Private Credit: What is really going on?

Not all that glimmers is gold. But some is. The difficulty investors and their advisers increasingly face is understanding how to identify the gold from the glitter when it comes to private credit. These assets have performed well for investors, offering attractive returns with stable income, yet media coverage and some high-profile stories have changed the perception of risk.

The discussion focused on:
• What’s changed in Australia’s private credit market over the last 12 months and what that means for investors
• Private credit and risk – Unpacking the risk /reward balance behind private credit’s attractive returns
• What really happens when loans go bad
• How can investors better understand what they’re investing in

Catch up on what Sebastian Paphitis (Alvarez & Marsal), Ryan Donnar (Privity Credit) and Tim Samway (Scarcity Partners) discussed what’s really going on in private credit.

Please note this transcript is machine generated.

Tim Samway 00:04
Good afternoon, everybody, and welcome to what’s going on in private credit. That’s the topic of our conversation this afternoon with me on this webinar today. We have Sebastian pathitas from Alvarez and Marcel. We have Ryan donner, managing partner at privity credit, and I’m Tim samway from scarcity partners. In short, we have the advisor, the lender, and I guess the investor. What I might do is, just before we start quick housekeeping, so there’s Q and A, please put questions. We’ll attempt to answer them throughout the course of the webinar today, some of you have sent any questions, and we will answer those today. I thought, before we start though, please just give us a bit of background on your business. Sebastian, just so that people know what what do you do? Yeah, sure. No problem.

Sebastian Paphitis 00:52
Well, thank you for having me along. So I’m at Alvarez & Masal in the corporate finance business. So my business is advising corporate clients on going to the debt markets. So that involves going to the more traditional markets, like the bank and bond markets, but equally, the growing private credit market, great, so helping them go through the process of accessing all the new capital that’s in the market. So we help clients with that.

Tim Samway 01:15
Very good. Ryan?

Ryan Donnar 01:17
Ryan Donner, Managing Partner of Privity Credit. We’re a mid market direct private credit lender in Australia and New Zealand.

Tim Samway 01:24
Brilliant and Scarcity Partners is a private equity manager specialising in partnering with investment managers, and we’ve partnered with privity credit. So today we’re going to explore multiple angles of private credit with a focus on distinguishing between the gold and the glitter in this market. And I’m going to start with you. Sebastian, so commentators have been calling the top in the private credit market for over a year. Not hardly a day goes past where don’t read something in the paper. The market’s grown substantially in the last 10 years. So can it continue? And I know you’ve brought on a couple of slides, so let’s go with a picture is worth 1000 words. There’s a slide you’re going to put up there. So can you just talk to that slide, please?

Sebastian Paphitis 02:07
So, yeah, look, I think, I think certainly the commentary is, is that people might be expressing that view, but we’ve been in this market for, you know, the last 10 years, and seeing the growth of private credit. And you’ll see in the chart there that we’ve been actually sharing information on the size of the market over that period. So the light blue shading at the top is the size of private credit, and that’s that’s based on an annual survey. And you’ll see at the moment, it’s around $205 billion which is quoted in the press as the as the rough size of market. So we’ve seen that steadily grow, grow at a faster rate than bank and bond markets, which are also represented there and then. Based on some industry estimates, we expect that to continue to grow to well over 300 billion in coming years. So the trajectory is still very positive. There’s still plenty of growth to come. And interestingly, you’ll see not on that chart, but in our data, that it still only represents around 14% of the corporate lending market and 17% of the commercial real estate lending market, so still only a small percentage of the overall lending market. So plenty of scope for growth, indeed. And compared to the US, for example, where it’s a very substantial component of the whole market, yeah, in the US and European markets, it’s estimated to be over 50% Yeah, so we’re well, well short of that, yeah. So there’s plenty of room for growth in coming years.

Tim Samway 03:28
Indeed. Well, there’s an obvious question that follows that point. So why do companies use private credit? I think they’ve got another slide here, which I was looking at earlier. So if we could just pull up that. So why will private credit continue to grow? Can you just give us a bit of a look at that, please?

Sebastian Paphitis 03:43
Yeah, sure. So rather than just coming from my perspective, this is based on a industry survey that was recently completed of private credit managers in the market, in the Australian market, and they’ve identified some key reasons for, you know, why they see future growth. You’ll see that it includes, you know, the banks continuing to have a more tighter risk appetite, and they’re sort of more impacted by the regulatory frameworks that they operate in. You’ll see there that there’s an increasing awareness of the corporate borrowers. So a lot, a lot more of the business and corporate community is aware of the private credit market and accesses it more regularly. And then the other key theme is the level of capital in the market. So you’ll see there that investor appetite is a key driver. And so what we have seen is a lot of new entrants come into the market. In Australia, we’ve seen existing credit managers grow, and we’ve seen m&a and consolidation as as more capital comes into the market, and that gives the corporate borrowers a lot more a range of of capital they can access, and so that that’ll continue to drive growth in the market.

