Private credit: Navigating the risks and rewards

Pete Robinson, Head of Strategy at Challenger Investment Management

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As traditional banks retract from commercial lending, private credit emerges as a compelling alternative. In the latest episode of the Portfolio Construction podcast, Paul O’Connor, Head of Investment at Netwealth, and Pete Robinson, Head of Strategy at Challenger Investment Management, offer insightful perspectives on the rise of private credit and the inherent challenges, such as lack of transparency, higher credit risk, and lower liquidity. They explore the strategic placement of private credit within a diverse portfolio, investor considerations regarding liquidity, and the sector’s key risks, all while highlighting where the most valuable opportunities may lie.

Paul O'Connor:

Welcome to the Netwealth Portfolio Construction Podcast. I'm Paul O'Connor, and my role at Netwealth is the head of strategy and development for the investment options offered on our investment menus.

On today's podcast, we'll discuss private credit with Pete Robinson, from Challenger Investment Management, or Challenger IM, who is the head of investment strategy for fixed income. Pete's responsible for Challenger IM's multi-strategy credit portfolios, including the Challenger IM Credit Income Fund, Challenger IM Multi-Sector Private Lending Fund, and the Challenger IM Private Lending Opportunities Fund. Thanks for joining us on today's podcast, Pete.

Pete Robinson:

Thanks for having me, Paul.

Paul O'Connor:

Challenger IM is part of the Challenger group that includes Challenger Life, who offer annuities, Challenger IM, that originates and manages assets for leading global and Australian institutions, and Fidante, who partner and distribute investment managers across equities, fixed income, and alternative strategies.

Pete Robinson, head of investment strategies, is the lead portfolio manager at Challenger IM. Pete has over 19 years' experience, specialising in credit and real estate investing, and has experience in public and private credit markets in Australia, the United States and Europe, with a particular focus on securitized credit. Prior to returning to Australia in 2010, Pete was based in London at Y Tree Asset Management, a specialist asset manager focused on credit opportunities in residential real estate markets.

He started his career at Challenger holding responsibility for the Alternatives credit portfolio, and graduated from university with a combined bachelor of commerce science degree, from the University of New South Wales, and is a CFA Charter Holder, so certainly eminently qualified and experienced to talk to private credit today.

The Nipwell Super and IDPS investment menus offer Challenger annuities, a number of Fidante-issued funds, and the Challenger Credit Income Fund that Pete manages, is being added to the menu as we record today, and will likely be available by the time you hear this podcast.

The Challenger Credit Income Fund can allocate up to 50% of the portfolio to private credit, so it will be another option for investors seeking exposure to this fast-growing sector. Private credit, as a sub-asset class of fixed interest, has been growing for 30-plus years, and in recent years, this growth has been turbocharged, courtesy of the major banks globally, reducing their commercial lending books.

Private credit refers to lending to companies by institutions other than banks, and the loans are typically more tailored to borrowers' needs, in terms of size, type or timing of transactions. Like bank loans, however, the majority of private credit lending is in the form of floating rate investments, so the rate actually changes as interest rate changes, and hence, provides some interest rate protection, compared to the traditional fixed rate bonds.

This has been particularly appealing to investors in the current rising interest rate environment. Private credit covers property lending and commercial lending, such as business loans, and the lenders work directly with borrowers to negotiate and originate privately held loans that are not traded in public markets.

There are typically four types of loans, and these are direct lending, mezzanine, secondly, in debt and preferred equity, and then, finally, distressed debt. These loans all vary in risk, but I'll let Pete elaborate on the risk of these loans in more detail.

As the loans are private and not publicly traded, liquidity needs to be understood and considered by investors before investing in these strategies. But obviously, a significant benefit is that additional illiquidity premium, that can translate to higher returns for a given level of risk.

Maybe for starters, Pete, can you explain to listeners what attracted you about working in the fixed income, private credit, and your career path, I guess, back to Challenger?

Pete Robinson:

As you mentioned, I spent some time in the UK looking at European and US markets during the global financial crisis, and coming out of it, so I was looking at public markets, but they were very liquid during that time. So I think, US subprime mortgage securitizations, we were trading in those securities in 2009 and 2010, as we were coming out of the financial crisis, and really at the trough of the financial crisis, I was involved in launching a fund that launched right after Lehman went down, so ...

