Why you shouldn’t invest in private credit

There are several reasons as to why you shouldn’t invest in private credit and in this article we will explain those reasons, and why some still do.

With the crisis of Bathla group, the acute fall in property prices and some of Australis biggest private credit funds, putting a freeze on redemptions. It is clear that private credit is a bad investment decision, or is it?

The allure of private investments and private credit

Private investments typically form the bulk of most family office investments, from real estate, through to private credit. Private credit however, by its nature offers investors security, and above all an illiquidity premium on the yield it provides. Because of the very nature of the investment, being less liquid than publicly traded debt, investors get a higher risk adjusted return for the illiquidity of the investment.

Private investments also offer a better opportunity to earn an alpha return, because not all information in the private market is easily accessible or known by all market participants. This allows for easier first mover and competitive advantages to take place, compared with publicly traded securities.

Because of the illiquidity of private investments, what this means is that further work needs to be done to derisk them. Which requires a thorough understanding of the investment, by investors.

What are the reasons you shouldn’t invest in private credit

There are very strong reasons for you not investing in private credit, and we’ve listed them below.

1. You are interested in capital growth only and not income.
2. You are dealing with a fund manager that has sold you the upside of private credit, but not the downside, nor have they explained the mechanics to you of how recovery works.
3. You don’t understand what is being taken as security for the funds you’re providing in a private credit investment. Is it property, is it heritage plates, is it a car, it is an invoice?
4. You don’t understand what state the underlying security is in, that you are lending against. Is it a construction loan? Is it lending against an as is asset that is complete?
5. You don’t understand what happens if a private loan goes bad, and how liquid the security will be in its current state at that point in time. For example, with a construction loan, will you need to find a new builder to finish the project and the associated costs?
6. You don’t understand, where your money ranks if a private loan goes bad? Do you have a first mortgage, second mortgage etc?
7. You don’t understand where your money ranks, if you invested in a private credit fund.
8. You don’t understand the recourse position if the loan goes bad. What needs to be done to recoup your funds, its cost and how long it will take.
9. You don’t understand the exit for the private loan you are investing in (how funds will be repaid).
10. You don’t understand the marketplace for the underlying security being provided for the loan, and how liquid the asset is.
11. If you’re investing in a private credit fund, you don’t understand who makes the decisions and how they will act under various circumstances.
12. You don’t have any idea of how valuations are done, and on what basis. A low LVR loan, doesn’t mean less risk, if it’s based on future value of an asset and not the current value.
13. You are relying on an investment manager to make all the decisions, instead of you having oversight of your own money.

Given all of the above reasons, you 200% shouldn’t be investing in private credit if you don’t have clear answers to the above. In reality 80% of private credit investors probably have never asked all of the above questions.

So why do some investors do so well with private credit and others don’t?

The devil is in the detail.

Who invests in private credit?

Whilst the retail market currently runs away from private credit, due to the bad media and some investors getting burnt by the incompetence of some investment managers. Family offices investments are still heavily focused on private credit, but why?

Why family offices invest in private credit?

Private credit is an integral part of family office investments and their portfolios for several reasons. One of the critical reasons is that unlike other investors, family offices have large amounts of wealth, that gets quickly eroded by inflation. To maintain the purchasing power of each dollar they have, family offices need to ensure their capital is continuously working for them.

So what are the core reasons, family offices invest in private credit?

1. They have security for their capital, usually in the form of a business or property.
2. The returns of private credit, counter the effects of inflation.
3. They take the same security as a bank but get significantly higher returns than a bank term deposit.
4. It provides regular fixed income.
5. It diversifies their portfolio.
6. It doesn’t carry the risk and variance of equities.
7. It provides them with a high degree of control over their investment.

Why do some private credit investors succeed and other don’t?

Family office and HNW investors that succeed with private credit, do so because they do things very differently to how most others do it. At the heart of their success, it is because most investors retain a degree of control, and don't leave it to blind faith of the investment manager. Those investors, that retain a degree of control, do the best with private credit.

Below we’ve listed what they do differently.

1. A number of family offices, have set up their own private credit lending businesses, so they increase their net margins and have end to end control.
2. They invest with select private credit funds, where they have deep understanding of the product and the investment manager. Some will even underwrite certain loans that the fund does, and they will always conduct a review of where capital is going.
3. If they invest in a private credit construction fund, they do so an SPV project basis. What this means, is they will provide funds a to a contributory mortgage SPV made only for that project. They ensure they like the project, it has market demand, and that the right players are in place.
4. They use firms like ours as originators, for direct lending private credit investments. Essentially, we originate for family offices and HNW investors. This ensures that loan contracts and security, is in their lending entity’s name, and they can manage everything end to end if they wish. It can also nets them up to 50% higher returns than investing in a comparable private credit fund lending against the same security.

To lean more about private credit click here.

To learn more about direct lending investments click here.

To have a confidential discussion and put your capital to work click here.