Tim Samway 04:51
Now, out and about, we’re talking to advisors, investors. They just ask me, Why don’t they? Why don’t these borrowers just go to the bank? Thanks. So what is actually driving the growth in the private credit market? You’ve got another slide. That third slide I saw earlier, I think that actually gives us a pretty clear idea. Could you talk to that, please?

Sebastian Paphitis 05:11
That’s it, yeah. So yeah. And I think that’s all the slides we have for today, but it’s just helpful to give some context of what people are seeing, you know, on the ground, yeah. And so this was a part of that survey as well, and it gives the reasons why corporates go to private credit. And you’ll see there they use it for a range of reasons, like acquisition finance, growing their businesses, property development, refinancing. You’ll see stress situations and bridging, and equally, project and infrastructure finance. So it’s quite a wide range of reasons why Australian borrowers go to the market, and often it’s driven around events in their business and growing a business or building a new property project. And so it is a it’s a strong supporter of those businesses, but equally of the economy more broadly.

Tim Samway 05:57
So that’s fascinating, because I just thought if you if you just listen to the media, that property development was the major part of this market, but actually, you’re saying it’s not its acquisition and expansion. That’s growth of the Australian economy. Ryan, I might bring you in here. You aren’t in that property development space, but you are dealing day in day out with companies looking to acquire and expand. Is that right? So what does that look like?

Ryan Donnar 06:21
Yeah, that’s correct. So we, we focus on growth and expansion for for growing corporates effectively. So, you know, we as a manager, have decided to stay away from cre basically because of the experience of our of our team, but also there’s we’ve we feel investors have access to that sort of exposure in other other ways, so we offer that diversification away from that. Gotcha, yeah, it’s the expansionary capex, growth capex. It is very much that event driven thing where private credit does step in. I think the banks in Australia, we’re very lucky to have a well regulated system, very strong banking system, supported by a great superannuation system. But in that middle market space, when there’s an event because of the resources required to actually service and do those sorts of transactions, that’s where private credit steps in and looks after, you know, certain clients for a number of years, and ultimately, once those businesses are back to steady state, they may opt to go back into more traditional banking markets.

Sebastian Paphitis 07:25
Yeah, just going to add as well, they also, often, the borrowers will benefit from the flexibility of the private debt market that they can get in the funding structures, there’s a few, there’s a wider range of funding options that that offers them so and also often in some of these financings, they’re driven by time frames, and often private credit can can move more quickly than a bank process.

Tim Samway 07:48
So that actually looks like a tailwind for private credit lenders. In my in my book, it’s such a great area with attractive returns. Why won’t the banks come back? Is it your point that really just requires that level of flexibility that the banks don’t have. Or what is the what is it that’s driving the opportunity for private credit lenders?

Ryan Donnar 08:08
Yeah, look, I think the banks are great in certain areas, in certain SME markets, where there’s property backing to for people in their businesses. They’re fantastic top end of town. They’re still fantastic where then they’ll and securitization structures, where they will turn things out into the market, they’re great at there’s additional capital that’s required to be held against these sort of assets in the mid market. So when they’re steady state and not event driven, things happening, they are good. But in this space, you know, the average relationship person now in a emerging corporate or corporate bank would have anywhere from 50 to 100 relationships that they’re looking after. That’s 50 to 100 companies. The last thing they need is something to actually happen, because they just don’t have the resources to be able to service that. So that’s where private credit steps in, and we work cohesively with the banks, which we need to do.

Tim Samway 08:56
So take us through a transaction with a borrower looking for funds to finance and expansion, sort of from initial initiation to repayment and the next opportunity. What does that look like in so, you know? So, so the people actually watching us listening today get a feel for what it look what it looks like in real life?