Paul O'Connor:

All about timing?

Pete Robinson:

Exactly. It's better to be lucky than smart, at times. And so, we were fortunate enough to launch a fund at really, the bottom of the market, and spent a lot of time picking through highly illiquid opportunities during that time. And I think there certainly wasn't a lot of talk about private markets at that point in time, but there was a lot of talk about illiquidity.

And I think sometimes, when we think about private markets, we put a label on something as being public or private, and we think that that sufficiently describes the opportunity or the investment. And what I found during the GFC was, there's really a continuum of liquidity profiles, and I like to think about public and private as being on a continuum, as well.

So I came back to Australia, coming out of the GFC, and one thing that attracted me about the Australian credit markets was the level of illiquidity, and the lack of transparency in the market. I saw that as an opportunity and on the securitization space, which was my background, but along with my colleagues at Challenger IM, we really looked to develop close relationships with borrowers, and understand their needs, and certainly coming out of the GFC, where there were gaps in the financing markets.

I like to think of our role within the financial markets as being the plumbers of the financial system. So really, finance is just about the flow of capital from those who have it, to those who need it. And sometimes, that plumbing gets blocked, because the capital can't be provided in an efficient way.

That efficiency can be cost, it can be the price of that capital, it can be the speed at which that capital is provided, or it can be how tailored it is, as you alluded to earlier, Paul. And so, our role really was identifying where those gaps were, where the blockages in the financial system were, and trying to provide timely, tailored and cost-effective capital there.

For me, that started with securitization. It started with the warehousing market, or the private securitization market. We were already, as a group, very active in the direct corporate lending markets, and had been doing that since before the global financial crisis, but really, that grew coming out of that, because you can imagine, coming out of a recession, and in Australia we certainly didn't have as deep a recession as we had offshore, but coming out of that period of macroeconomic stress, there were a lot of borrowers who needed really tailored solutions.

And I think you called out distressed credit at the beginning. It's not something that we do here at Challenger Investment Management, and really, within the Australian market hasn't been a substantial part of that private lending opportunity. But certainly, if we look at parts of Europe, with the retrenchment of the banking system in places like Ireland, Portugal, Spain, Italy, Greece, there were significant distressed opportunities for private lenders, coming out of that crisis.

Within Australia, given the dominance of the major banks, it's really been about more niche opportunities. But as you said more recently, the market has experienced really significant growth, as there have been areas where those gaps or those blockages in the financial system have really increased, as exacerbated by COVID, the Royal Commission into the banks, and other factors driving the ability of banks and public markets to provide that timely, cost-effective, and tailored capital to borrowers.

Paul O'Connor:

I've heard portfolio managers called a lot of things, Pete, but I've never heard one refer to themselves as a plumber. But I do appreciate the analogy there.

For starters, then, in terms of the questions for today's podcast, I mentioned in my opening that the banks have reduced their commercial lending books, but can you perhaps explain in more detail why private credit has grown so significantly in popularity?

Pete Robinson:

I think, when we talk about the banks, as you can imagine, spend a lot of my time doing this, having conversations about what the banks are doing, because what we're trying to do is sort of fill the gaps where they're stepping back. There's no one universal answer. So when we look at the banking system, in fact, coming out of COVID, they did provide a lot of credit to corporate Australia, and distinct from offshore markets, where it really was private lending markets and public bond markets that provided liquidity during COVID. It was a combination of equity and banks, domestically, in the aggregate.

But if you look below the surface, there's been plenty of areas where opportunities have expanded. If we look at corporate direct lending, and sponsor-backed lending, banks have traditionally struggled with that part of the market. It's capital intensive lending for them, because it's typically sub-investment grade, so there is an element of credit risk to it.

There's not strong asset level security, so you're secured over the cash flows of the business, and you're dealing with private equity-sponsored businesses, so there's perhaps not the same level of relational banking, or transactional banking opportunity, that sits within those parts of the market.

