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Australia’s credit market continues to experience increased interest and thus demand for assets, pushing listed credit asset yields lower, which has flowed through to private or unlisted markets. As a specialist in asset backed securities or lending to lenders,  we see increased competition both from other fund managers and domestic or international banks who are actively seeking to grow their portfolio of credit assets. While domestic banks are governed by APRA primarily under APS120, limiting their risk profile/appetite, some international banks have less restrictive policies/regulations or may even have access to alternate sources of capital (I.e. in house or related party investment funds) enabling a higher risk profile/appetite. It is, therefore, of the utmost importance that credit standards and access to transactions remain at the forefront of our approach.

The above dynamic is a natural progression of the Australian credit market moving towards a more mainstream asset class rather than a less prevalent ‘alternative’ in investor portfolios. This evolution dynamic shall drive more significant investment and sophistication by the Fund manager that operates within it, while also seeing investment models with high manager fees and yields lose relevance. Overall, we welcome this evolution as we are constantly reassessing to ensure our investment model is a beneficiary of such industry changes and thus, an attractive destination for transactions.

As our minds turn towards the festive season and end of the calendar year, we would like to thank all our investors and advisers for their increasing support and engagement. Our continued investment in our team and investment process is only possible with your support.

Manning Asset Management’s Josh Manning joins Livewire for a very different interview on the burgeoning private credit space.

Note: This interview was recorded on Thursday 10 October 2024.

Australians would have heard plenty of reasons over the last few months for investing in private credit right now.

Asset managers and financial advisers have repeatedly told us that they are allocating more and more to the asset class. The high-net-worth world is reportedly also positioning more of its portfolios towards private credit. And private credit managers – across the asset class spectrum – are quick to spout its benefits.

But what about the reasons why you shouldn’t invest in the asset class – particularly as new managers and lenders come to the fore?

In this interview, Livewire sat down with Manning Asset Management’s Josh Manning for his insights into the red flags he is seeing in the market right now, the biggest lies he’s been told (and repeatedly so) by lenders, and why the idea that there’s no cycle in private credit is a bit of a furphy.

Why you should be careful when investing in private credit

When Manning Asset Management was established back in 2015, private credit was a relatively unknown asset class and was not prevalent in many portfolios.

“You then went through a stage where people thought all private credit was interchangeable; construction finance was the same as asset-backed securities, or lending to lenders was the same as non-investment-grade corporate lending,” Manning said.

“Fast-forward to today, everyone’s talking about it, and there are lots of glossy brochures around the benefits of investing in it.”

In recent years in particular, we’ve seen an explosion in construction financing, at the same time as the Australian property market has continued on its path higher.

“What that means is if you purchase a property and then you hold it for 12 months, typically, you’re selling it for more than what you bought it for, and that covers up a lot of challenges in the fundamentals of that loan,” Manning said.

Going forward, Manning believes we are unlikely to see the same level of price appreciation – meaning the fundamentals are far more important.

“At the same time, we’re seeing this huge influx of capital and competition into that asset class. If there’s one takeaway, I think investors really need to think about that – how strong these actual loan opportunities are and how clear is that exit,” he said.

Does private credit have a cycle?

While we are taught that all asset classes have cycles – equities go through booms and busts, commodities ride the rollercoaster, and bonds, linked to interest rate expectations, also can swing wildly – whether or not private credit has a cycle remains up for debate.

“The idea that private credit doesn’t have a cycle is quite novel. I don’t necessarily agree with that,” Manning said.

“So, typical asset classes ride an economic cycle, boom to bust, it’ll oscillate in a range with returns there. Credit, I think, is a bit different.”

Manning argues that credit has had its own cycle as an asset class – from its very early stages to the growth curve that it is experiencing today. Shifting credit spreads, he argues, demonstrates that there is a cycle in private credit. Credit conditions, such as the terms of loan arrears, also appear to shift and shape, and thus have a cycle.

“At some stage, [we will see] a maturing of that cycle, and the characteristics of that maturing will be more institutionalisation of that asset class. This is not dissimilar to what we’ve seen in US and European markets,” he added.

“At that stage, there will be more divergence in those that prevail and those that don’t succeed in that environment.”

That said, he doesn’t believe the maturing or institutionalisation of the asset class will result in losses for investors.