Ryan Donnar 09:14
Yeah, sure, we’ve got one that we’re just, you know, completing at the moment is actually an existing client. So they were with us for a number of years when they took the opportunity to change their shareholding structure. And there were various things going on in the industry at that time, so we had to do a lot of additional DD recently, they were looking they were potentially going to refinance and go back to the bank at the board level for that group and across their shareholders, they decided to go for the next level of expansion. So what that meant was the best way for them to get there, and this is where it’s quite different to being in a bank environment. We took the opportunity to lend them more money so that they could they required additional equity to be raised down the track to really get to where they want to get to. Couldn’t just be done by debt, but we helped them buy back certain hours. Assets. So bought assets in so everything looked a lot cleaner from business operation perspective, and they optimised some of their supply contracts. And so in that instance, we were comfortable, because if we needed to, we could sell each of those assets, or we could monetize those via the cash flows. As it turned out, we did that that that allowed them to then take time and get a good equity raise away to compensate our investors, we increased the interest rate through that period and picked up some some warrants of an equity upside to share that more efficient outcome for the client, they’ve just completed their equity raise. They paid us down to lower than where we were before we went through that process. They are still with us, and they’re now well and truly on the path to IPO in the next couple of years. So it’s that flexibility that you offer people to support that growth.

Tim Samway 10:51
Yeah, and so zooming out a bit, have the opportunities improved or declined in quality over that, you know, the last couple of years in your view?

Ryan Donnar 11:00
I think in this specific niche where we are in that mid market space, it is increasing, you know, it is a pretty regular space where events happen. So there’s always people investing in private companies through the cycle. You don’t have the same sort of headwinds of, you know, IPO requirements or larger private equity transactions taking place. People are still investing through the cycle. So events are constantly happening. There’s just more things that then keep coming across our desks that the banks don’t have that resource really to look after.

Sebastian Paphitis 11:35
And we don’t necessarily look at it as one market or the other info, but some clients will consider both, and in some circumstances, will work better to have the flexibility, as Ryan just mentioned in that deal situation. In others, they’re more comfortable with the bank facility. So this, we’re still both going to have a role to play. But you know, we think there’s certainly a high growth rate in the private credit market than the more traditional markets, but they’ll both have a role in different circumstances.

Tim Samway 12:06
And I might put the same question to you, what are you seeing in the quality of borrowers that are stepping up to the private credit market?

Sebastian Paphitis 12:13
I think we’re seeing as the pool of capital that comes into the market increases and the range of lenders increases. We’re seeing the mix of borrowers changing. So we’ll see new markets emerge. For example, you might see more investment grade borrowers because of institutional funders like super funds and some of the Global Investors offering larger amounts of capital. So we’re seeing a little bit more investment grade, but potential for that market to see more private debt. And there’s, there’ll be other niches like project and infrastructure finance, we’ll see a little bit more private debt. So I think it’s a little bit of broadening and widening and the range of situations that’s relevant, rather than necessarily, sort of the quality or the borrowers changing as such.

Tim Samway 13:00
I mean, investors should be focused on getting their principal back. This is what this business is all about. Obviously, the quality of the borrower is important, and the points you’ve just made are valid. But there’s also the extra protections loan structuring. Ryan like, can you just give us a bit of a flavour for that? Because I don’t think a lot of investors really understand the opportunity there to increase protection.

Ryan Donnar 13:24
Yeah, look, it’s the, it’s the key building block in anything you do when you’re lending money. It’s the, you know, you’ll often hear us say, structure, structure, structure. And it’s that structuring and documentation from the outset. So we will work and provide a flexible arrangement for a corporate but things are done in a manner that if we need to step in, and as we need to step in, all the protections are there. That starts with your covenants. We don’t negotiate on covenants. We’ll have things that protect the balance sheet, things that protect the earnings and, most importantly, things that protect the cash flows coming in to service our loan, and that’s an easy one, and with good quality advisors, they understand it’s in not just our investors interests, it’s also in the interest of the underlying corporate so, you know, we need to get around the table and have a discussion. If things are diverging, it’s not something that, you know, you loosen up and let go. So the advantage in the direct sort of space is you do have control over that documentation? I guess it’s you’ve got less control in wider held syndications and some of those sorts of issuances as well.

Sebastian Paphitis 14:30
Yeah, that’s certainly true. Is your you’ve got a direct relationship. So you’re in the direct lending market, you’re directly negotiating terms and covenants and structure, so you’ve got the ability to to protect your investment.

Tim Samway 14:43
And indeed, every now and then it goes wrong, and I’m going to go straight to a couple of questions that were asked to us earlier on, before the webinar started. Tell me about arrears, rising, falling, stable. I mean, I’m going to cover a whole range. There’s a whole lot of questions. What’s the direction on payments in kind call it, pick warrants. How many workouts? Just give us a flavour for all of that, because it’s the part that nobody really wants to talk about.

