Private Credit. Is it safe?

Australia has had numerous financial sector inquiries over the years, addressing various aspects of the financial services sector. These include Royal Commissions, parliamentary inquiries, and independent reviews. Some notable ones are:

1. The Campbell Inquiry (1979-1981): Examined deregulation and competition in the financial sector
2. The Wallis Inquiry (1996-1997): Focused on the financial system’s structure and regulation.
3. The Hayne Royal Commission (2017-2019): Investigated the misconduct in the Banking, Superannuation and Financial Services Industry.

Interestingly, none of these inquiries were highly critical of Private Credit which has existed since the mid 1970’s.

Outside of these formal inquiries it is not uncommon for the regulator (and in the case of private credit) ASIC, to publicly express concerns that they may have around private credit or indeed any other sector within the broader financial services industry.

Currently ASIC is zooming in on private capital funds, and some of the commentary coming out of ASIC, could be interpreted as private capital needing more regulatory oversight and better disclosure regimes to investors.

As someone who has been involved with private credit (non-bank investments and lending), in a leadership role since 1987, I can say without hesitation that private credit is safe, and it is well regulated by ASIC. Sadly, the latter point was not acknowledged in ASIC’s recent commentary on the private credit sector.

Another critical fact that was not acknowledged, is that private credit providers must obtain an Australian Financial Services Licence (AFSL) from ASIC before they can operate. If potential private credit funds do not pass the rigor of ASIC’s AFSL application process, then they are not granted an AFSL.

The Case for Private Credit in Australia: Driving Innovation and Ensuring Safeguards

Private credit has emerged as a dynamic and indispensable segment of the global financial system, providing tailored funding solutions to businesses, infrastructure projects, and investors alike.

In Australia, it offers a meaningful alternative to traditional bank lending, fostering competition, innovation, and diversification in the financial sector. While the rapid expansion of private credit has sparked concerns from regulators, such as ASIC, regarding transparency and investor protection, it is crucial to strike a balance.

Effective regulation can safeguard investor interests without stifling the very competition and innovation that private credit delivers.

This opinion piece explores the economic and societal benefits of private credit while proposing a comprehensive framework of checks and balances to ensure the safety of investor funds.

The Benefits of Private Credit

1. Enhanced Access to Capital: Private credit fills a critical funding gap, particularly for small-to-medium enterprises (SMEs) and specialised industries that may struggle to secure financing from traditional banks or public markets. Unlike traditional bank loans, private credit is often more flexible and tailored to meet the unique needs of borrowers.For instance, start-ups and emerging industries, such as technology or renewable energy, frequently require innovative financing structures that traditional banks may view as too risky. Private credit providers can step in to support these ventures, fostering economic growth, job creation, and innovation.
2. Diversification and Attractive Returns for Investors:For investors, private credit provides an appealing alternative to traditional asset classes like stocks and bonds. This asset class often offers higher yields, making it particularly attractive in a low-interest-rate environment. Wholesale and retail investors alike benefit from the opportunity to diversify their portfolios while potentially earning higher returns.Additionally, private credit can be structured to meet specific risk-return preferences, enabling investors to choose between lower-risk senior loans and higher-yield subordinated debt or mezzanine financing.
3. Competition in the Financial Sector:Private credit introduces healthy competition to Australia’s financial landscape, particularly for Authorised Deposit-taking Institutions (ADIs) regulated by APRA. By challenging the dominance of traditional banks, private credit fosters innovation and efficiency, benefiting businesses, investors, and the economy as a whole.This competition is particularly significant in fostering financial inclusion, as private credit is often more willing to serve businesses and communities that are underserved by traditional banks.
4. Flexibility and Customisation:Private credit is characterised by its ability to offer bespoke solutions tailored to the specific needs of borrowers. Unlike one-size-fits-all bank loans, private credit transactions are often negotiated directly between the lender and borrower, enabling greater flexibility in terms of loan structure, repayment terms, and collateral requirements.This flexibility is particularly valuable in industries with unique or rapidly evolving funding needs, such as technology start-ups, infrastructure projects, or renewable energy initiatives.

Addressing Regulatory Concerns

ASIC has raised valid concerns about the rapid expansion of private credit in Australia, particularly regarding transparency and the potential risks associated with high-risk investments. While these concerns merit attention, it is important to recognise that many private credit operators already adhere to stringent regulatory requirements under the Australian Financial Services Licence (AFSL) framework.

For example, operators managing a Managed Investment Scheme (MIS) must obtain both retail and wholesale AFSLs, ensuring compliance with investor protection and disclosure standards.

Rather than imposing onerous regulations that could stifle competition, a proportionate and balanced approach to regulation is needed to address the specific risks associated with private credit. Below, I have outlined a comprehensive framework of checks and balances to ensure investor protection while preserving the benefits of private credit.