Those are some considerations, and certainly coming out of the Royal Commission, what we've seen strategically is banks have really focused on their retail franchises. They've wanted to have direct relationships with their customers, so really trying to, as best they can, avoid intermediated credit. And we've certainly seen that on the corporate side.

In securitization markets, for instance, it's much more regulatory capital driven. So banks get very punitive capital treatment for mezzanine lending, even if that mezzanine lending is secured over home loans, which is something banks, as we know, that's a core part of their business, but they can't provide asset backed facilities that are non-recourse, where they're not in a senior position. It's just highly inefficient for them to do so. It's also inefficient for them to hold auto and equipment loans on balance sheet, relative to mortgages.

The capital treatment for an auto loan to a consumer is 100% risk weight, versus a mortgage to that same consumer, could be as little as a 15 to 25% risk weight for the advanced major banks. So there's pockets of opportunity that come about as capital, there's pockets that have been a result of the Royal Commission.

And I think what we've seen in the commercial real estate market, which we can get into in a little bit more detail, is that development construction finance, particularly where the developments are not fully pre-sold, is really inefficient for banks to do. And if you read the quarterly financial stability reviews, and listen to the RBA and the Prudential Regulator, APRA, it's certainly something that they've been encouraging the banks to stay away from, so anything that's sort of cyclical or pro-cyclical, in terms of the lending, they've really encouraged the banks, and this goes back seven or eight years, is really encouraged the banks to step back from.

So, a variety of reasons. In aggregate, the banks still lend, there's still active lenders to corporate Australia, but there are those pockets that I described, where there are really significant and meaningful opportunities to step in, where the banks are stepping out.

Paul O'Connor:

Interesting comments there, I guess, from the regulatory impact on banks and the lending book there, but I also tend to think, from a broader portfolio perspective, that the credit market in Australia, list of credit markets, historically, been dominated by the banks. So the growth of private credit, I think, has opened up a far more greater diversified opportunity set for investors to consider allocating in their overall portfolio, or within their fixed income portion of their portfolio.

So I tend to think that this area will just continue to grow, and is more of a strategic play than a tactical play in a portfolio. If an investor's already holding listed credits, why should they consider private credit, and can listed credit provide similar exposures to private credit?

Pete Robinson:

Paul, I think you made a great point there, which I'll touch on, but it relates to your question, is the fact that so much credit in Australia is intermediated by our banking system, and if you're building a portfolio, whether you're an institutional investor, or a mum and dad, you really can't avoid the banks. It's very difficult to, because they intermediate so much of the flow of credit.

As you say, the public bond markets are dominated by financial issuance. And one thing we don't have is an active and vibrant and diverse sub-investment-grade bond market. So if you're looking to really get into credit and credit-intensive parts of the market, the opportunity in public markets is quite limited. And that's really in part due to the fact that so much of that credit is intermediated by the banks.

And so, that is a point I think that doesn't get appreciated as much about private credit, is the role it serves in providing investors with significant diversification benefits. And if you think about the difference between listed bond markets and the private credit markets, there's certainly name diversification. So in private markets, you're typically not getting exposure to names that are in the ASX 200. The vast bulk would be unlisted.

There will be some listed names that come to market, but they're very much at the smaller end of the market. So not only is there not a lot of overlap in single name exposures with the public bond market, but there's also not a lot of name overlap with the listed equity markets, either. So there is a lot of diversification benefit you get.

There's also diversification in terms of the sectors that you can access within private lending markets, that you can't necessarily access within the public markets. Particular sub-sectors like healthcare may not feature as greatly in the public bond markets. Also, tech, software-based businesses that are subscription-based services, may not feature as much on the listed side as they do on the private side. I think the public corporate bond markets in Australia, if it's not financials, it's regulated utilities, REITs and infrastructure style names that typically feature in the bond market.

And so, using private credit is absolutely a way to get access to names and sectors that you just don't see, to the same degree, that you do in public markets. So certainly, I think that's a powerful benefit, in addition to the illiquidity premium that you mentioned earlier.

Paul O'Connor:

What role do you believe can private credit play in a diversified portfolio, and what liquidity issues do you think investors need to consider, before investing in this sub-asset class?

