Published 21 April 2025 on AFR | Original source: https://www.afr.com/markets/debt-markets/private-credit-needs-to-lift-its-game-to-be-taken-seriously-20250417-p5lskx
Private credit is not a passing trend. But if the industry doesn’t address lingering concerns, it risks being treated like one.
This month may go down in history as the moment global markets turned away from the United States.
According to Goldman Sachs, five-day realised equity volatility on the S&P 500 was the third highest since Black Monday in 1987, behind only COVID-19 and the default of Lehman Brothers in 2008.
Long-dated Treasuries traded in a 70 basis point range, again only trailing the pandemic and the global financial crisis.
If this marks a true turning point, then the role of bonds in a traditional 60/40 strategy must also be questioned, bringing renewed urgency to the debate around the role of private credit as a credible alternative to traditional approaches to portfolio construction.
Private credit has drawn significant attention in recent months, and not always for the right reasons, as the sector faces real scrutiny for the first time in its short history.
Several listed private credit vehicles are now trading at discounts to their net asset value, and the corporate watchdog has stepped up surveillance, raising concerns about opacity, valuations, liquidity mismatches, leverage and weak governance standards.
Yet demand remains strong. Moody’s expects global assets will reach $US3 trillion ($4.7 trillion) by 2028, with most investors planning to increase their allocation over the next 12 months.
It’s easy to see why. Private credit offers income levels comparable to equities, lower correlation to growth, and little to no correlation with bonds. For many investors, allocating to private credit has reduced reliance on both equities and bonds, offering insulation from shifts in the correlation dynamics that have dominated portfolio construction theory for decades.
But with rapid growth comes harder questions – and rightly so. Private credit is not a passing trend, but if the industry doesn’t address these concerns, it risks being treated like one.
If investors lose confidence in the asset class, outflows will exacerbate performance pressures.
In Australia, demand surged after the Australian Prudential Regulation Authority started to phase out Additional Tier 1 instruments as income-seeking investors turned to private credit for its steady yields, diversification, and low correlation to public markets.
The appeal is obvious, with current annualised yields of 8 per cent to 10 per cent versus 4 per cent to 5 per cent dividend income from equities. Importantly, the asset class is not systemically risky.
The Reserve Bank of Australia and the International Monetary Fund have both separately concluded that current financial stability risks stemming from the growth of private credit appear low. The IMF highlighted that “the use of leverage appears modest, as do liquidity and interconnectedness”.
This is not to dismiss those calling for caution. There have been significant flows into parts of the private credit market and where capital flows, risks increase and prospective returns generally decline. In Australia, growth in private commercial real estate (which is largely construction) lending has increased by 25 per cent per annum over the past four years – almost double the rate of growth in non-CRE private lending.
After two decades traversing both public and private credit markets, I’ve seen firsthand how investor outcomes depend as much on product design and governance as they do on asset selection.
Private credit can deliver consistent income and portfolio diversification – but it is far from a cash alternative, and it should never be presented as one. The moment it’s misrepresented as capital-stable or low-risk, trust begins to erode.
Private credit is a broad church, covering a range of risks and returns. At its core, however, it carries sub-investment-grade risk. So, performance should be measured against public high-yield markets – and by that benchmark private credit has performed well.
Since 2004, the Cliffwater Direct Lending Index – a US private credit gauge – has returned 9.6 per cent per annum, outperforming the S&P UBS Leveraged Loan Index by over 4 per cent per annum.
It is not a zero-risk strategy, averaging annual losses of over 1 per cent and having experienced drawdowns of 5 per cent and 8 per cent during COVID-19 and the GFC, respectively. But drawdowns on the S&P 500 were 34 per cent and 57 per cent over the same periods.
Disclosure and standardisation are needed in both public and private credit. It would be naive to suggest that the lack of transparency in private markets does not exacerbate the risks. Existing disclosure rules, which govern how products are targeted and how fees are reported, weren’t built with private credit in mind. That’s left too much room for subjectivity in what’s disclosed.
The Australian Securities and Investments Commission is right to focus on the issues. All require stronger governance, improved transparency and clearer standards to better assess where private credit fits within a broader portfolio strategy.
But if investors lose confidence in the asset class, outflows will exacerbate performance pressures. Stale valuations and fears of excessive leverage will encourage a prisoner’s dilemma where investors rush to redeem from funds worried that other investors will redeem first and leaving them exposed to mispriced assets.
Today, more than ever, private credit has a role to play in providing a diversifying alternative to a traditional 60/40 portfolio. It is not a dirty word, but unless the industry raises the bar, it risks being dismissed as exactly that.