With the traditional dominance of banks in the private debt and credit markets declining, combined with an ongoing lower interest rate environment, we are seeing new opportunities arise for investors from a centuries-old, but previously inaccessible investment sector.

Numerous non-bank financial intermediaries (NBFIs) and specialist fund managers (local and global) are now participating in these markets and, as they are not restricted by bank capital regulations, they are filling a much needed financing role for small medium enterprises (SMEs) and mid-market corporates.

This opening up of private debt markets has given investors the ability to participate in the attractive 'net interest margin' that was typically available only to the banks and larger financial services institutions, resulting in a 'disruption effect' on private debt markets, where excess lending capacity is being taken up by NBFIs.

But how did we get here? And what does it mean for investors?

Traditional options

With interest rates in Australia at record low levels - and possibly to fall even further - the traditional ways of generating income in an investment portfolio are becoming more challenged.

Low interest rates mean many sovereign and investment grade securities - including the old favourite, term deposits - are returning well below 2.5 percent a year.  At the same time, property market yields have also declined thanks to the price appreciation, particularly in the residential market.

As a result, traditional income-oriented investment options have become increasingly less attractive to investors. This is occurring at a time when demand for income rather than pure growth oriented exposures is rising due to an ageing population and investors are increasingly entering the post accumulation phase of superannuation.

Traditional  forms of income

Some of the options traditionally used by investors include:

• Government securities - while these are very safe, they are also very low-yielding due to the current RBA cash interest rates of 0.75 percent. Current yields range from 0.75 percent for a 2 year maturity out to 1.07 percent for a 10 year maturity.
• Corporate bonds - investment grade issues are also very safe but also relatively low yield.  For example, Stockland (rated A-) 3 year November 2022 bond currently yields 1.92 percent , Qantas (rated BBB-, below investment grade) 7 year October 2026 bond yields 2.50 percent and Telstra (rated A- ) April 2027 bond is yielding 2.09 percent.
• REITs - while listed property securities are relatively safe, they are also vulnerable to the current fluctuations in the Australian property market.  They are also offering lower yields as a result of higher asset price levels'
• Securities such as mortgage-backed securities (MBS) also provide income alternatives for investors as bank and non-bank mortgage lenders have created securitised pools of residential, commercial and asset backed loans.  These offer blended forms of risk exposure across rating categories and deliver returns ranging from 2 percent for higher rated tranches, and upwards for lower rated subordinated tranches.

The private debt alternative

Until the changes in banking regulations, and following the global financial crisis, private debt lending opportunities were largely the domain of the banks and larger financial institutions. But they are now an option for investors through a range of private debt lending funds offering different strategies.

A key point is that not all private debt is created equal. There are a myriad of options that fall under the broad banner of 'private debt', including syndicated lending, property loan funds, direct lending to SME and mid-market corporates, and peer-to-peer lending, amongst others.

• Syndicated and leveraged loans - these allow access to larger bank-originated loan transactions that, for regulatory capital reasons, are now sold down directly to institutional investors and fund managers launching listed and retail investment trust offerings. These loans are typically senior (not always secured or perhaps covenant lite) but against stronger rated credits with returns ranging from 3 percent upwards to 5 percent. 
• Property loan funds - these forms of private debt funds have been available to investors for longer than the others mentioned, as a result of Australia's traditional investment interest in the property asset class. The lending exposures vary across senior and mezzanine lending structures with returns ranging from 5 percent to mid double digit returns subject to risk exposure, ranking and payment profiles.
• Direct lending to SME and mid-market corporates - this generates bespoke loan transactions that seek security across all forms of collateral including business assets and perhaps property where available. These loans can be written at senior secured through to mezzanine or subordinated levels which increases the risk exposure for investors.  However, they should attract equivalent return enhancement ranging from 8-15 percent, depending on the credit quality and level of security. Diversity of collateral, strong legal documentation and tight covenant packages are all key requirements for capital preservation and strong returns in this segment.
• Peer to peer lending platforms also link borrowers and lenders directly through online credit assessment portals which calculate rates of return based on perceived risk and position in the capital structure. Many loans are often unsecured or against collateral that may not be as easily recoverable in a default scenario due to the size of the loans and cost benefit of recovery actions given the unsponsored nature of these transactions. Returns for these loans are typically in the order of 8 percent or greater but with potential for larger loss given default rates in the event of a default scenario.

These private debt options have become more readily available to investors in the past four or five years in Australia and some have been available for 10 years or more in the United States and Europe.  Although less established as a retail or wholesale investor option in Australia, recent figures from the Reserve Bank of Australia estimate that the Australian private debt market exceeded $2.8 trillion in 2018, which covers these abovementioned lending options  as well as direct property loans and mortgage backed securities.