Pete Robinson:

I think liquidity is an absolute consideration. We can't ignore the fact that these investors, these investments are less liquid, than what you would find in public bond markets. But I think it's also important to remember that a lot of the lending we do in private markets is shorter dated.

When we go into private markets, one thing we say at Challenger IM is, we talk about the KISS principle, which is, "Keep it short, stupid." So we're always reminding ourselves to keep our lending short because when we're going into private markets, we are charging a higher return to borrowers. And we're charging that higher return, either for something that's a bit more tailored, for something that's a bit more timely, or for something that has a bit more credit risk.

And so, the borrower, in all likelihood, doesn't want to pay that elevated return for a long period of time. They'd much prefer to refinance us into the public bond markets, or into the bank market, where they'll typically get a much cheaper cost of funding. And so, by virtue of that, we want to incentivize repayment, they want to repay us early, as well, and de-risk the exposure.

What that essentially means for us is that a lot of the lending that we do is pretty short-dated. On average, a mature portfolio in private lending will have an average maturity in the one- to three-year type time horizon. So when we think about illiquidity, it's not illiquidity in the sense of the illiquidity that you'll find, say, in venture capital or private equity, or even in direct commercial real estate.

These are assets that typically are self-liquidating over a short period of time. And so, really it's about filling, if you think about a liquidity bucket, it's about that bucket of making sure that you don't need that money in the next few months, or within the next year or so. Many of the funds in the Australian market, including the funds that we offer, offer monthly or quarterly liquidity. And so, there's the ability to access your money, it's just not money that's available on a daily basis, and I think that's really appropriate.

It's not a cash substitute, it's definitely further out on the illiquidity spectrum from that, but as I said, not quite as illiquid as some other parts of the market. And it's important, I think, that investors remember that, and understand that.

In terms of where it sits in an asset allocation, if we set aside the liquidity point, and really go back to what it is that the portfolio provides, it provides regular high levels of income with capital stability. So as you said, the assets are typically floating rate. What that means is, the capital value of your investment doesn't vary with interest rates.

With a traditional corporate bond portfolio that has a lot of interest rate duration, if interest rates rise, the value of the existing portfolio declines. And so, you have a capital loss. That's what a lot of people have experienced over the last few years is, we've had that repricing of interest rates.

When your assets are floating rate, if interest rates increase, the yield you get on your portfolio increases, and the capital value doesn't change. So you're getting high levels of income with capital stability.

Now, a lot of people have thought about this asset class as being, because it's a fixed income asset class, as coming out of your fixed income allocation, we actually talk about sitting on the credit fence, and we think you can draw from both your equities and your traditional fixed income allocation. It's effectively blending the two together, to generate income and capital stability, with a lack of correlation, with those more traditional markets.

Because it's floating rate, it's not correlated with traditional fixed income, and it typically has, in our view, the correlation with equities is somewhere around that sort of 50 to 60% area. So it's a lower correlation with equities, and that's got portfolio construction benefits to it, as well.

A lot of institutional investors have an allocation that they call alternatives, and those are assets that are alternatives to equities or fixed income, and there's a bucket called defensive alts, or defensive alternatives, and that's typically where you'll find private credit sitting. So it's a low correlation to traditional asset classes, but with higher levels of income and capital stability.

Paul O'Connor:

Yeah, yeah, I have noted a lot of people do allocate to private credit within the defensive alt bucket in a portfolio, but I guess my thinking, from a portfolio construction perspective, is that you're firstly making a call over your duration exposure for traditional bonds, compared to your credit exposure. Once you make that decision on the allocation, I think you then, when allocating to credit, you need to be diversified as possible.

And I think you well articulated the benefits, in terms of diversification of sector, of issuer, of moving away from the having too much exposure to the banks, being perfectly good rational reasons why you should consider allocating to private credit. So yeah, I guess I struggle with that alternatives piece there, Pete.

I tend to think it's just an extension of your credit exposure, in fixed income in a portfolio, but we've all got different views. Are there times in the cycle when private credit is more attractive than public credit, and vice versa?

