Avoiding the pitfalls of private credit with direct lending investments
Private credit have become one of the fastest-growing asset classes in Australia, attracting investors with regular income and higher returns than term deposits. Most investors gain exposure through private credit funds, which is perfectly fine when all is well, but chaotic at best during rough seas. Which is why selecting the right investment manager is paramount.
To be clear this isn’t a criticism of private credit funds, there are some very good ones. But attention needs to be brought to the fact that there are fund managers who are not competent or purely motivated by greed.
At Royce Stone Capital, we believe private credit investors deserve a clearer view of what they are investing in. Direct lending investments give investors that view and control. Below, we look at the major problems with private credit fund investments and explain how investors can avoid them.
The problems with private credit fund investments
Trust put in the fund manager
When you invest in private credit funds, investors do not choose the loans that the fund is investing in. You are choosing a manager and trusting their judgement on every lending decision. The manager selects borrowers, negotiates terms, decides how much risk to take and determines how to act if a borrower falls behind.
Managers face pressure to deploy capital, grow funds under management, maintain distribution rates and those incentives do not always align with protecting investor capital. The reason, is that there are only so many good deals out there that will tick all the boxes. So for fund managers to make more money, they need to deploy more money. Which may mean, a manager may stretch on loan-to-value ratios on the back end or accept weaker borrowers to keep returns flowing. Your outcomes largely depend on people you never meet or know of.
If a private credit investment manager is competent, then the trust you put in them is perfectly fine. Especially if they have their own funds invested in that fund, or a cornerstone investor is a family office, that is also the owner of the fund.
No transparency of where funds are going and deal flow
Most private credit funds report through quarterly updates showing broad sector allocations, average loan-to-value ratios and headline returns. What they rarely show is the individual loan your money has funded.
Investors often cannot see who the borrowers are, which properties secure the loans or how the funds are being used. Deal flow is a black box. Capital may be loaned to related parties, rolled into repeatedly extended loans or moved into higher-risk development exposures without investors being consulted.
Valuations don't tell the full picture
Private credit is only as good as the security that it is taking for the funds it is providing. If the security isn’t 100%, nor is the loan. Just because an investment manager asks for a valuation by a third party and a loan is done against that valuation within the prescribed IM limits, doesn’t necessairly mean it’s a good loan.
Several questions need to be asked, that goes beyond the valuation.
Is the loan on the property or asset being done against its current as is value, or future best use value?
If a property is valued based on its up kick in permit value for a project, does the feasibility stack up based on current market prices for construction? If a builder wouldn’t buy it, then the site is worth nothing with its permits.
Is the property or asset easily liquid? If it takes a long time to sell, then the LVR of the loan will increase if the borrower can’t make repayments, whilst penalty interest accumulates.
Is the asset that is being developed something that the market wants to buy? This is especially true of construction loans, where the end project may not be desirable. In other words, just because a credit committee approved the deal, as it met lending metrics, doesn’t mean it passed common sense, of developing the right type of project in the right area.
Shared security pool and no control over recovery
In a pooled fund, investors do not hold security over any specific property. The fund holds the mortgages, and every investor shares in the overall pool. When one loan defaults, the loss is spread across all unitholders, including those who may have never have approved that loan.
Recovery decisions sit with the manager, who decides whether to extend, restructure, enforce or sell. If several loans go bad at once, recovery can take months and redemptions may be suspended in a worst case scenario.
Direct lending investments for private credit investors
Direct lending offers a different model. Instead of buying units in a pool, investors fund individual deals secured against specific assets. You still access the income and security benefits of a private credit investment, without handing every decision to a fund manager.
This typically suits family office investors, HNW investors, asset managers and sophisticated investors that have the capacity to fully fund one deal. Typically deals start at $300k up to $10M.
Private credit investors have direct control over investments and security
With direct lending investments, the investor decides which loans to fund. Each opportunity is presented on its own merits, which you can accept or decline based on your risk appetite, deal size, term and return requirements.
The security is registered for the benefit of the individual investor on a particular loan. If a borrower defaults, recovery relates to your loan and your security, not a wider pool affected by other borrowers or investors. This gives direct lending investors a level of control that fund structures cannot offer.
Direct lenders know who the borrower is and how capital is used
Every direct lending investment comes with a clear picture of who the borrower is. Investors can see who is borrowing, their track record and why they need the funds. Whether refinancing, releasing equity, funding a business or bridging to a sale, the use of funds is clear, helping to derisk the loan.
