By Taline Chater, Partner Restructuring and Insolvency, John Moutsopoulos and Matthew Farnsworth, Partners, Financial Services
It is hard to believe that the Global Financial Crisis (GFC) occurred nearly 20 years ago. Many will recall the consequent change in banking regulation increasing the cost of lending and the flight of foreign banks to focus on their domestic markets. Since then the private credit (non-bank lending) industry has evolved and grown exponentially. It is now attracting significant negative media attention and both APRA and ASIC have recently announced it is a key area of focus for them. Fundamentally, APRA as the prudential regulator is concerned that private credit may be a new and emerging (possibly systemic) risk to the banking sector and ASIC as the conduct regulator, is concerned that investors in private credit funds may need more protection – for example because they may not be receiving adequate disclosure and operators and managers may be subject to unacceptable conflicts of interest. There is a familiar ring to this backdrop, including back to 2012 when ASIC looked at retail mortgage schemes.
The RBA has reported that global private credit assets under management have quadrupled to approximately US$2.1 trillion in 2023 and that in the Unites States, private credit is now at the same level as the bond and leveraged loan markets. When we turn to Australia, however, the private credit corporate and real estate market is estimated at A$188bn+ accounting for approximately 13% of the total of the corporate debt market[1] and is well below the bond and leveraged loan markets.[2]
At this point in the cycle and in light of the regulators’ focus on the sector, it is timely to identify the key themes that have recently emerged, globally and domestically in the private credit markets and provide our views as to the future outlook.
1. Private credit is here to stay: it is now seen as an attractive asset class for investors with strong tail winds
Private credit generally involves investing in an investment vehicle that lends capital (on a secured basis) to unlisted corporate borrowers including in the commercial real estate infrastructure, energy and healthcare markets. In Australia, the lending vehicle is typically structured as an unlisted and unregistered unit trust and its target investors (for the most part) consist of wholesale investors. The trustee of the trust would be required to hold an AFSL as would any manager of the trust involved in marketing activities or advising on or dealing in assets that include financial products. From an investor perspective, this is increasingly being seen as an attractive asset class not traditionally available to wholesale or retail investors. The number of wholesale private credit funds being set up to aggregate non-bank investor capital has ballooned worldwide and in Australia, following the GFC. Many Australian businesses including start-ups and scale ups benefit from these new non-bank lender vehicles particularly as they are not able to access Australian bank funding at all or on competitive terms. Whilst retail private credit funds exist, they are very highly regulated and whilst superannuation funds invest in private credit neither of those groups of investors are a focus of this paper. The focus of this paper is on private credit funds that target wholesale clients who are generally unsophisticated individuals and other investors like high net worth individuals and cash rich retirees.
2. ASIC focus on some bad eggs in the private credit sector is a good thing
When you look at some of the recent claims being made in the media about private credit funds it is no surprise that the sector is now getting increased attention from ASIC. Claims relate to conflicts of interests, opaque fees, poor quality valuations, generally inadequate disclosure and circumvention of the National Credit Code (ASIC’s current proceedings against Oak Capital). The bell you may have heard ringing above is one that the broader financial services sector has heard before. It is fair to say that ( like any sector) there is a wide spectrum of practices including bad practices in the private credit sector and of course ASIC are just doing their job by focussing on these bad practices. A similar situation occurred with retail mortgage schemes and when ASIC got involved, they improved disclosure for retail investors by issuing Regulatory Guide 45 (Mortgage schemes) in 2012 which required disclosure against benchmarks and principles to more appropriately reflect the risks associated with investing in mortgage schemes with a view to facilitate better informed retail investors. Maybe that will be a precedent for wholesale private credit funds on this occasion. If so, that will indeed be a precedent which will rattle the wholesale market a little since ASIC generally operates as a consumer regulator (which is reflected in its published policy), even though it also has jurisdiction over wholesale products and markets.[3]
3. Australian laws set a minimum standard of business behaviour
The other point to keep in mind is that Australia has a perfectly effective, long established regime which prohibits unconscionable and misleading and deceptive conduct (and other conduct that falls below a statutory minimum standard) that applies to financial services providers. ASIC recently commenced enforcement action against a non-bank lender for engaging in unconscionable conduct by providing loans to companies – rather than the individuals requiring the loan – to avoid the operation of the National Credit Code and the National Consumer Credit Protection Act, in circumstances where the lender knew, or ought to have known, that the loan was for a domestic, personal or household purpose (such as a home loan) and would otherwise be captured by the Code.[4] In addition, ASIC has separately, successfully exercised its enforcement powers under this regime to send a strong message to its regulated community that it will not tolerate greenwashing behaviour. The central claim in 3 recent greenwashing proceedings commenced by ASIC against fund managers and super funds was similarly, that the entity had engaged in misleading and deceptive conduct. So it seems that ASIC has a choice of regulatory pathways available to it regarding the private credit industry should it ultimately determine that it needs to take deterrent action to steer the ‘bad eggs’ in the private credit market in the direction it considers aligns with ASIC’s views.