Pete Robinson:

Yeah, Paul, this is a really important question, I think, a great one. Because at Challenger IM, we invest in public and private credit. And across all the portfolios that we manage, even the ones that are mainly invested in private credit, we invest in both. And it goes back to the point I made at the outset around, they're not really being a hard label for private, and a hard label for public, and when we think about illiquidity, thinking that there's a continuum of opportunities.

And it goes back to the very beginning of my career, when I was investing in, I guess you would call it stress credit, but it was public markets that had become highly illiquid, and there were great investment opportunities. The best deals I did in my career were at the times when public markets were most illiquid, and certainly, even investing in performing and stable credit, you can buy really, really good credits, provided you are buying them in public markets, providing you are buying them at the right time and the right price.

And I think one thing that we really pride ourselves on here is the value judgement . So even in private markets, we're making sure we're getting paid an appropriate liquidity premium. And what we tend to find is that private markets offer the best illiquidity premiums.

So when we talk about that illiquidity premium, what I mean by that is that excess return over what we could get in public markets for the same credit risk, we tend to find that that illiquidity premium is most elevated, when markets are stable. So there's lower levels of volatility. Public markets are typically at the tighter end, and pretty much the environment that we find ourselves in today.

So we're sitting here in May of 2024, we've had a strong rally in credit markets. Year to date, US high-yield markets are very close to the cyclical types. And what we're finding is that's resulted in an expansion of that illiquidity premium.

And typically what we find is, it's a good environment, coming out of a period of stress or volatility or uncertainty, because what you have is a lot of borrowers who are looking for solutions, and tailored solutions for lenders. So the combination of all the issues we had in COVID, the higher interest rate environment that we're facing here today, and the lack of volatility in public markets has made the current environment illiquidity premiums in the current environment quite attractive.

You can contrast that with periods like March and April of 2020, when there was elevated volatility, or even going back to the Silicon Valley Bank and Credit Suisse issues a little over 12 months ago, where there was a lot of volatility in public markets. And actually, it was a great time to be investing in public markets during those times.

As a portfolio manager, what I like to do is I like to go into those public markets when valuations are attractive, and illiquidity premiums are compressed, and I like to invest in the public markets. I can hold those assets for a short period of time as markets normalise. This might be six to 12 to 18 months, markets normalise, and then, I go back into the private markets, and harvest that illiquidity premium.

One of the interesting things about private lending strategies is because the funds are designed not to offer daily liquidity, they're actually very well-placed to be investing in public markets during periods of illiquidity. What you tend to find is strategies that offer daily liquidity.

If you think back to March and April of 2020, they were worried about redemptions, and they were effectively hoarding liquidity, so buying only the most liquid assets within their portfolio, and even then, trying to hold a significant buffer of cash, over and above those assets. So strategies like the ones that we run here at Challenger IM, we're able to go into those public markets, and harvest the illiquidity premiums that were available there at that time.

I tend to guide people to roughly a 90-10 rule. I think 90% of the time, you'll find that markets are stable, and that illiquidity premium that private markets offer is attractive, and you overweight your strategies to private markets in those environments. But 10% of the time, there are significant opportunities in public markets.

And as an investor, we're agnostic between the two. We'll just go to where we think the best risk adjusted return is.

Paul O'Connor:

Yeah, I remember well back in 2009, when good quality listed credit or public credit was marked down 30-40% from face value. So, phenomenal investment opportunity.

But I think that also your comments there articulate worldwide, it makes sense to have an active manager that can allocate, both across public and private markets, for credit exposure.

Paul O'Connor:

What do you think, Peter, are the main risks in private credit?> From a portfolio perspective, is credit risk higher in terms of the individual loans, and are the funds, the private credit funds as diversified as the traditional fixed interest strategies?

Pete Robinson:

For me, there's a few things I think that people need to be aware of, and there's two elements when you think about risk. I think there is a lack of transparency in private markets. And so, governance is a really critical factor, when you're going into a private lending strategy, or any strategy that involves levels of illiquidity, or lack of transparency.

The reality is, and we haven't touched on this yet, but it's probably a good time to talk about it, is in private markets, you're typically dealing with credits that are not externally rated by a credit rating agency, so an independent body that assesses the underlying credit risk of the investments, and you're also not benefiting from independent valuations of those assets a lot of the time.

