and European markets, where this segment dominates the private debt landscape. The simple reason for this is that in more established markets, the stakeholders are giants. When a corporate lend goes wrong, they have the private equity skills and resources to manage the sale of the underlying securing asset. They are able to ensure repayment of loan principal and penalty interest rates and possibly make a pretty penny on the equity sale of the business.

The domestic players in Australia simply do not have the private equity experience and the internal resources. We understand that direct lends by Australian managers in this vertical tend to be highly selective, targeting defensive industries and businesses with more defensive cash flow profiles. But that is not really the point. A fund manager in this vertical needs to bring the full spectrum of expertise – from origination all the way through to workout.  We do believe this segment will evolve in Australia, but that evolution, should it occur, will be driven by large global players. Such loan exposures are unlikely to be made available to Australian wholesale and retail investors, rather be institutional offerings.

We know that in the U.S. market over the last 5 years to 3Q2023, an average 1.5% yield premium has existed for holding debt in companies not controlled by private equity firms (i.e. ‘non-sponsor borrowers’) over debt controlled by private equity borrowers (i.e., ‘sponsored borrowers’) (Source: Cliff Water Direct Lending Report). We posit that a contributing factor is that non-sponsor borrowers might be viewed as riskier because management behaviour, particularly under corporate distress, could be less predictable and costlier to lenders compared to sponsor-backed borrowers.


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