“I don’t see there being this cataclysmic cliff that we’re going to drive off and huge losses,” he said.

“I think we’re seeing a huge increase in competition in the asset class – a lot of new managers, a lot of new players bidding for transactions. That will bid down credit spreads, that will bid down expected returns, and not everyone will be able to endure.”

For instance, those that relied on wide spreads to survive, with big upfront fees to propel their businesses, will likely face challenges going forward as spreads tighten.

And while more managers are likely to enter the space as investor interest skyrockets, fewer managers are likely to prevail. Although those that do will likely become more sophisticated in the face of tougher regulation, Manning said.

Red flags to spot the fakers from the true private credit winners

1. Documentation risk

As Manning explained, this is lending where the fundamentals of the documentation vary considerably in terms of quality. Lower quality or inadequate documentation may have worked in a buoyant market when the borrower can easily make repayments, and the investors are getting a good rate of return – but when there are headwinds, and the borrower is unable to make their loan payments, they may want to challenge those documents, and that is a risk.

2. Fraud

Whether we like it or not, there’s fraud in every asset class, Manning said, so investors need to think about this when assessing lenders and managers that they want to invest in.

3. Highly leveraged exposures

Highly subordinated or very leveraged exposures are another area that investors should be aware of. There’s a lot more risk, Manning said, and you may not be getting as rewarded for taking on this risk as you used to.

4. Arrogance

If investors get a “whiff of arrogance” from managers they are dealing with, that’s an important telltale warning sign and red flag, Manning said. The big banks, who are fantastic underwriters, are very careful and realise they can get bitten if they make the wrong decision. Private credit managers are also not immune to mistakes.

The big lies lenders are telling managers

As a specialist in asset-backed lending, Manning Asset Management looks at all the lenders across the Australian market and assesses whether or not they should be providing wholesale funding to them.

“We speak to probably 15 or 20 lenders a month. And there’s a mix of people that give us the bare bones, “This is what’s happening. These are the things in our book.” And there are others that put a marketing spin over it,” Manning said.

1. “We don’t have any problems in our book”

While this would be ideal, it’s probably a furphy, Manning said – noting that even if lenders make the best possible underwriting decision, facts can change and the borrower may not be able to make their repayments.

“That’s no fault of the lender. That’s a reality, and you need to just work with those borrowers and find a way to get your capital back,” he said.

If a lender is saying they “don’t have any problems” it either means they haven’t been lending for long enough, they’re not thinking about the risks, or they’re not being completely transparent.

2. “We’ve never had a loss”

Holding up the concept of zero losses as a holy grail is also fraught with risk, Manning said, as losses from lending and credit have been “very lumpy” throughout history.

“There’ll be periods where there are heightened losses. It’s not this beautiful smooth line through time that oscillates marginally,” he said.

Just because a lender hasn’t faced a loss so far, doesn’t mean they are immune from losses in the future – and the arrogance that they won’t is a red flag, Manning added.

Why investors should consider the asset class

Lending has been a very prevalent and sophisticated asset class in Australia over the last 40 years, Manning said, with well-understood risk management approaches, mechanisms and philosophies around transaction and lending management.

“I think, if you can really pull the complete understanding around that sophistication in the asset class and embed that in your business and how you run money, you can mitigate a lot of the risk,” he said.

Glossy marketing brochures, for all their issues, aren’t completely wrong – the asset class provides investors with consistent inflation-adjusted returns and income.

It doesn’t mean the asset class is immune from risks, and investors need to be careful about which managers they align themselves with as competition increases, but there’s still plenty of opportunity on offer – you just need to know where to look.

And remember, if it sounds too good to be true, it probably is.

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With Australian credit the in-vogue topic, there is no shortage of compelling pitches for why to invest. Lending against residential property or to high-quality businesses, what could go wrong? Thankfully for many, very little of late. Although that partly is due to the favourable market conditions, including rising property prices, which have seen unimproved properties typically sell for more than they were purchased for with business conditions remaining strong. We are not anticipating a sharp turnaround in the asset classes’ fortunes, although there are some areas where risk is pooling that investors should watch out for.

Before wading in, it’s important to remember that these risks can be problematic in isolation or in combination. We view many current market participants overlooking these aspects, as frankly, they haven’t been bitten by them in the last 30+ years (since the early 90’s recession). This is why we have prioritised industry tenor in managing these assets, leveraging the extensive track records of our Investment Committee with members that predate this buoyant era.