It's a not inconsiderable sum, similar to the total size of the Australian superannuation market.

SME and mid-market private debt

Independent research based on RBA and banking research data in 2018 identified the SME and mid-market private debt market as a $460 billion dollar subset of overall private debt markets in Australia which were traditionally serviced by the banks until recent years.

Due to the tightening of global bank regulatory capital requirements - such as the Basel Accords (which provide recommendations on banking regulations in regard to capital risk, market risk and operational risk) and the recent Banking Royal Commission - banks in particular are pulling back from the SME and mid-market private debt market.

This less aggressive bank activity in this sector, has opened up an opportunity for wholesale and retail investors to take the place of banks in lending to this large and diverse sector in Australia.

There are currently over 50,000 businesses in Australia which fall within the SME and mid-market corporate sector with around $460 billion in loans outstanding as noted above.  This has grown from around $300 billion in 2009. With the banks pulling back, SMEs and mid-market corporates are looking for other funding sources.

Exacerbating the situation for SME/mid-market borrowers is that banks will now often only consider property as acceptable collateral on a loans to these borrowers. This has two potential effects:

• It results in banks having high exposure to property market trends (and often illiquidity in the property market in the event of a credit crisis)
• It means there is a lower collateral borrowing base available for businesses seeking a loan to help them grow

In our view, only considering property as suitable collateral is very limiting for such businesses in a growth phase and results in significant lending caution amongst the major banks. In fact, lending against a business's more liquid assets - such as trade receivables; inventory; plant and equipment- provides an opportunity for both the borrower to broaden their borrowing base and for the lender to hold security against a more liquid and diverse asset base.

A key part of this strategy is that a lender should be the sole or lead senior secured lender to ensure they are first in line and able to drive the loan recovery in the event of default. Monitoring of loan exposures via strong, well documented covenant packages should also be standard practice. These should be a key due diligence considerations when retail investors are considering the investment options available to them in this sector.

'Credit arbitrage' and collateral diversity

A differentiating opportunity for investors arising from lending against these diversified asset pools is a form of "credit arbitrage." Often, SMEs and mid-markets corporates will do business with investment grade corporates and government entities. When security is taken over a firm's trade debtors, these investment grade debtors may form a large part of the security collateral base, which means the lender attracts a higher interest rate from the unrated borrower but the security of a higher credit rated and/or more diverse collateral pool.

The size of the sector in Australia (over 50,000 businesses) also  means there is typically great diversity of industry sectors, as well as granularity of exposures and collateral types across debtors, inventory and plant and equipment.  This form of lending generally includes low or no exposure to property as collateral security, which means it diversifies an investor's portfolio exposures away from a sector where they may have significant direct or indirect exposure to through residential, commercial or REIT investments.

What are the key considerations for investors?

Not all private debt managers are the same. Investors considering this area should ensure that in choosing a private debt manager they meets three key criteria including:

• High standards of credit assessment and sound risk management focused on capital preservation, targeting competitive risk adjusted returns for the credit exposure taken
• A network of trusted advisors to source and assess quality leads across industries, sectors and geographic exposures with transparent and comprehensive financial reporting
• Experienced credit management personnel capable of: ?
  • Effecting sound credit policies and procedures; ?
  • Prudent deal structuring and strong covenants; ?
  • Thorough due diligence; ?
  • Efficiently managing the documentation process; ?
  • Performing ongoing loan review; and ?
  • Possessing strong loan management, restructuring and recovery skills. ?

This type of private debt lending may best suit investors who are:

• Focused on capital preservation: this will be achieved by experienced managers taking senior security over borrower assets to ensure an investors capital is recoverable in the event of a default.
• Seeking to achieve attractive risk adjusted returns in excess of 9% per annum after fees against a diverse and granular pool of current, fixed and real assets.
• Seeking diversification away from traditional asset class exposures. Recent studies by Citibank and Morningstar show that in Australia, private debt has a? -0.26 correlation to the S&P/ASX 200 Index and 0.34 correlation to the Bloomberg AusBond Composite Index. These figures show a low positive correlation to bonds and low negative correlation to equities which implies that forces affecting these two markets have a minimal or negligible effect on the SME/mid-market corporate loan segment.

In the event that we see near term corrections in core asset markets therefore, exposure to private debt may provide a smoothing of overall portfolio performance through competitive income returns.

Mike Davis is co-founder and director of Causeway Asset Management, a boutique alternatives asset manager operating in the private debt market, founded in 2002.  He has over 30 years experience in the financial services industry. He began his career with Deutsche Bank before spending 14 years with Merrill Lynch in a number of roles both in Australia and overseas. He was also the chief executive of Tyndall Asset Management.