The decade long global easing cycle has set the scene for record-low interest rates. This has spurred an increased appetite for risk in search of greater yield and return which has helped, in part, drive equity markets to record territories. The thirst for yield and return, in combination with the comfort with equity-like risk, has increased the focus on private debt.  The thesis is that by harvesting an illiquidity premium investors can achieve superior risk-adjusted yields and all-in returns by gaining access to differentiated exposures.

 

Private debt is not by any means a new concept, but interest in these investments has expanded rapidly since the financial crisis, as shown in figure 11. At a high level, private debt provides investors with equity-like risk and returns and bond-like volatility. The growth of the sector emerges not only from low-interest rates and increased risk appetite on the part of investors but from the overhaul of supervisory and prudential structure for global banks. Increasing regulatory and capital requirements have made certain risk exposures increasingly expensive for traditional banks. These regulations have created a funding gap that is being filled by non-bank market participants, most often using private debt strategies.

 

 

The evolving lending and debt landscape in Australia further exaggerate the characteristics that have driven interest in private debt.  Australian banks possess capital ratios that are relatively high compared to global peers. Such ‘unquestionably strong’2 capital ratios are enough to withstand a shock of equivalent magnitude to the majority of historical bank crises3.  But increasing regulatory and capital requirements have made certain risk exposures increasingly expensive.  And this is just the supply side! The demand side, those who consume the capital, have also faced increasing regulatory barriers to doing business. For example, in 2018 the Australian Prudential Regulation Authority (APRA) began to enforce new capital requirements around commercial property lending. Property developers now have a maximum loan-to-value (LVR) ratio on developments of 65 percent and require, potentially, 100 percent pre-sales for residential property development4.  These regulations help create a market for sophisticated private debt providers to capital-hungry borrowers.

 

We believe private lenders will play an increasingly important role in meeting the capital needs of borrowers both as a result of additional capital requirements of banks and the growth of efficient fintech platforms.  One key advantage of private debt over traditional debt is the ability to direct capital towards sectors that offer the most attractive risk-adjusted returns, as well as, the ability to create bespoke terms and conditions to protect investors.  As noted in Figure 2 private debt in Australia incorporates a broad range of private financing formats from high-quality infrastructure to senior debt to private borrowers and property development. Expected net IRR on private debt can be anywhere between 4% and 12-15% or more, depending on the term, borrower quality, transaction structure, and security.

 

 

Conclusion

Private debt can offer meaningful risk-adjusted returns in today’s yield-starved environment. There are a number of regulatory and economic tailwinds in Australia that enable private investors to fulfill a crucial funding gap in many sectors.  In the real estate sector alone there is high demand in residential and commercial sectors with high-quality developers seeking credit on a strong risk-adjusted basis.  There is a significant opportunity for investors within this asset class and we see it continuing to play a key role in attractive returns and diversification.

 

by  Gavin Ezekowitz

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