Areas where risk is pooling

1. Loans where the exit is unclear: when making any credit investment, the exit must be clearly understood. Ideally, this involves some verifiable avenue rather than a ‘refinance’, which, by nature, is difficult to forecast as lending conditions or the fundamentals on which the lending decisions are made can change. For example, if the business is no longer profitable, a refinance of a business loan becomes challenging. That risk grows based on the tenor of a loan, given it is more difficult to forecast further into the future. I.e. a 1 year loan is far less risky than a 5 year equivalent. Other elements include security for the loan, with liquid hard assets like property, wheeled assets (cars, utes etc) providing a far more robust primary or secondary exit. Crucially here, there needs to be confidence around the future value of the asset. More recently developed technology assets like electric trucks or new solar panels present significant downside risks if the technology fails, as it can, and the security is worthless. The same can apply to construction finance, where the future value, either as a performing project that was completed on time and on budget or a problematic project that wasn’t, is unknown. Large loans or loans in areas where few lenders participate reduces the ability of a refinance and, therefore, on a like-for-like basis, are riskier. This risk can compound when loans do not need to be paid down over the term of the loan and only require interest payments (not amortising loans).

2. Documentation risk: when credit markets are propelled by strong economic fundamentals and shrinking credit spreads that push the face value of credit assets higher, it’s rare to hear of skirmishes between lenders and borrowers. Afterall, everyone is happy, with lenders and investors receiving strong returns and borrowers benefiting from cheaper financing. At some stage, that harmony will no longer prevail due to a borrower or lender issue at which time, parties will need to revisit the legally documented agreements to assess their rights. In some cases, this can expose previously overlooked elements which either party could potentially exploit, typically the borrower. Recent examples include the borrower attempting to change/reduce the security pool that supports the loan and allowing further debt to be taken on (for example as reported, Pluralsight in the United States and GenesisCare locally), which can include new parties who may not have much alignment of interests with current debt holders. For example, those new lenders may trigger a default to open up all possible avenues to get their hands on any assets available, with a recent unconfirmed example playing out in Australia.

3. Highly subordinated assets: it should come as little surprise that subordinated assets primarily in the form of subordinated notes in securitisation transactions, subordinated corporate debt or second mortgages against property assets shall be a natural collection point for risk. Very simply, when investing, you need to ensure the party negotiating or making the investment decisions has significant, relevant longitudinal experience and truly understands the investment and how it will perform today and in a less kind environment.

4. Fraud: while fraud is extremely uncommon, it is part of every financial market including even the most highly regulated markets. In our experience, Australian credit markets are well developed, with significant industry experience learnt from isolated examples, which has developed specific controls and monitoring practices which should not be discounted. Irrespective of where you invest, a keen eye for telltales and domain knowledge around current industry best practice controls remains paramount.

Seek out deep understanding and experience

The purpose of these points is not to suggest that credit does not have merit—quite the contrary. Rather, it is to underscore the importance of skilled, highly experienced teams in navigating these risks effectively to extract the full value from the asset class. Too many see credit investing as a simple investment endeavour, but it requires a deep understanding and experience to manage the potential challenges. It is also one where high historical returns may be manager skill or simply, excessive risk taking. We believe if you are a specialist with deep domain expertise and have been around long enough to understand risk, these compelling pitches can translate into attractive returns over time.

Manning invests in a range of asset-backed portfolios which we quantitatively and qualitatively assess to determine their resilience and overall credit quality.

Central to the Fund’s strategy is rigorous transaction analysis and robust structural protection mechanisms across all assets. Each investment is evaluated with stress testing and credit protections embedded in the transaction documentation, ensuring comprehensive risk management safeguards our investments.

As part of our analysis, the following are some of the factors considered:

• Borrower Default Rates and Asset Value: Increases in borrower default rate assumptions and a reduction in asset / collateral value that reflect prolonged recessionary conditions and rating agency criteria. Further haircuts will be assumed on assets that are likely to experience more volatile valuations during periods of stress. Likewise, individual borrower and loan characteristics will be considered in the determination of stressed default rates.
• Asset Yield: A reduction in asset yield caused by market fluctuations and rising arrears, and investors demanding increased margins resulting from a trigger event or deteriorating economic conditions.
• Delays in Liquidation: We assume significant delays in liquidating assets that are securing underlying loans. We incorporate the accrued interest on defaulted loans during this liquidation period in our analysis.