4. APRA regulation of non-bank lenders
APRA does not currently prudentially regulate non-bank lenders. This is one of the key differences between a bank and a non-bank lender. It can be seen both as a strength ( in terms of the lighter touch regulation that private credit funds enjoy as compared to bank lenders) and a weakness (from an investor perspective in terms of ASIC not really focussing on non-bank lender business models and prudential credit and risk issues). Since the enactment of the Treasury Laws Amendment (Banking Measures No.1) Act 2018 (Amendment) in 2018, corporations which engage in the provision of finance whose loan portfolios exceed $50million in value are required to be registered with APRA in accordance with the provisions of the Financial Sector (Collection of Data) Act 2001 (Cth) (FSCODA). Once registered, a non-bank lender must provide periodic reports to APRA. There appears to be some suggestion that a company acting in the capacity of trustee of a private credit fund is somehow exempt from registration. That seems too cute a position to take really.
APRA also has powers under the Banking Act 1959 (Cth) (BA) to determine rules for corporations registered with APRA under the FSCODA if it considers that the provision of finance by the lender(s) “materially contributes to risks of instability in the Australian financial system”. While it is unclear in what circumstances APRA might determine that this threshold has been met,[5] and APRA has broad powers to apply these rules at its discretion, the size of the private credit sector and its ability to materially affect the market is a relevant factor. APRA’s announcement of its new cross-industry stress testing will consider the risks of contagion and market instability given the growth of the private credit industry. Any new rules which APRA may choose to make under the Banking Act will likely come as a rude shock for the sector, which awaits APRA’s determination on the market instability question. The good news at this stage is APRA’s comment that “We have got a very large pool of superannuation money, and only a small proportion of it is actually in private credit.”[6] And the comments by the Reserve Bank of Australia that “Due to its small size, direct risks to financial stability from the private credit market in Australia appear low’, that ‘Risks stemming from overseas private credit also appear contained’ and that ‘liquidity risks are low’
5. Opportunities for offshore debt funds
What seems clear so far is that some portion of the Australian private credit industry has weaknesses in it which will likely be the subject of ASIC enforcement action in the coming 12 months or so. This means there will be investment opportunities for offshore debt funds to purchase distressed portfolios or private credit funds or their management rights.
6. Syndicated loan/private credit dynamics
There have been some signs globally, that the banks and private credit funds are now competing on the same deals. Certainly in the United States, in the first quarter of 2024, over US$13.2 billion of private credit owed by US companies has been refinanced in the broadly syndicated loan (BSL) market.
We do not see this playing out in the Australian market yet, which is still very much a developing market and focused on commercial real estate assets, as compared to overseas markets which focus on various assets classes including large sale industrial and digital infrastructure. If one considers the way in which the private credit market has emerged here, a major factor was APRA’s adoption of the global capital rules, which led to increased capital adequacy requirements on the Banks, and APRA’s discouragement of Bank lending in respect of ‘illiquid assets’, particularly commercial property.
Given the prudential requirements on Banks remain, we do not expect a similar market dynamic playing out in Australia in the short term, which again is consistent with the anecdotal accounts of our clients. Rather, clients have said that they see themselves collaborating with banks on deals to provide borrowers the full spectrum of capital solutions.
7. Loan structures
We have seen the flexibility of private credit play out in global leveraged loan markets in recent years in the form of covenant light loans and liability management exercises, the most infamous being the transaction involving technology learning platform, Plurasight. In that transaction, the company engaged in a “drop down” manoeuvre, where under the loan documents, it was able to transfer its IP (which was a significant portion of the company’s total assets value), to an entity sitting inside the company’s restricted covenant group but which was not a guarantor of the current debt, in order to support new financing offered by its owner Vista Equity Partners. This new financing was structurally senior to the existing private credit lenders, which were effectively left with no secured assets. In addition, we have observed:
In Australia, where the majority of private credit funds are set up as unit funds hold underlying assets in commercial real estate we have not yet observed the same dynamics play out, although there have been slightly looser pre-sale with downside protections in form of parents guarantees have still been required.