Ryan Donnar 15:11
Yep, yep, sure, yeah. We’ve been pretty upfront with with the market and with investors. You know, across our four vehicles, typically there’s one or two significant restructures that take place, you know. So that’s that’s just a feature of what we do. We have good track record in covering money, and in actual fact, making more money for our investors through that, through default interest. Get a lot more grey hairs. But, you know, that’s what people pay us to do, and we have the experience to manage those sorts of situations. Generally speaking, you know, the economy has been tough for a number of years now, so in terms of the arrears and the focus, we’ve been managing the book, you know, basically as though we’re in a full blown recession for the last 24 months, that’s been our approach. You know, there has certainly some tightness in some of the underlying performance of some of the companies, and that’s where it’s important to have the right people around the table, supportive shareholders and so forth. Terms of your question about pick, you know, we do use that as a tool from time to time. So payment in kind that’s effectively just capitalising your interest. We prefer to use that, and it can be used to relieve some of the cash strain on an underlying business. But if something’s in a deteriorating environment, you’re just Compounding the problem for later on is our approach, where we will look at it is if we’re going into a new opportunity, and it’s such a high growth opportunity that company can use those additional cash flows to generate further growth. That’s when it is an appropriate tool, and in that case, it probably flows into some of the other parts of the question. If we were to do something like that, and we don’t do it that often, because we focus on the cash yield, strong cash yield for our investors, we would always want warrants for doing so. So then now come you know, our investors are actually sharing in that upside that those additional cash flow relief is giving, though the underlying corporate.

Sebastian Paphitis 17:07
I think the other thing to add is, you know, if you’re in a lending business, you’re always going to have some loans that have challenges, whether you’re a bank or whether you’re a private credit lender, or even if you’re A bond investor. So that’s a part of the lending business. And also, you know, we think about private credit and what we’re seeing now, and you know, we often forget that we’ve already been through a number of major events in the last few years. We’ve been through a COVID pandemic, we’ve been through a fast rate rising cycle. We’ve been through a very high cost inflationary cycle, and so private credit has weathered a number of those major events, so we’re still going to see more, you know, evolve over time. And you know, there will be, you know, we expect that you’ll have situations where there’s problems, but generally has performed well today.

Tim Samway 18:01
Do you think investors have more expectations of private credit, other than just return of capital and and the interest payments I’ve you know, I hear people saying they’re looking for alpha in in private credit. I mean, clearly that comes with risk. What are you seeing in the market?

Sebastian Paphitis 18:20
I think the big topic at the moment is certainly the comment around the regulatory oversight, and what that is driven by is the request for more transparency and understanding of what managers are lending in, where they’re investing the capital. So I think that that’s a common that’s a theme that’s going to emerge is just more transparency, more information about what are in the portfolios. Are they being independently valued, so investors are more aware of what their managers what their managers processes are to lend, to manage the book, and then also what are the underlying loans in those portfolios.

Tim Samway 18:57
Are you seeingthe same Ryan? Is that that desire for transparency, and is it a desire for homogenous transparency, where everybody’s transparent to the same level and the valuations are the same as as applies in other jurisdictions?

Ryan Donnar 19:14
Yeah, it’s a good, good question. And you know, I agree Sebastian’s observations. Yeah, there’s definitely an increased focus around that, you know, from investors, from our perspective, absolutely, people want to know more. So you can go one or two ways, because you’ve obviously, we like to be transparent with how the other the underlying loans are structured, set up the protections that are there, as opposed to giving someone a name. So a name doesn’t necessarily mean much unless you understand the underlying context of the loan and why we set it up, and what we’re doing, which is actually quite sensitive information, if it got into their competitors hands, you’re actually damaging the opportunity for your underlying client. But yeah. So that’s there is a lot more focus around that. It’s not just purely on the cash returns, although obviously everyone wants to get that stable return and and return of capital in terms of the alpha component, it’s probably in certain pockets you are able to get a strong return relative to the risk.

Tim Samway 20:20
I really worry that investors pick private credit managers, like they pick a bottle of wine at the bottle shop, and that actually they do it on return and stuff the rest. I mean, I’ve had a couple of conversations where investors haven’t worked out the difference between syndicated loans and direct lending. I mean, could you just go through that? Because I think the more you dig, the more you scratch, the more you can understand the difference in the various risk profiles. So that’s one example that I might throw out here now.