Checks and Balances for Private Credit

1. Checks and Balances for Private Credit:One of the key concerns raised by ASIC is the lack of transparency in private credit markets compared to listed companies. To address this, regulators should establish mandatory disclosure requirements for private credit operators. This could include:
   • Detailed information about the underlying assets and investment strategies of private credit funds.
   • Regular updates on fund performance, risks, and potential conflicts of interest.
   • Clear and concise disclosure of fees, ensuring investors understand the costs associated with private credit investments.
2. Strengthened Governance and Compliance:Private credit operators should be required to demonstrate robust governance frameworks, ensuring accountability and ethical behaviour. This could involve:
   • Regular independent audits of private credit funds to validate compliance with regulatory standards and the accuracy of disclosures.
   • Enhanced training and accreditation requirements for fund managers and financial advisers involved in private credit.
3. Risk Management and Diversification:To protect investors from excessive risk, regulators could introduce guidelines for diversification and risk management within private credit funds. This might include:
   • Limits on exposure to high-risk or illiquid assets.
   • Stress testing of private credit portfolios to assess resilience in adverse market conditions.
   • Contingency plans for managing defaults or market downturns.
4. Investor Education and Support:Retail investors, in particular, may lack the knowledge or experience to fully understand the risks associated with private credit investments. To address this, regulators could introduce investor education initiatives, such as:
   • Informational campaigns highlighting the risks and benefits of private credit.
   • Tools and resources to help investors assess the suitability of private credit products for their individual circumstances.
5. Alignment of Regulatory Standards:To ensure a level playing field, regulators should align the standards for private credit operators with those applicable to traditional ADIs where appropriate. However, this alignment should avoid imposing unnecessary burdens that could stifle competition or innovation.For example, private credit operators could be required to maintain capital buffers or insurance mechanisms to absorb potential losses, ensuring stability and investor confidence.

The Importance of Proportional Regulation

While the need for regulation is clear, it is equally important to avoid overregulation that could stifle the growth and innovation of private credit markets. Excessive regulatory burdens could deter new entrants, reduce competition, and ultimately harm borrowers and investors.

Proportional regulation should be guided by the following principles:

• Risk-Based Approach: Regulations should be tailored to the specific risks posed by private credit, with a focus on protecting retail investors while allowing experienced wholesale investors greater flexibility.
• Industry Collaboration: Regulators should engage closely with private credit operators and industry associations to ensure that new regulations are practical and effective.
• Innovation and Growth: Regulations should encourage innovation and growth within the private credit sector, recognizing its potential to drive economic development and financial inclusion.

PRINCETON PROPERTY INCOME FUND (PPIF)

As Chairman of both the PPIF Compliance Committee and Credit Committee I can confirm that PPIF has the following features which address ASIC’s concerns around Private Credit Funds.

1. Independent, institutional grade, Trustee and Custodian (Corporate Governance)
2. Independent Credit Committee (Corporate Governance)
3. Independent Financial Audit: Transparency and Accountability (Corporate Governance)
4. First Loss Reserve: Princeton Puts Its Own Capital at Risk First (Alignment of Interests)
5. Clearly Defined Reporting (Reporting & Transparency)
6. Clearly Defined Valuation (Valuations Policy)
7. Aligning a clearly defined Redemption Policy with the duration of a short to medium-term portfolio. (Liquidity)
8. Exclusive Focus on First Mortgage Senior Secured Debt (focus)

PRINCETON CONTRIBUTORY DEBT FUND SERIES

As Chairman of both the Princeton’s Compliance Committee and Credit Committee I can confirm that Princeton’s Contributory Fund Series has the following features which address ASIC’s concerns around Private Credit Funds.

1. Each loan resides in a separate discrete unit trust thereby providing wholesale investors with the highest level of transparency. (transparency)
2. Independent Custodian (Corporate Governance)
3. Fully Independent Credit Committee requiring unanimous decisions (Corporate Governance)
4. Quarterly Investor report for each Trust / Loan (Reporting)
5. 50% of Mortgage Management Fees are deferred until all investor capital is returned (Alignment of Interests)

Conclusion

Private credit represents a vital and growing segment of Australia’s financial ecosystem, offering unique benefits to borrowers, investors, and the broader economy. By fostering competition, supporting innovation, and providing attractive investment opportunities, private credit plays a critical role in driving economic growth and diversification.

At the same time, it is essential to address the risks associated with private credit through a balanced and proportionate regulatory framework. By enhancing transparency, strengthening governance, and supporting investor education, regulators can safeguard investor interests without stifling competition or innovation.

Ultimately, the key to ensuring the success of private credit lies in finding the right balance – one that protects investors, fosters competition, and unlocks the full potential of this dynamic and transformative sector. All food for thought!