The Manning Team models varying degrees of economic stress to estimate expected losses and determine required structural protections, such as the arrears tolerance on underlying loans and subordination prerequisites. Unlike direct lender funds (funds where the manager is also the lender/originator of the loans), where investor capital losses typically occur immediately if a borrower defaults and the asset value falls below the loan amount, our structures offer additional protection. In an asset-backed structure, investor capital is at risk only when the first loss or subordinated capital is eroded. We have implemented structural protections that trigger amortisation before losses or arrears reach a level that threatens investor capital. These protections prioritise investor interests and mitigate downside risks.

These are a sample of the measures we implement to protect investor capital and have been instrumental in maintaining our 8+ year track record of achieving the Fund’s RBA cash rate 5% net of fees objective through the economic cycle.

Examining the Australian economy, the case for the RBA cash rate falling in the near term remains overstated. In early 2024, we outlined two-way risk for the RBA cash rate (a chance it may rise or fall), with the likelihood of an increase fading although not dismissed. For credit investors, it remains essential to exercise caution in sectors most affected by the higher RBA cash rate and cost of living pressures. Most notably, consumer loans, which the Fund has not held for over 12 months, and construction finance/property development which the Fund is completely precluded from investing in due to the cyclical and high-risk nature of these investments. Furthermore, the case for active management, as demonstrated by the fund’s track record and varying sector exposures through time emphasises the importance of shifting away from certain market areas towards those that generally present lower risk, thereby achieving better risk-adjusted returns.

In the prior month, we assessed 14 opportunities for inclusion within the portfolio with strong market activity. These opportunities include transactions where our higher yielding fund can provide further credit support to the Manning Monthly Income Fund, lowering the investment’s risk profile.

During the month, we changed our External Valuation agent from Eticore to Nuwaru, who acts as our tax advisor and shall be complemented by an additional specialist provider in the coming weeks.

The Fund continues to grow its client base of high net worth and smaller institutional clients, resulting in further investment portfolio diversification.

As we take a broader look at Australia’s current economic position, we recognise some typical signs of a contractionary phase, such as a softening labour market, higher interest rates, and changing business conditions and sentiment. Historically, Australia’s economic contractions from peak to trough have averaged three quarters, followed by an expansion phase lasting around 15 quarters on a GDP per capita basis (Melbourne Institute Phases of the Australian Business Cycle, January 2024). With the last peak in December 2020, we are now considering when we might reach the trough and see more accommodative policies, including a lower RBA cash rate to support employment and business conditions.

The labour market will be a key indicator in this process. A tight labour market has been a significant factor in driving services inflation, which affects various sectors like healthcare, education, and hospitality, as well as consumer spending. As this dynamic shifts and households face fewer employment opportunities or lower incomes due to rising underemployment and unemployment, we expect inflationary pressures to ease, setting the stage for potential monetary policy easing and a lower RBA cash rate.

Government spending and fiscal policy will also play a crucial role in shaping employment conditions. While incremental spending may delay monetary policy easing, it’s important to balance economic perspectives with societal needs. Currently, we view fiscal policy as accommodative, which may postpone an RBA cash rate decrease.

We have observed many companies implementing cost-cutting measures and redundancies, with recruitment agencies reporting a weaker appetite for new hires. Among the circa 36,000 loans we monitor monthly, arrears rates are slightly increasing but remain within acceptable limits for all positions in the Fund. These observations, though anecdotal, align with our view and are likely to be reflected in widely discussed market data in the coming months.

We believe the conditions for RBA rate cuts are gradually forming. As noted earlier, it will take time for the data to confirm this and for the RBA to gain confidence in adopting a more accommodative policy in the medium term.

From the Fund’s perspective, this outlook calls for heightened sensitivity to areas most affected by weakening GDP, employment conditions, and contractionary policies. Our cautious approach, maintained over the past 18 months as we exited consumer loans in the portfolio, ensures the Fund’s resilience in navigating economic challenges. The Manning Monthly Income Fund has an unwavering commitment to offering investors a truly ‘through the cycle’ investment proposition, focusing on capital preservation and delivering a strong, consistent monthly income stream.