Even when you do get people coming in and providing those independent valuations, they're typically infrequent, and they're not based on observable trading in the underlying instruments, because they're private, and they're illiquid. And so, those are challenges that investors need to need overcome, when they're investing in private credit. And ultimately, the question is whether that illiquidity premium that private credit offers is sufficient to justify the incremental governance risks associated with that.

Because you could have a manager saying, "Well, I'm investing in a portfolio of investment grade private credit, and I'm generating a 4% incremental return over what's available in public markets." The risk here is that the manager is not actually investing in a portfolio of investment grade credits, they're just telling you that they're investment grade, and if a rating agency came in and rated that portfolio, it might be some investment grade.

So that illiquidity premium that you think is 4%, it might be 2% or 1%, or even lower. I think that's a really important factor, when investors go into these strategies, is really bridging that gap in transparency between what a manager's telling you the portfolio looks like, and what the portfolio actually looks like. And that's a critical part of the due diligence process.

The other part is actually the actual credit risk and level of diversification and granularity in private lending portfolios, versus public lending portfolios. And I'd say, generally, if we think about the Australian experience, the Australian listed credit market is largely investment grade, heavily dominated by financials, as we've discussed. Certainly, I think, when you're looking at a private lending strategy, you are generally taking on a higher level of credit risk than the public bond markets.

Most private lending strategies are sub-investment grade, and deliberately so. Now that's not to say that it's inconsistent with the banks. I think a little appreciated fact about the banks is that around a third of the lending that they do to commercial borrowers is below investment grade lending. So that's the part of the market that we're competing with the banks in. So certainly, there is an element of higher credit risk compared to listed strategies.

In addition to that, the portfolios will typically be less granular. So you might have in a pure private strategy, depending on the style of the manager, and the risk profile of the strategy, you might have 10 to 30 names in a portfolio. You might have up to a hundred or more names in a portfolio, but still, it is typically, I'd say, the median private lending strategy would have less issuers than the median public credit strategy.

But lastly, there's that point about diversification. I think you are getting access to a lot of exposures, a lot of issuers that you just don't get access to elsewhere. So that's kind of an offsetting benefit of the strategy, versus a public credit strategy. It's just the diversification.

Paul O'Connor:

We've covered the illiquid nature of private credit, not, I guess, then, the illiquidity premium for a similar credit, versus a public credit. But given the huge growth in the whole private credit market, is secondary market liquidity starting to develop in this sector?

Pete Robinson:

Yeah, look, there is secondary market liquidity in private lending markets. It's harder to come by, and there is a cost associated with that liquidity. What you tend to find is, there's not the same need for it, either.

Because, as I said, the funds that hold private lending exposure tend to have pretty specific terms about redemptions, and when they have to meet redemption requests, so you don't typically see a lot of selling that's driven by a fund that's got a large redemption request.

What drives that turnover might be asset allocation decisions or liquidity. So someone's got inflows, and they want to acquire a portfolio, or a manager's exiting the market for a strategic reason, and might seek liquidity. That can happen. So certainly, all of these loans are tradable, and I like to remind investors of that.

Yes, it's less liquid, but it's not completely illiquid. Just like when you buy a commercial property or residential property, you can sell it, but there's large transaction costs, and it'll take you time to sell the loan.

I think it's equally true within private credit. I can't recall a deal that we've done, where there's been no ability to sell the exposure. They might have covenants around it, there might be restrictions around who you can sell the exposure to. That's absolutely true of private credit.

It's certainly not completely illiquid, and as you say, there is a secondary market. And that is getting better with time. But I certainly don't expect it to get anything close to what we see in public markets.

Paul O'Connor:

What do you think, Pete, investors need to consider, when investing with a private credit manager? And I guess one thing that comes to mind is that banks employ a large number of staff, that assess each proposed loan. So how do these skills and resources compare to private credit funds?

Pete Robinson:

Well, I'm going to go from being a plumber, to being a manufacturer, because one thing in private credit markets is, you actually manufacture the exposures that you get. If you think about a public bond manager, there was an old saying during the GFC about two guys or two girls and a Bloomberg, that's really all you need to be able to trade public credit.