Sebastian Paphitis 20:54
I think theone thing to factor in there is that, as a as this is a market that’s still emerging and growing the level of awareness in the last five years has increased astronomically, of kind of what, what is happening in this market? What are the what’s lending types? You know, what? What are the managers investing in? And that’ll continue. It’s an evolving thing. Will the investors understand every nuance of the debt markets? Probably not, but they’re increasing their knowledge, and I think that’ll only continue.

Ryan Donnar 21:26
Yeah, I think the, you know, the comments around, I guess syndicated loans, they certainly do provide a good offering, certainly here in the Australian market, and just for everyone there, that just means you’ve got a large Syndicate, typically, of banks and other investors. So you might have 1020, 30 lenders. I guess the when you need to manage and do things, that direct relationship makes it a lot more efficient terms of time for you to actually do things and restructure or whatever might be required to preserve the equity value of that corporate as well as preserve, you know your investors protections effectively, at least that’s, that’s, that’s our kind of view of the world. You are starting to see internationally, even in the large syndicated loans, there’s now mega deals with the private credit funds having these large exposures. And it’s the companies that are actually seeking that out, because they want somebody who can move quickly and have that direct relationship in a syndicated loan environment. If something were to go wrong by the time you get to the meeting of all of the lenders, someone could have sold their exposure at the 25th hour, and you’ve got a completely different stakeholder group, and you have to start again, and that’s all valuable time in terms of protecting investors and the underlying corporates.

Sebastian Paphitis 22:39
And there is the market is not just one market. It’s not as we saw earlier. It’s not just direct lending, it’s not just corporate lending. It’s, you know, there’s so many different facets, and so the investors really need to understand who the manager is, which part of the market are they lending in? Is that part of the market something they understand, and are they comfortable with the risks.

Tim Samway 22:57
I might get you to reflect, without going into any names on the varying quality of the lenders out there in the market? Because there’s got to be, it’s got to be a pretty broad sort of range. I mean, seriously, this is not an area like if you want to be a knee surgeon, you’ve got to be qualified. There are plenty of people, I think, who’ve set up recently who perhaps their backgrounds don’t suit what they’re doing. I mean, I’m being careful here, but we said we weren’t going to be too PC today, and in private credit, you’re particularly well placed to give us some feedback on what do you see out there as the quality of the lenders out there? Because that that actually drives to Ryan’s point is that structuring, well actually, is in the interests of everybody, both the borrowers and and and the investors.

Sebastian Paphitis 23:50
I think there’s a couple of things we can throw in the mix there. One is that the in addition to the manage new managers emerging and the growth in the market, a lot of talent has moved out of the Banking Markets into the private credit market. So the quality of the people in the private credit market is increased substantially now when one of the challenges we have as an advisor is really understanding where to which private credit managers to access for which deal, because some of them will be better suited to, you know, deal a versus deal B, yes. And so you’ll find that there’s, you know, there’s different skill sets in some of the managers. They’re better suited this type of lending versus that and and so yes, there is a mix, but often it’s, it’s a little bit more nuanced than a bank market where everything’s more consistent, yes, and it’s a set risk profile, yes, and everyone’s just bidding a price. Yes. Here you’re now talking about, well, I’ve got a deal in this sector, and who’s who’s very familiar with that sector, who can understand that more easily and help my client get a good outcome. And so, so that’s where you do see. The differences between the different managers.

Tim Samway 25:03
I’ve seen a number of businesses set up here offering European and US private credit to Australian investors. And the first thing that jumps to mind is, and this is not an area of my expertise, I think the credit protection is completely different in the US, is it not? I mean, we have a very thorough protection system for for lenders here in Australia, compared to offshore. So horses are not, it’s, you know, horses for courses, but you’re not buying the same thing. Is that, right?

Sebastian Paphitis 25:34
I think so. I mean, I think, you know, we’ve, we’ve grown up as a market based on senior, secured lending. So generally, you’re, you know, you’re, you’re right at the top of the capital structure in terms of priority. A lot of the lenders here will focus on asset backing. You know, what assets are supporting the loan, what collateral is there? And they’ll structure a loan to suit where you have a much broader market, like in Europe and the US, you might find the borrowers, like the PE firms, driving a lot more flexibility in the structures, so that creates a lot more risk for the investors. So you just need a little bit more awareness in participating in those markets. And maybe a, you know, market like Australia.

Tim Samway 26:17
and you know, I see the growth and you clearly, you just demonstrated in the slides that you put up earlier. Do you see private credit managers moving into new areas? Are there new verticals that perhaps have been the mainstay of the banks that the private credit market will move into? I mean, I’m asking you to pull out your crystal ball here.