8. Diversification of underlying asset classes
Larger private credit funds, particularly in the Unites States and Europe which have traditionally focused on commercial real estate assets have been diversifying their portfolios into student accommodation, build to rent properties and into infrastructure and in particular, digital assets, particularly date centres. The latter, is of course ceasing the opportunity presented by the rise of artificial intelligence and the significant energy consumption required to meet expected medium-longer term demand.
9. Managing distressed loans
In Asia, we have observed the increased use of formal insolvency processes including take control transactions by way of credit bids to manage distressed loans, particularly in the commercial property space. Hybrid equity instruments being part of the flexible toolkits of private credit funds, have continued to be offered in overseas markets and for Australian obligors as part of wider global corporate groups, particularly in the context of debt restructures where private credit providers have continued to support borrowers but have sought to manage downside risk exposures.
These trends have not yet borne out in the Australian market where distressed loans here have continued to be managed by “lend and extends” and covenant waivers. This has certainly suited sponsors who have continued to experience challenging exit opportunities.
Future outlook
Regulatory risks
APRA’s existing jurisdiction over private credit providers is limited to reporting obligations. However, given the broad and discretionary rule making powers, it is conceivable (but unlikely given its relative market size at the minute) that APRA may decide to enforce more onerous reporting requirements for private credit fund lenders or may implement specific rules (including prudential rules) against individual funds or the sector as a whole, if it considers that a funder’s behaviour or the size and direction of the sector as a whole may increase the risks of instability in Australia’s financial system.
Separately, ASIC however is more likely to increase its enforcement activity over the next 12 months and even issue new regulatory guidance for the sector, for example by requiring increased disclosure to investors in respect of conflicts of interest and fund managers’ fee structures. Market participants should be trying to get ahead of this now and carefully monitoring developments in the regulatory landscape.
Implications for fund structures
Private credit fund trustees and fund managers are no doubt reflecting on their own situation and seeking to identify material risks and risk treatments in their current approach. One positive by-product of all this ASIC attention will be a strengthening of existing fund processes, disclosures and supervision.
Debt restructuring
Looking ahead to 2025, we do expect there to be more instances of credit bids in Australia, where secured private lenders will look to manage their distressed debt exposures by way of a debt for equity exchange in their obligor group (by either a full or partial discharge of their secured debt). These transactions may take the form of solvent (bilateral share and asset sale agreement or shareholder schemes or arrangements), or insolvent transactions (voluntary administrations, or creditor scheme of arrangements) and may involve complex cross border considerations, if debt instruments and significant assets within a group are located in foreign jurisdictions. We see these type of transactions increasing as international funds with special situations mandates look to Australia for investments opportunities.
Please feel free to get in touch with either of Taline Chater, John Moutsopoulos or Matt Farnsworth if you would like to discuss further. The Mills Oakley Team are here to help if you would like to discuss your situation.
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[1] AIMA Alternate Credit Counsel Australia Private Credit Guide at page 6.
[2] RBA Bulletin October 2024 Growth in Private Credit. This estimate is based on lending to Australian businesses facilitated by asset management firms from investor money pooled into managed funds. It also includes direct lending from superannuation funds as part of a syndicated loan but does excludes non syndicated direct lending by superannuation funded.
[3] https://www.afr.com/companies/financial-services/asic-says-opaque-private-credit-funds-will-face-more-scrutiny-20240723-p5jvzn; https://www.afr.com/companies/financial-services/overdue-loans-swamp-private-credit-giant-lending-to-sydney-s-wealthy-20240807-p5k0cn
[4] See ASIC’s media release dated 30 October 2024: https://asic.gov.au/about-asic/news-centre/find-a-media-release/2024-releases/24-243mr-asic-sues-oak-capital-alleging-unconscionable-conduct-designed-to-avoid-the-national-credit-code/
[5] We note for completeness that the question of whether the provision of finance “materially contributes to risks of instability in the Australian financial system” has not been judicially considered by the Courts.
[6] https://www.afr.com/companies/financial-services/private-credit-must-be-less-secret-say-banks-regulators-20240723-p5jvsm
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