ASIC’s warning of questionable practices in the private credit sector applies not just to retail products, but investors of all ilk need to ensure they have proper expertise and due diligence processes in place to assess these investments, Frontier Advisors says.
Questionable practices in the private credit sector, as identified by ASIC last week, are not limited to retail products and institutional investors need to ensure they have strong due diligence processes in place and access to relevant expertise to assess these investment vehicles.
Last week, the corporate regulator released an independent report on the $200 billion private credit market in Australia and identified several issues, including opaque fee structures, related-party transactions and liquidity structures, that needed to be addressed.
As a result, the regulator will issue guidance principles in November and also flagged new industry standards and surveillance of the sector in the future.
Asked if the problems discussed in the report were limited to the retail market, Paul Newfield, Director of Research and Specialist Services at Frontier Advisors, said the popularity of private credit had made this a broader issue.
“I would say they’re probably more prevalent in the retail market than in the wholesale market, but they’re not uniquely targeted to retail investors. The explosion of private credit has been far and wide and deep, and covering all areas of investment,” Newfield says in an interview with [i3] Insights.
But where retail investors are relative newcomers to the sector, institutional investors have a much longer history of performing due diligence on private credit strategies and know what to look out for.
[The issues are] probably more prevalent in the retail market than in the wholesale market, but they're not uniquely targeted to retail investors. The explosion of private credit has been far and wide and deep, and covering all areas of investment
“They’ve always been mindful of related-party transactions, of the totality of fees, even well before things like RG 97 existed,” he says.
Regulatory Guide 97 provides guidance to trustees on how fees and costs should be disclosed in Product Disclosure Statements. But not all fee structures are addressed by these guidelines.
“What are the frictional costs that create imposts on the total net return that you ultimately receive? What gives rise to those frictional costs? Who bears the frictional costs? These are the sort of principles that have always been well embedded in institutional thinking,” Newfield says.
“But there are people who are coming into private markets for the first time, or early in their journey, or who think that you can do due diligence without spending a reasonable amount of time to unpick what it is you’re buying. I think sometimes you might get surprised when you actually uncover what’s underneath.”
Related-Party Transactions and Equity Holdings
A key area ASIC addresses in the publication of the report is the issue of related-party transactions.
Not only have there been instances where loans have been transferred between different funds, but there is also a danger of managers trying to cross-subsidise between different vehicles, which can lead to questionable fee structures and changes in investor rights and entitlements.
Investors of any ilk should ensure they understand exactly where they sit in the capital structure, while managers need to use clear language about investor rights and entitlements in their communications, Newfield says.
“Are there different cohorts of unitholders that have different rights, some of whom could get traded off against the other cohort of unit holders? Which group do you want to be in? As long as those things are defined and known and can be tested, that’s very important,” he says.
“[It is] important that people don’t come in over and above you who diminish your rights.”
The report questions the practice of entities holding both equity and debt in a company, even if these assets are held in different investment vehicles, and describes the situation as “concerning practices” that would require “regulatory focus”.
A recent example of this is Metric Capital Partners’ decision to take an equity stake in Pacific Hunter last year. This contributed to the decision by rating house Lonsec to downgrade several Metric funds, citing governance concerns.
Yet, it is not unprecedented for managers to take equity in a company as a measure of last resort, and it is sometimes explicitly written into a contract. Newfield says this is especially the case with distressed debt managers.
“If you’re dealing in the very lower end of credit, and you’re dealing with distressed debt markets, particularly overseas, and you go back to the GFC (Global Financial Crisis) or early days of COVID, there would have been some credit managers who would have bought distressed credit [during this time]. They probably did have various options to take equity if stress conditions arise,” he says.
Upcoming ASIC Guidelines
ASIC has announced it will release the findings from its private credit surveillance across retail and wholesale funds in November. This release will include two additional expert reports, along with the regulator’s response to the surveillance findings, expert insights and stakeholder feedback.
“We will outline guidance principles for compliant private credit and provide a forward-looking roadmap that includes industry standards and future surveillance activity,” ASIC said last week.
Are different cohorts of members being treated equitably, so that you don't have some people getting paid out 100 cents in the dollar, only for other people to find out that they have to bear their own losses, as well as those of people who get paid out 100 cents in the dollar
Newfield expects the regulator to require further disclosure of potential conflicts of interest, fee structures and investor treatment.
“Are different cohorts of members being treated equitably, so that you don’t have some people getting paid out 100 cents in the dollar, only for other people to find out that they have to bear their own losses, as well as those of people who get paid out 100 cents in the dollar,” he says.
“I think you’re going to get an uplift in recommended practice.”
Liquidity is likely to be another area where the regulator will place more scrutiny. Some retail products sit on adviser platforms that offer daily liquidity, while the underlying assets are largely illiquid. How managers solve this liquidity mismatch needs to be clearly explained to investors.
“They might need more disclosure as to how much genuine liquidity there is. I think people think you can add this private market in a retail construct and enjoy the same liquidity as you could in public markets and in many cases that is not congruent,” Newfield 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.