Investors also see the exit strategy, whether it be a sale, a bank refinance or business event. You fund a known borrower, for a known purpose, with a clear exit for your money.
Direct lending investors have full visibility of the security
Direct lending investors can review the security in detail before committing, including an independent valuation, the existing debt position, the loan-to-value ratio, market appeal of the security, liquidity of the security and any other things that may effect the value of the security.
Rather than relying on a portfolio-wide average, you know exactly how much equity sits behind your loan. For private credit investors who value capital preservation, this clarity is a major advantage.
It is not uncommon for us to visit sites, with our family office clients to ensure the security meets our own requirements plus that of our investors.
The types of direct lending investments we have at RSC
Royce Stone Capital offers direct lending investments across four categories of private credit. Each loan is reviewed for borrower strength, security quality and a credible exit before it is presented to investors. Most importantly, we focus on quality security. If we wouldn’t put our own money on the deal, we wouldn’t present it to an investor.
At Royce Stone Capital, we only present deals to investors, that match their individual risk appetite and investment requirements. You won’t get a weekly email from us, but only as your criteria is met.
Our focus on quality security
At Royce Stone Capital, we don't run a private construction fund and we don’t lend based on future values. One of the main issues with private credit construction funds, is that they are lending against the future value of an asset, where the asset that is being taken as security is not yet complete, and the exit of the loan is reliant on the completion of the asset being taken as security.
Compare this to what we do at RSC, where we provide a business loan to a business, taking their property or other assets that are in completed state as security for the loan. The exit from our loans, comes most of the time from a business liquidity event or refinance. Only in a worst-case scenario or where agreed, is the underlying security taken for the loan, sold as an exit for the loan.
First mortgage private loans
First mortgages are the foundation of our direct lending offering. The lender holds the primary registered security over the property and, if the borrower defaults, the investor has priority over any other security interests.
Loans are secured against residential, commercial or industrial property, typically for terms of six months to 12 monhts, and at times two years. These loans have clearly defined exits such as a bank refinance, a business activity or asset sale. Indicative net returns typically range between 8% and 14% per annum. Deal sizes typically range from $500k to $10M.
Second mortgage private loans
Second mortgages sit behind an existing first mortgage, giving borrowers fast access to equity for business funding, Combined debt (first and second mortgage) is generally capped at around 80% of the property's value, preserving an equity buffer.
Because the lender ranks second, investors are compensated with higher returns, with indicative net returns of 16% to 26% per annum. Deal sizes typically range from $200k to $2M.
We will only allow our investors to take on a second mortgage deal, where they have capacity to underwrite the first mortgage. So in an event of default by the borrower, they have the capacity to payout the first mortgage and take control of the asset. In other words they make second mortgage returns, with high LVR first mortgage risk.
Heritage plate private loans
Heritage plate loans are secured against valuable Victorian heritage number plates. Loans are typically up to 70% of the independently valued plate value, over terms of three to twelve months.
A key protection for investors is that plate title is transferred to the investor and the physical plates are held securely for the loan term. Heritage plate loans offer indicative net returns of 12% to 18% per annum. Deal sizes typically start from $200k up to $2M.
In many respects, these loans are more favored above property transactions. Because the security title is already transferred in the investors name, and the plate can be sold quickly. Secondly, they are favored because of the diversification they provide away from property transactions.
Private corporate debt
Private corporate debt facilities are loans to established private businesses that need capital banks cannot provide quickly nor on flexible terms. Facilities are secured through general security agreements, key business assets and corporate guarantees. These deals typically range from $4M to $10M.
These larger transactions require deeper due diligence on cash flow and management. Returns vary from 12% p.a. to 18% p.a., and sometimes an equity position can be gained as well. These are typically for businesses that have valuations above $20M.
Special situation cashflow loans
For special situation cashflow loans, these loans usually help businesses with immediate cashflow loans. Loan terms are 3 months to 6 months, with net returns of up to 60% p.a. Typically deal sizes here start from $200k and go up to $1M.
Facilities are secured through general security agreements, key business assets and corporate guarantees. Similar to private corporate debt however, a stronger emphasis is put on loans secured against corporate entities that hold leases, special assets or special licenses that are critical for the business to function.
For investors seeking the income of private credit investments without the blind spots of pooled funds, direct lending offers transparency, control and security over real identifiable assets.
Speak with the Royce Stone Capital team today to start.
This article is general information only and does not take into account your objectives, financial situation or needs. Investments are only available to wholesale investors only.