Sebastian Paphitis 26:39
Certainly there will be. I mean, I mean, I think some of the areas will be driven by broader growth in the economy. So areas like the energy transition. So you know, that sort of, you know, the level of capital expenditure needed in to drive that transition is one area that, you know, the rollout of AI and digital infrastructure that’ll drive kind of new areas for for lenders to fund that capex and roll out. So I think some of that will drive where the investors go, you know. So we are seeing more funds look at infrastructure and lending in areas like that, for example, or the larger global funds who are accessing insurance money and now participating in wanting to provide funding to investment grade borrowers. So we’re starting to see the market broaden so that if you’re a corporate borrower in any part of the market, you’ve got an avenue to go to.

Ryan Donnar 27:36
I totally agree with that. It’s definitely broadening and increasing in reach. So, you know, we’ve seen something from some offshore big groups who, you know, they talk about wheelhouses of about 40 different sub segments within, you know, it’s not just property, it’s not just direct. There’s a lot of other things. It’s funding of water rights. It’s all other sorts of royalty streams, anything where you can get cash flows and and secure. There’s going to be increased private credit opportunities and lending in the future.

Tim Samway 28:05
So let’s now pivot to an area where I think people are really interested in, and that is ongoing valuations. You know, my understanding tell me if I’m wrong, the banks lending to credit funds are demanding external valuations. I don’t know whether that’s true or not, but the reality is, you know, the whole valuation process is fraught with danger if you don’t do it right. Where are we sitting in Australia with that? At the moment, I might get both of you to comment in in turn.

Sebastian Paphitis 28:32
I think what we see is a mixed approach, so different managers. I think in the last five years, it’s often been investor driven. So if you are, if your investors were demanding a little bit more rigour or independent external valuations, that was sort of driving an approach. Often the managers themselves will have an internal valuation approach, and that’ll be driven by what market they’re lending into. Because some of the markets, there is some example transactions, there’s some pricing, and some of them are a little bit more bespoke deals, yes, so you’re just looking at is the loan performing versus not performing. So they’re the kind of two areas. So then the managers themselves should have their own robust internal process. And then what we’ve seen is investors drive an external valuation process as more lenders come in to fund the credit funds themselves, we’ll see a little bit more demand for that external valuation. So I think it’s evolving, and was a mix of approaches we see.

Ryan Donnar 29:32
Our approach has always been to use third party valuers.

Tim Samway 29:36
Do you get asked in meetings. Do investors through mostly the wealth channel advisors, do they ask the question about, How do you do valuations? Who’s doing them for you? How independent they are?

Ryan Donnar 29:49
Increasingly, increasingly, that’s a focus.

Tim Samway 29:51
Well, that’s a sophistication point, isn’t it?

Ryan Donnar 29:56
Whilst private credits been around for some time, it’s new to a lot of investors. Yeah. Yeah, so we’ve all been doing for quite a while. It’s still, we’re opening up to a new audience, in effect. But yeah, no, people are focused around that. It’ll be interesting as how the industry evolves on that space. So our approach is, we’ve got, you know, a third party valuer, which we go through as a as our standard process, and then we use an external firm, if something is happening, for an event to come into a specific there’s actual costs the in actually doing those valuations. So to do a full blown one on a business that’s performing that will be quite a heavy cost to put on to investors effectively. So it’ll be that sort of will land in some sensible middle ground. I think they still haven’t really resolved it. Over in Europe, speaking to involved with Aima and the ACC, which you’re involved with Sebastian as well, we got the experts from Europe, and they’re still resolving there what to do. And in the States, so it’s interesting. I think in Australia, we’re actually probably ahead of the curve in terms of getting around this sort of space and having that discipline around valuations as an industry.

Tim Samway 31:05
And just just to be clear, we covered a bit of this earlier. I mean, you were talking about the demand for credit. Sebastian, from your view, borrowers are still keen to use private credit. There’s no question. I mean, I don’t want to leave anybody wondering, private credit has a real opportunity, because people see that as a valuable alternative to the banking system or to be used in corordination with the banking system.

Sebastian Paphitis 31:30
Oh, definitely, yeah. So, I mean, we’re working on, you know, number of deals at a time, and I’d say, you know, some of them will be in the bank market. Some of them were in private credit, yeah. And it’s just a function of the client needs at the time. So I think what it does give you though is the two. If you look at that chart we talked about earlier, we’ve got the bond market, we’ve got a bank market and a private credit market, the three work quite well together in offering a range of capital solutions to Australian businesses. And so that means having all three of them are complimentary rather than competitive, is the way we’d look at it.

