Are private credit funds a good investment?

Investing in private credit funds can offer attractive returns, but also carries increased risk. 

Here is some of the key information you should know before making any financial decisions.

What are private credit assets?

Private credit funds are a type of investment that involves lending to developers who cannot secure loans from traditional banks due to their higher risk profile. These funds offer impressive returns of around 10% which can make them look like great investments. 

At a glance, these funds, offer high returns similar to equities but with fixed interest characteristics. However, the reality is more complex and there are significant risks that investors need to be aware of.

Are private credit funds a good investment?

Private markets are less transparent compared to publicly traded assets, making it harder to assess the true value and risk of investments.

What we can tell you is that there’s generally a significant premium to safer assets embedded in the high interest rates and fees they charge. While the fund managers are well credentialed with rational processes, they have not experienced a downturn in Australia meaning their risk mitigation skills are untested. 

While many funds will probably make money, some are already experiencing loan repayment issues and have stopped paying distributions and limited or frozen redemptions.

Speak to your Financial Planner about your personal risk appetite before making changes to your investment strategy.

These are high-risk investments

Economic downturns have a significant influence on the performance of private credit funds. When borrowers default on their loans, investors inevitably face potential losses. Key risks include: 

Illiquidity

These funds are unlisted and not marked to market, meaning their unit prices do not reflect the risks involved. This can make them difficult to sell during a downturn.

High risk of default

If we estimate the risk of a collapse in the property development sector to be around 4% (meaning that in one out of every 25 years, under similar conditions, there could be a sector-wide issue) and consider that the average loss during a default is approximately 75% (as half-finished housing developments in outer suburbs are typically unsellable when the overall property market is down), we can conclude that there is a notional expected loss of 3% to subtract from your returns.

Limited diversification

While deducting 3% may still yield better returns than safer assets, private credit funds are closely correlated with equities in times of crisis. Therefore, during a downturn, not only might you find it challenging to sell your investments, but your equities could also decline. From the perspective of portfolio construction and diversification, the potential for extra yield comes with considerable risk. Investing in these funds implies a bet against the occurrence of a downturn, which may be an overly optimistic gamble given current market conditions.

Risk mitigations

The way fund managers talk about risk mitigations is a good indication of the level of risk involved. These might include having direct access to the developer's accounting and being able to see (and sometimes having to approve) every invoice. 

Remember that these measures are necessary because the loans are not secured by saleable assets, and the borrower's source of income is not secure enough to avoid constant auditing.

Our verdict? Niche investment

Overall, private credit assets are a niche investment. They have the potential for good returns but are hard to fit into a diversified portfolio because they are correlated with equities in a crisis. Add in the illiquidity of most of the funds, and we conclude that most investors don’t need to add these to their portfolios.             

RSM Financial Services Australia Pty Ltd (AFSL 232 282)

The content of this document is general advice only and doesn’t take into account your personal situation or needs. 

For more information about private credit funds or other investments, please contact Grace Bacon or your local RSM adviser.