The cannibalisation of private credit, and what investors can do
The problem
The reality is that across standard mortgage-backed private credit products, margins are eroding in Australia, despite the boom in the industry. In this article we cover why this is occurring and the strategies you can adopt like some of our family office clients to grow your margins.
What are private credit margins?
Private credit investments work at a margin above the bank rate and move with central bank rate movements. The margin a private credit product works at above the bank rate, is a function of the type of product it is, borrower risk profile, demand for the product, supply of capital for the product, pricing by investment managers and the power each side has.
For example, the BBSW rate may be 4%, and a first mortgage private loan at 65% LVR loan may be sold for 9% p.a. Therefore the private credit margin for that product is 5% above the bank rate.
Whether the product is a standard first mortgage private loan, second mortgage loan sub 70% LVR, or a private construction loan sub 70% LVR, margins are eroding for several reasons.
There is no doubt that healthy bank rates, allow for healthy margins for private credit, and in many respects makes it more competitive with mainstream lending. However, even if RBA rates were to rise investors aren’t necessarily better off in real terms.
This is because investor returns are a function of investment return, less the inflation rate and the applicable tax rate on their structure. If rates are moving north due to higher inflation figures, then in real terms investors aren’t necessarily better off. So their margins may actually be wore off.
Why are investor private credit margins eroding?
There are several reasons private credit margins are eroding, that we list below. However, the main reason is that retail, professional and even family office investors are now competing with institutional capital and sovereign wealth for the same deals.
Borrowers are making less profit
Because borrowers themselves are facing lower profits margins across various industries, this affects how many of them are willing to borrow and their capacity to pay.
Higher asset prices
Higher asset prices, means a higher volume of dollars moves out the door. However with more principal debt, borrowers can only afford to pay so much in interest and become more rate sensitive. We have seen the explosion in asset prices since the GFC, and the QE that has followed.
Higher bank rates
Whilst higher bank rates make private lending more competitive against bank capital, and causes movement in the borrower market, which can boost private credit investments. In the long-term higher rates can detrimentally affect private credit markets.
This is because the end consumer borrower, that is taking a home loan now has a lower ceiling of how much they can borrow based on their serviceability, which in turn effects how much they can pay for property. This cap on consumer borrowing in turn effects property prices and developer margins, which impacts how much developers are willing to borrower from private credit. In addition to the higher rate the developer must also pay for their construction loan.
Rising competition in private credit investments
As private credit investments grew in popularity, the number of fund managers that emerged exponentially grew creating more competition. With more supply, margins eroded. But the question is, where did this capital come from?
Overseas fund managers
Cheaper capital is entering the market via investment managers out of Asia, especially on larger transactions for development funding (we work with 2 of them for construction loans), and their terms are far more reasonable, when compared to local providers.
This has made it harder for local Australian private credit investors to earn a premium return, either forcing them out of the market, or forcing them to accept a lower return.
Second tier lenders doing what was typically private deals
Second tier lenders like La Trobe and Liberty are offering interest only products and are starting to take on deals that the private lending market typically would have done 4 years ago. Even Judo bank in some instances have taken good credit deals off us.
As second tier lenders started to pinch deals that would typically go to private lenders, a number of private lenders started to offer quasi low doc products for first mortgage private loans and low LVR second mortgage private loans. These loans had to meet low doc lending criteria (good credit score, no major defaults and financial sign off from an accountant).
The problem however was that for private credit investors, these quasi low doc deals, didn’t offer the returns they were typically used to. So private lenders had to find new sources of capital for these types of transactions, which came mainly from warehouse funding facilities.
The entry of warehouse funding facilities for lenders
Providers of warehouse funding for lenders, have had an explosion of growth since the boom in private credit. Warehouse finance facilities are either funded by investment banks, banks or private fund managers that have their own subset of private credit investors. These facilities typically demand lower returns, than individual professional investors.
Most warehouse facilities require the lenders they work with, to lend their funds to borrowers with good credit scores. Because these warehouse providers source capital from a range of sources including overseas banks, sovereign funds, pension funds, or are banks themselves, their cost of capital is relatively cheap.
Once again this puts downward pressure on the margin premium local Australian professional private credit investors can ask for, pushing them out of the marketing or forcing them to accept lower returns.