Tim Samway 32:05
And when things go wrong, as they sometimes, sometimes do. Do you think private creditors are perhaps more I don’t want to say forgiving, because that’s not the word flexible is, is that a key to choosing to go with a private credit manager where you need that flexibility, because banks can’t be that flexible, can they? I mean, I’ve just watched this week, you know, like, we don’t want to just sit and comment on on what’s happening in the market today, but you can imagine how somebody high up in a bank would just say, let’s stop lending for a while. This is all a bit hard, whereas private credit managers don’t think like that. Is that right? I mean, am I being stretching it too far?

Ryan Donnar 32:45
I think that’s a it’s a good insight, and it’s, it’s correct. You know, there’s often people say, why would someone want to pay 10 or 11% for something that they could have got out of a bank for maybe three, 400 basis points lower in pricing, and some of that’s to do with the timeliness of getting the offer in place in the first place, enabling them to capitalise on the new opportunity. So, you know, if it means that they can fulfil a new contract, win the you know, the bank might say, go and win that, and then we’ll talk about financing and after but the opportunity has gone at that point in time, and for that, it enables a company’s enterprise value over a few years to go from 50 up to 150 mil. Then they don’t really have to worry too much about that additional interest cost. Yeah, that’s got them to that outcome.

Sebastian Paphitis 33:35
And we’re certainly look. I mean, I must admit, we’re seeing good and bad outcomes in both bank and private credit markets, you know, I remember the GFC, and there’s many corporates who kind of had a bad, you know, outcome with their bank, and said, I’m never going back to that bank again, you know. And so it’s, you do get a mix into a mixed approach from both both markets.

Tim Samway 33:57
So we’ve gone through every question that was given us prior to the presentation today, and now we’ve got some coming up on the screen from from people who are watching live question for Ryan, how do you balance the growth in your funds while staying in the zone which made you successful? We’ve seen many funds grow quickly and then essentially change their investment thesis to deploy more capital and then become more bank like. That’s a good question. That is a great question. I’m so keen to hear you answer this.

Ryan Donnar 34:29
It’s very relevant. We do get this from a lot of investors. It’s really avoiding style drift, if to support fast scale. And you know, we could have deployed a lot if we went into the CRE space. There’s a lot of opportunities there. There were, but it’s not where our expertise is. And if someone’s showing us that deal that’s been across eight other desks where it should be placed, not ourselves. So it’s important to stay to your knitting in what you do. And that’s just about a sensible. Growth and deployment to space in terms of ourselves, we knock back a lot of deals we’d like to do just because of the size of the portfolio. So it’s important to have that breadth of knowledge of deals that you can do and go into to support growth, so that you’re not rushing and doing something that isn’t where you know the experience of the manager lies.

Tim Samway 35:20
Another question, how can investors better understand what they’re investing in? Good question,

Sebastian Paphitis 35:29
I think there’s, there’s so much information available now. I think, I think there’s a wealth of resources people can look to. So there’s, certainly, you know, the, you know, there’s, there’s various industry bodies like, as we mentioned, Amer and the ACC publishing market introductory guides, so they kind of give a nice overview of the different elements the market. That’s why we’ve put out sort of regular thought pieces on what’s happening in the market. So reaching out and accessing some of that information, both here and offshore kind of can help, help give investors a little bit of background on, you know, what are the different aspects of the market, how’s it developed, and what are the key issues I should be thinking about.

Tim Samway 36:12
Well, that leads into this next question for you. Sebastian, what has been going wrong in commercial real estate related private lending? Because something is not right. If you’re reading about it in the paper every day, something’s not right. But how not right is it?

Sebastian Paphitis 36:26
I think you have some market driven events, sort of impacted series. So certainly there’s real estate lending has been a core component of lending in Australia for many years. And development construction’s a key driver of economic activity, and so private credits participated in that. And some developments don’t necessarily go to plan. Now, what we did have as well in the last few years was some challenges with the construction industry. We had rising interest rate environment. So there was a number of market events that have impacted that market in general, for both banks and private credit. So the lenders who’ve had some large exposures on large projects, you know, there has been some challenges that they’ve had to work through, but we have to remember too, that if there’s a headline around a problem with a particular loan, often the private credit lender can still recover the capital they’ve been they’ve Lent, because you’re still backed by assets. So it’s, it’s a little bit about understanding that it is a natural part of, you know, the construction and development that you have problems. But equally, then understanding or what are the implications of a problem with loan. Can it be recovered or not.