Everything's centrally cleared. You can pick up the phone, and you can look at the screen and say, "I want to buy this exposure with this price." It's not too dissimilar to retail investors trading equities off an exchange. It's pretty straightforward.

Whereas with private markets, what you need to do is, you need to go out, and you need to find who you're going to lend to. Find the borrower, build a relationship with them, to originate the credit. So you need an origination team or an origination ability.

You also need the ability to assess the borrower, assess their credit profile, assess the strategy of what they're trying to do, and understand their business, understand their financials, which may not be publicly available. And then you need to underwrite the credit. You need the ability to underwrite, so a credit risk team.

You also need the ability to negotiate the terms of the loan. So, "I'm going to lend you this amount of money for this term, at this price, with these covenants or protections," built into the transaction.

And then, you need to document that. So you have a term sheet which agrees the commercial terms, but then you have a set of legal documents, which describe the terms of the loans, and the security that you are taking over the business, so that if something goes wrong, you can affect that security appropriately.

And then, once you've written the loan, you need to be able to fund the loan itself. There's not a clearinghouse that does all the hard calculations around interest payments and reconciliations that are required, when you do bespoke lending. So you need a team that's able to do that.

And then, lastly, you need to monitor the loan through the life of the investment. And if something does go wrong, you need to have a team that's able to step in, and negotiate with the owner of the business, or the sponsor of that business, and potentially, take over control of that business, if required.

So there's a lot of parts to that manufacturing process, and like any manufacturing process, what happens is, you layer an additional required return in return for providing that service. So in the public bond market, someone else is doing all of that, and they're getting paid for doing that, so typically, an arranging bank, whereas in private markets, you're doing all of that yourself, and that's part of what you're getting paid for.

So part of that illiquidity premium is all the lifting work that you are doing, to get the loan done. So it is a labour-intensive business. And that was my long-winded manufacturing analogy, to basically agree with what you said, which is, it takes a lot of people to run a private lending business.

And so, I think, if you think about the due diligence that investors do when they go into a private lending strategy is one, assessing the resourcing within the business. Do they have enough people to be able to originate and underwrite credit? And in particular, at this point in the cycle, to be able to work out problem credits, in the event that they do emerge? Do they have a long history of doing that? Can we see the history of doing that?

I think one thing that the banks have done really well for a very long period of time is, they've separated the risk from the investment decision, so they've always had an independent credit risk function. And that's something we've built here at Challenger IM. We do the same thing, because we think it's appropriate to have an independent assessment of the credit risk of an investment, but we're running just a front office investment team of 35 to 40 people doing this sort of work. It's not a small team.

Behind that, we've got legal, we've got tax, we've got operations teams, we've got, even ESG sustainability professionals that come in, and support our investment process. So you're talking about triple digit number of people that are touching this private lending process at various stages along the way. So it is labour intensive.

I think, when you think about the banks, one thing to remember, though, is that they're doing a high volume of loans, a very sort of repetitive way. Each loan typically fits within a box and a set of parameters that they define, or a policy that they have, whereas every loan that we do is bespoken and tailored to the needs of the individual borrower. So there's even an argument to say that our lending is even more labour-intensive than what the banks do.

Paul O'Connor:

And requires a very defined skill set, as you've mentioned, right across governance and legal, and understanding risks, and I guess, tailoring each loan. So I think some salient points there, in terms of investors considering what private credit funds to actually invest in.

I guess, succinctly, what areas of private credit are you seeing the best opportunities at the moment? What areas are you concerned about, or avoiding, in your portfolios?

Pete Robinson:

Yeah, I think we've seen a huge amount of capital flow into the asset backed finance part of the market. We've been active in that market for a very long period of time, and we've started to see newer entrants come into the market, daily liquid funds participating in private securitizations, which you can argue, if it's a small allocation within their portfolio, whether it's appropriate or not, I think that's certainly been something we've seen emerge.

And so, valuations there have started to come in, particularly for the more vanilla part of that market. Where our focus there is started to move more towards less traditional parts of the market, so assets that aren't easily securitized, and we're seeing good opportunities there.

