Taking a sectoral or regional approach to private credit can cause investors to overlook attractive transactions in unloved areas of the market, IFM Investors says
Private credit has seen a stellar rise in popularity in recent years. It started to gain traction after the Global Financial Crisis (GFC), when regulators clamped down on risky lending practices by prop desks in banks, thereby allowing third parties to fill the lending void.
This popularity has accelerated in recent years as interest rates were raised in an effort to combat inflation after the COVID 19 pandemic, enabling debt investments to produce attractive returns for institutional investors.
According to data from Preqin, global total assets in private credit have nearly doubled between 2020 and 2023 to US$1.6 trillion, and Preqin expects the asset class to increase in size to US$2.3 trillion by 2027.
But not all private credit is equal and identifying the risks in these investments requires more than a cursory glance at the asset’s attributes.
At IFM, they prefer to think about attractive credit opportunities in terms of the quality of the borrowers, rather than merely analysing the sector, geography or even which part of the capital stack a certain credit instrument sits in.
“Key to our philosophy is to think about good borrowers and bad borrowers, and not over-emphasise sector and industry views,” Hiran Wanigasekera, Executive Director and Co-Head of Australian Diversified Credit, Debt Investments at IFM Investors, says in an interview with [i3] Insights.
“Our experience is that what historically may have been an unloved sector, industry or something that isn’t necessarily flavour of the month may actually be a really good borrower with much tighter terms than you can get in a very loved sector or industry that’s in high demand,” he says.
Key to our philosophy is to think about good borrowers and bad borrowers, and not over-emphasise sector and industry views – Hiran Wanigasekera
And IFM has a long history of transactions to look back on. The firm started investing in credit some 25 years ago in an effort to give its industry super fund owners access to this asset class. It has since expanded its activities in markets across the globe and this year alone, the asset manager secured 110 credit investments, worth around $3 billion across its Diversified Credit strategy.
So what constitutes a good borrower? Of course, they need to have the ability to repay the debt in full, but it isn’t always about the numbers alone. Often, the experience and quality of the management is paramount to the risk profile of the investment, Lillian Nunez, who is also Executive Director and Co-Head of Australian Diversified Credit, Debt Investments at IFM Investors, says in this interview.
“A mistake that lenders typically make is that they only look at the capital stack, and they look at the priority ranking and think they’re in a strong position,” she says.
“They get comfortable with that, and they don’t necessarily look at the behavioural risks, potential behavioural risks, or look at the fact that management didn’t perform as well through previous cycles or may be inexperienced.
“It’s really important to look at how management has behaved, how the business has performed, how the product has performed through challenging cycles. Some of the failures that have happened with assets are where investors haven’t looked at whether the borrower can handle those situations,” she says.
The recent COVID-19 pandemic provides a good example, Nunez says. Suddenly, many companies were faced with the loss of business and even important clients. How management handle these headwinds is an important indicator of how resilient a business is and says much of the risk associated with lending to it.
“We just went through the pandemic and [we looked at] how certain businesses handled the sudden loss of customers and contracts. How did they manage and take corrective action to preserve the capital liquidity and shift gears? How did they manage their way through stress?” Nunez says.
“It’s not just their governance policy – we do look at governance all the time, especially when we’re doing due diligence – but it’s about their ability to pivot to offset weaker economic conditions” she says.
Nunez also takes a close look at how businesses incentivise their employees and plan the next level of growth. Do they take a sustainable approach to growing their activities over the long term, or do they take excessive risk in achieving their ambitions?
“There needs to be the right balance between growth and margins,” she says. “What we don’t like is cowboy behaviour. We don’t look for uncontrolled pursuit of growth which could result in failures or negligence of existing activities.
“We prefer to make sure that their business plan is well-considered, and the assumptions are stable,” she says.
This doesn’t mean that IFM expects companies never to face difficult situations, but it is about how these businesses deal with adverse situations and, equally important, how they communicate these problems to their lenders.
“Borrowers sometimes do go through cycles and we’re there with them, alongside them,” Nunez says. “We prefer a borrower that is comfortable with telling us when there is a problem arising. We don’t wish to be just notified only when a covenant has failed. Keeps us informed. I think that’s very important in a relationship for us.”
Finding the Right Mix
Once good borrowers have been identified, the attention then shifts to portfolio construction. Because sometimes a good borrower is not the right fit for the existing portfolio.
“How we actually construct portfolios is to be as diverse as possible, so we seek to actually have as many exposures as possible. But then we think about how correlated they are within our portfolio mix?” Wanigasekera says.
“We want to have as many good borrowers as possible, and then reduce the potential correlation risk within the portfolio. Don’t get over-concentrated in certain sectors or industries that then maybe leave you open to a lot of tail risk situations,” he says.
There needs to be the right balance between growth and margins,” she says. “What we don't like is cowboy behaviour. We don't look for uncontrolled pursuit of growth which could result in failures or negligence of existing activities – Lillian Nunez
Although IFM takes a relatively strict bottom-up approach to credit investing, Wanigasekera says they do tend to avoid some sectors.
“We don’t really like cyclical corporate companies very much,” he says. “We try to avoid them as much as possible, particularly if it involves cyclical corporates with a lot of consumer exposure.
“What we’ve found is that historically consumers are actually very resilient. In Australia, over multiple decades, they’ve been shown to be extremely resilient. But that resilience in the consumer doesn’t always translate very well into discretionary spending and cyclical corporates.
“You experience a lot more volatility in these cyclical corporates, even though the underlying exposure is actually quite stable and has shown to be resilient,” he says.
The Role of Banks
In the United States and Europe, banks have largely stepped away from private credit markets after the GFC and now focus more on providing advisory services, and act as arrangers and distributors to corporates seeking to borrow.
But in Australia, the banking sector is still a large part of the credit market. Asked if that will change and Nunez says she believes it will. Nunez sees this as being part of a natural transition, where Australia will gradually align its practices with other countries around the world.
“We do expect that that will occur. And [banks] will allow that room for institutional capital to step in to take those relationships. They will still play a part with regards to perhaps more revolving facilities or more transaction-based services,” she says.
Wanigasekera agrees and points out that it might take longer in Australia than overseas, because the country has not gone through all the steps of disintermediation that the US and European markets have gone through.
For example, Australia never really developed a high yield market, he says.
“I think people forget sometimes about how this theme of disintermediation has actually played out overseas. If we’re talking about it in the context of the US market, for example, disintermediation started in the late 70s and the early 80s,” he says.
“And the first way disintermediation happened in those markets was actually through the high yield bond market. The birth of the high yield bond market with all the private equity buyouts happened back then [in the 1970s], but also the birth of the securitisation market was an early phase of disintermediation.
“Disintermediation via private credit is actually something that’s been happening more recently and has been accelerating in the last 15 years. Australia is on the same path. We’re just a number of decades behind,” he says.
He also points out that certain parts of the private credit market in Australia have developed faster than other parts of the market, which reflects the composition of the domestic economy.
“Real estate credit and real estate funding is one that has become significantly more disintermediated than other segments of the market,” he says. “We actually have a deep private credit source for real estate, particularly real estate development financing across the board. And that’s actually been happening at a much faster pace in that space than compared to others,” he says.
“So we’re definitely on the same path, it just takes time for this to happen,” Wanigasekera says.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.