Tim Samway 37:39
Thinking back through the COVID period, prices, the cost went up so rapidly. It’s it’s a testament to the quality of our of our system out here that it all didn’t go pear shaped back then. I mean, clearly, the covenants were strong, the assets were strong, the lending was was reasonable, but every now and then something’s going to happen. Is that really what it is, is that, you know, sometimes developments just go wrong for a reason.

Sebastian Paphitis 38:08
I think, yeah, so certainly look, you know, during COVID related event you had during COVID through various government initiatives and also the lenders being very accommodative, I think we sort of rode through that period quite well, but once you have the level of cost escalations going through some of the construction activity, yeah, that just was, was a level that was difficult to manage, yeah, and it was just inevitable that that was going to result in problems for marginal projects. Some projects were still okay, but the more marginal ones were challenging.

Tim Samway 38:41
So we have another question. I’mgoing to direct the to direct this to you, Ryan, because you get to handle these all day every day, don’t you? We know this, not all day every day, hopefully just once a year. Yeah. What happened? What happens when a loan goes bad?

Ryan Donnar 38:54
Look, the only thing that’s inevitable when you lend money. And, you know, we get to work with great people like Sebastian, and there’s, you know, all models and so forth and different scenarios that you plan for. The only thing that’s inevitable is it won’t end up the same as what that financial model was when you start. Yeah, so everything’s done with the best of intentions when you’re looking at things, but there’s a living breathing companies and living breathing loans effectively. So things change with their businesses. So in terms of when a loan goes bad, it really is about that active management and engagement. So if you’re a direct lender, you can move quickly, and hopefully you can deal with that before it escalates, and you can look to recover so maintaining that equity value in that underlying business, understanding what that is and the levers that you’ve got to pull, you know, sometimes it gets to the approach, and hopefully not often, where you have to get down to more formal processes of administration and receivership. You know, we do have a good system here in Australia. It’s expensive, not as expensive as the states, but it’s expensive. So. Try to avoid getting to that position, but once you’re there, it’s a it’s a standard process. What you do need to do as a manager is have that experience in how to get the most efficient outcome at that point in time, and that’s even just managing the costs of the various providers in that space, because it can be expensive, so knowing which law firm to use, or what’s the appropriate level of people to get the most efficient and maximum outcome for investors.

Tim Samway 40:27
And you charge penalty interest, and that’s, that’s a good outcome for investors, if it all gets recovered, when it all gets recovered, and and you, you earn penalty interest on that.

Ryan Donnar 40:36
Yeah, correct. And our experience today has been, you know, full capital interest, and majority of the default interest has been recovered.

Tim Samway 40:44
What is, what is roughly default interest in this market, I think investors would be interested to hear what that was. It’s somewhere from?

Ryan Donnar 40:52
It’s anywhere from 2% to 5%. We have it there, because there’s a lot of time and resources goes into it, and our investors should get compensated for the risk that they are experienced through that period alone.

Tim Samway 41:07
We’ve got another question, and we are running out of time, so I’m going to go quickly now, with interest rates likely to fall in the in Australia in the next 12 months, what changes in yield should investors expect from private lenders? Yeah. Look again, good question. Assumption, of course, that interest rates will fall.

Ryan Donnar 41:27
In our across our portfolio, so we have that’s our focus is really on the sustainable cash flows to service the loan. So through the cycle, we look to de risk the book and keep that returns around that kind of low double digits, rather than going to chase 15% when asked by investors, why we do that? Because we want to get your capital back. Our books roughly 5050, fixed floating, and on the floating, we actually have a floor, so you know, and across our book, it’s somewhere between 10 and 15 basis points is where the floor sitting across all those lines except for one exposure. So yeah, our investors should expect to get the similar yields and returns that we’ve been we’ve been providing in recent years.

Sebastian Paphitis 42:14
Yeah, I think, I think that’s right. And look, there’s a little bit of competition in some segments, so you might see a little bit of tightening of yields, you know. So, you know, you obviously get the benefit of any reduced rate. But equally, in some segments you’re you’re finding where a transaction is widely syndicated, there’s sort of a fear of missing out, and the pricing comes in a little bit. But where you sort of got that more direct lending relationship, it’s a little bit more set by the deal itself.

Tim Samway 42:44
All right. Well, look as we draw up to 45 minutes, we promised everybody we wouldn’t go over 45 and we’re going to stay true to that today. So thank you, Sebastian, Thank you Ryan, for joining us here today. That was a very useful conversation. I hope you all enjoyed it and and please come back and look at it again. We’ll post it so that you can click and watch it again if you want you so desire. Thank you, and good afternoon.