So non-vanilla asset backed finance, I think that's an emerging opportunity. We've certainly seen a lot of talk about that in US and European markets. There's less activity, certainly within the Australian market, for those types of opportunities.

I think commercial real estate has had a lot of headlines around it. Obviously, what we've seen offshore with what's gone on with office, and some of the valuation pressure in places like San Francisco, has been something we've watched closely. We've been underway within our lending portfolios, and for our funds, have been starting to allocate back into that space.

That's sort of a contrarian opportunity, I think, that we see emerging in the next six to 12 months. And this is lending against existing assets, where the loan was written in, let's say, 2021, under the presumption that interest rates would stay low forever, or for long enough, that it didn't matter. And what we've seen is that sharp increase in interest rates has put interest serviceability under pressure, and so, requires a more tailored solution.

What we're looking for is playing just outside of where the banks are, not trying to go to the more speculative end, where there's a lot of construction and development risk. Our focus is really, what are the loans that the banks have written, that we think are good quality underlying credits, but have some specific need for a more tailored solution? So I think we see opportunities there.

I think the corporate direct lending market is one where there's a sufficient amount of diversity, in terms of the underlying issuers that are coming to market, where we're always seeing opportunities. There are parts of the market that tend to get hot for a period of time, individual sectors, where you get a bunch of private equity issuers all going into the same thematic or the same opportunity, but in aggregate.

I think we think the opportunities are broadly fair value in corporate direct lending markets. So that's an area where we're sort of neutral. We're probably looking at commercial real estate and those non-vanilla parts of the asset backed finance market, where we see really interesting opportunities right now.

Paul O'Connor:

We'll draw the podcast to an end, but I think most importantly, from a risk management perspective, what provisions do you have in place to minimise the risks that a borrower you lend to just doesn't pay the money back, and they default on their loans?

Pete Robinson:

Yeah, look, when you do a tailored transaction, every deal, you will design covenants to protect against the specific risks that you identify in the underwriting of the business. So those covenants are basically, you can almost think of them as guardrails for the borrower, and so, they have to stay within those guardrails.

If they don't, then the lender can step in, either demand additional return, or demand changes to the business, to mitigate those risks. Otherwise, there's an event of default, and the lender can take over, and effectively run the business or sell the business to recover their debts.

A good case study for that right now is what's going on within the mining space. Certainly, that's an area where from a sustainability perspective, there's a lot of focus, there's a lot of transition going on. There's carbon risk, there's climate risk, around a number of these borrowers.

And so, when we go in, and when we see those opportunities from those sectors, one thing we don't do is we don't say, "We're not going to look at this business holus-bolus." What we do is we say, "Well, here's the guardrails we'll need to put in place, or here are the covenants we'll need to put in place, to protect us from that transition risk."

So if a business has too much exposure, say, to thermal coal, but a really credible plan as to how it's going to reduce that exposure, you can design terms and conditions to facilitate that transition, and even incentivize that transition in a really sustainable way. So we think that there's a great opportunity there for sustainable investment, within the private lending markets, where we can actually provide really tailored solutions, where we build in covenants that incentivize borrowers to behave more sustainably for the long term.

Paul O'Connor:

Well, Pete, I think we'll draw a conclusion to the podcast, but thank you very much for joining us on today's instalment. It's been, certainly, from my perspective, an educative and informative discussion, and I certainly hope, to the listener, you've also enjoyed the podcast with Pete, and we've all been educated a little bit more on this growing investment opportunity, in terms of private debt, and how we would consider and think about allocating to private debt within a portfolio.

So thank you again, Pete. I certainly appreciate your time and your input this morning.

Pete Robinson:

Thanks, Paul. I really enjoyed the conversation as well, so hopefully, the listeners do too, and hopefully, look forward to coming back in a year or two, to give you an update as to what's been happening in the markets. It's certainly an interesting time to be investing.

Paul O'Connor:

I would look forward to that there, Pete, so thanking you. And to the listener, thank you again, of course, for joining us on the Net Worth Portfolio Construction Podcast. Have a great day, and I look forward to joining you on the next instalment.

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