The entry of sovereign funds
A number of sovereign funds are now backing larger private lenders in Australia, Maxcap is just one example, and they also back several lenders providing warehouse lenders. Because the rate expectation returns of sovereign funds are lower than domestic professional investors in Australia, domestic investors returns end up getting hurt.
How to get higher private credit margins?
Below we list the unconventional ways investors can get a private credit premium.
Become a direct lender and cut middle man costs
One of the best ways professional investors in private credit can make higher returns, is by cutting out fund managers. Professional investors can do this by becoming lenders themselves, or by working with firms like ours, that originate directly for investors. Direct lending investments allows investors to have deal control, lending documents in their name, security in their name and 100% of the penalty interest go to them.
Loan management can be done by investors, or they can engage firms like ours to help.
Direct lending investments aren’t for everyone, as you must have capacity to write a whole deal yourself, or syndicate with one or two others and be willing to be involved in the decision-making process.
The benefit here, is that your returns will automatically be boosted by no less than 20% to 50%, when compared to investing in a fund for a similar type of product, where fund managers chew up most of the returns.
Provide capital quickly
Business borrowers are willing to pay a premium for quick and certain capital. What this means is that if you are investing in direct lending, and because you are the lender yourself. You can manage the speed at which a transaction is done, without the headaches of a credit committee that a borrower must typically go through with trinational firms. Secondly because it is your funds, you can provide certainty of funding to the borrower, in way most private lender can’t.
The lesson here is simple, you must take control of your destiny.
Have the ability to underwrite risk in deals
Alpha returns can be gained in one of two ways. Firstly, by getting a higher return in an investment, when compared with an alternative investment with a comparable risk profile. The second way is to is to get the same return as an alternative investment with a similar return, but with less risk.
A example of this is our second mortgage loans. Our investors only do second mortgage loans, where they have the capacity to underwrite the first mortgage. So in an event of default, instead of the first mortgage lender chewing up the available equity, and the second mortgage lender being at the mercy of the first. Our investor payouts the first and takes control of it. In other words, they get second mortgage returns, with the risk level of a high LVR first mortgage loan in a worst-case scenario.
This strategy considerably derisks second mortgage private credit deals, where usually most second mortgage lenders don’t have capacity to underwrite the first.
The lesson here is simple, if you have the balance sheet to underwrite risk, you can earn higher returns without having to take on greater levels of risk that others have to take.
Understand and manage risk
Risk isn’t just about deal or product risk, it is also about perception of risk and being able to mitigate for the risk in a transaction. So higher returns can be achieved, without taking on more risk, if you know how to mitigate for it.
An example of this would be if you had $10M liquid, would you lend it to a borrower doing a $5M developer needing a construction loan? The short answer, given all the risks in construction, it probably wouldn’t be prudent for you to do that deal, if you weren’t familiar with construction your self. However, if you were a builder yourself, like some of our clients are, then the risk of that loan would be far less, as they can mitigate for a number of factors, so the risk reward ratio becomes considerably better for them.
The lesson here is simple, invest in what you understand and the risk you can actively manage to earn higher returns.
Understand borrower pressure points
Most private credit funds focus on property as security and personal guarantees. Whilst property security is one of the highest forms of security (there are better ones), investors must look for other forms of security used in transactions, that also offer higher returns.
Sometimes we don’t’ take property as security, but we will have a GSA on an entity that holds critical regulatory licences that takes years to attain, that is fundamental to the business operating. Alternatively, we may have a GSA on an entity that holds a business lease, for which it is fundamental as a base of operations (due to machinery, fit out, location etc) that can’t be easily replaced. In either scenario if a borrower were to lose control of the entity, we have a GSA on, it would be worse in many respects than losing their home, as they would no longer be able to produce an income.
Other lenders may simply discount deals like these as they are not property backed but deals like these allow investors to earn higher returns, if they can understand the value of nontraditional property security.
Invest in unique private credit products
Investing in unique private credit products allows you to gain higher returns, in a marketplace that is less crowed by investors, and in higher demand by borrowers.
Examples of this include,
- Our heritage plate lending product.
- Second mortgage lending, where you have capacity to under the first mortgage.
- Lending against gold bullion.
- Lending against classic collectible cars.
- Lender warehouse facilities.
- Lending for special business situations.
- An invoice financing fund etc
For a confidential discussion click here.
To read more about private credit investments click here.
To read more about direct lending investments click here.
