Private Credit under scrutiny. But the proof is in the backing.

At a Glance:

• The private credit market is growing fast but faces regulatory scrutiny due to high leverage and reliance on cash guarantees
• Asset-Backed Lending offers a more structured and predictable risk profile making it an attractive option for institutional investors, especially during market downturns
• Collateral is king, but due diligence is queen. Thorough due diligence ensures loans are structured to withstand market volatility and borrower defaults, reducing risk for investors.

Are we witnessing a non-stop race to the top for the private credit industry? According to Morgan Stanley, at the beginning of 2024, the market reached $1.5 trillion — a substantial leap from approximately $1 trillion in 2020 — and is projected to grow to $2.8 trillion by 2028.

But not so fast. With higher levels of funding come increased scrutiny. Moody’s recently issued a warning of ‘systemic risk’ in the leveraged lending market, while the Australian Securities and Investments Commission (ASIC) has initiated a taskforce to explore the need for regulatory measures within the sector. ASIC Chairman Joe Longo expressed concern that investors in private credit funds may not be adequately protected.

A recent global survey from Moody’s shows that between 2021 and 2023, bank lending to private credit funds grew by 18% year-on-year. The trend was more pronounced in North America (23%) than Asia-Pacific (17%) or Europe (12%).

In 2023, loans linked to private credit accounted for only a small fraction of banks' total lending, approximately $525 billion or less than 4% of overall commitments. Despite this relatively modest share, regulators like the European Central Bank have expressed growing concern about the potential risks associated with this exposure.

Where the real risks lie

Credit rating agencies and regulators are raising their eyebrows due to the limited regulatory oversight and reporting standards of the industry. Private credit deals often have fewer disclosure requirements compared to traditional public markets. This can make it difficult to assess risk profiles and gain insight into borrowers' financial health and loan terms, leaving lenders potentially exposed to unforeseen risks.

Many private credit funds operate with significant leverage, yet the current reporting standards do not always provide detailed disclosures regarding this risk. In times of economic stress, leverage can magnify losses, but without clear reporting, stakeholders may not become aware of these risks until it's too late. Limited oversight increases the risk that deteriorating borrower creditworthiness or weakening cash flows may not be identified early enough.

This leads to what is possibly the most significant risk: the heavy reliance on cash guarantees. This is a common feature in many US private credit deals, especially in the direct lending segment. This form of lending typically appeals to private, non-investment-grade companies because of its flexibility and the speed at which deals can be executed.

While cash guarantees provide short-term liquidity assurance, they are inherently more volatile than physical assets, especially during liquidity crunches or volatile market conditions.

Cash guarantees are prevalent in deals where borrowers are looking for junior capital solutions, such as mezzanine or second-lien debt, which do not involve direct claims on physical assets. This structure gives borrowers flexibility but exposes lenders to greater risk if cash flow weakens due to market downturns​.

The US Federal Reserve reports that over two-thirds of private credit consists of term loans, while around 15% are hybrid pari passu loans, which sit lower in the capital structure and carry higher risk due to their junior status in default scenarios.

The Federal Reserve has raised concerns about this growing reliance on cash guarantees, and the European Central Bank has warned of potential adverse spillovers and volatility from the US to the euro area.

The case for Asset-Backed Lending

Asset-based lending (ABL) provides a more structured and predictable risk profile, which is particularly attractive to institutional investors. In ABL transactions, loans are secured by tangible assets with measurable and relatively stable value — ranging from accounts receivable and inventory to machinery and real estate.

For example, FC Capital recently provided a $16 million asset-backed term facility to a mining services contractor. Secured by the company's equipment, this facility gave the borrower access to crucial funding while significantly reducing the lender’s exposure. The clarity on asset value at the time of lending also allowed for a more precise risk/return evaluation.

On one end, asset collateralization shields lenders from potential losses, particularly during market downturns, as these assets retain intrinsic value even when liquidity tightens. On the other, the predictable structure of ABL appeals to investors seeking reliable returns with lower volatility compared to unsecured or cash-flow-based lending.

The Rise of ABL in Australia

Asset-based lending has seen substantial growth in Australia, largely due to the introduction of the Personal Property Securities Act (PPSA) in 2009. This legislation established a unified framework that made it easier to secure loans using personal property as collateral. Under the PPSA, businesses can register security interests in assets through the Personal Property Securities Register (PPSR), which provides legal protection and priority in the event of borrower default.

The act has simplified the use of a wide range of assets — from accounts receivable to inventory — as collateral, improving the speed and efficiency of securing loans. Moreover, the PPSA has standardised previously fragmented security laws across Australia, reducing legal complexities and making asset-based financing more accessible​.

This regulatory framework, coupled with stringent standards enforced by the Australian Prudential Regulation Authority (APRA), has made ABL a stable and attractive option for businesses and investors alike. The PPSA also increases transparency in lending, as all security interests are visible to relevant parties, which reduces the risk of hidden liabilities.

In Australia, APRA and ASIC are responsible for ensuring transparency and enforcing high capital requirements. APRA’s prudential framework is one of the strongest globally, giving lenders confidence that the system is robust enough to withstand market stress.

Australian businesses have access to a wide array of assets that can be used as collateral in ABL transactions, such as accounts receivable, inventory, real estate, and machinery. With strong regulatory backing and a broad range of eligible assets, ABL is increasingly the preferred choice for investors seeking lower-risk opportunities in sectors like manufacturing, real estate, and mining.

If collateral is king, due diligence is queen

A Moody’s global survey of 32 banks engaged with private credit found that “smaller banks in the sample are pursuing aggressive expansion that could raise credit risks, especially if they have less established track records in this multifaceted market or have less robust risk-management infrastructure.”

The report also suggests that the high leverage of middle market loans can be mitigated by well-structured collateral. Most of the banks surveyed secured their loans with first liens on loans to middle market borrowers (50%), large corporations (9%), or investors' uncalled capital commitments (27%).

Thorough due diligence plays a fundamental role in helping institutional investors mitigate risks when expanding their exposure to private credit. FC Capital’s due diligence process is designed to mitigate risk and maximise returns, with a strong focus on collateral and downside scenarios to test the security’s resilience under adverse conditions.

Our in-house team conducts an in-depth investigation of the borrower’s serviceability, analysing historical and projected cash flows (CFADS) to verify the loan’s viability. We review the borrower’s capital structure and existing financial liabilities, and require personal guarantees from key management where necessary. Our thorough, multi-dimensional process ensures that risks are effectively managed and capital is deployed efficiently.

For more insights into Australia’s private debt opportunities, contact us.