Myth busting private credit

Let me introduce our first speaker of the day, Roger Montgomery.

He's the founder and chairman at Montgomery and Brett Craig, director of Aurora Credit Holdings.

Roger established Montgomery Investment Management in 2010 and cemented his status as an expert in the industry.

Brett Craig, previously worked at Macquarie, is a trailblazer in Australian private credit.

They will unravel the mysteries surrounding private credit, debunk myths, and reveal untapped potential.

Welcome, Roger and Brett.

Thanks so much, Angelina.

Great to be with everyone today.

At Montgomery Investment Management, we provide exclusive access to a range of funds, domestic equities, domestic long-short funds, as well as global large-cap and small-cap equity funds, and private credit, which is what Brett has joined me today to talk to you about.

Now, 10 or 15 years ago, if you had asked me to lend money to a small or medium-sized corporate in Australia, I would have said, you've got rocks in your head.

And the reason I would have said that is simply because the only corporates that I would have the access to lend to would be those that the big banks had rejected.

But since the GFC and the Hain Royal Commission

What's happened is regulation around the capital that banks required to lend to these types of businesses has changed, making lending to these businesses more complex, more capital and labour intensive as well.

And the result has been that the banks have pulled back from that lending, creating a massive gap, a $200 billion gap between the funds that small and medium sized corporates in Australia would like to borrow for growth

and the funds that are available to them from the big banks.

Enter non-bank lending institutions, who with the benefit of technology are able to approve loans to qualified borrowers in a very short space of time, making them the preferred option in many cases to borrow money for these small and medium sized corporates.

The result of the change has meant that you as an investor can now lend money to these businesses

and generate the kinds of returns that were previously the domain and the preserve of those big banks who are no longer active or less active in this particular space.

As you can see from this chart, the returns since the inception of the AURA High Yield SME Fund have been attractive for two reasons.

Number one, with distributions or income reinvested, the returns have been higher than the ASX200

accumulation index.

So it's interesting that this private credit fund since its inception has generated better returns, in this case 9.62% per annum, which are better than the stock market over the same period of time.

But perhaps the more compelling reason to consider private credit is that in the past this fund has not only achieved a better return than the stock market, but it's done it with no volatility.

and that compares to rather high volatility for the ASX 200 Accumulation Index.

So for people who want regular income and for people for whom their investments, they don't want them to be volatile, these types of investments may have some appeal.

Now I'm joined today by Brett Craig, who you introduced earlier, and together we're going to answer some of the fundamental questions about investing in private credit

And I'm going to ask Brett to disabuse some of the myths surrounding private credit as an asset class.

So Brett, a lot of people would rationally conclude that given these attractive returns, there must be high risk.

But you've mitigated some of those risks and there's, I understand, three layers of security for investors to consider.

That's correct.

And look, no investment comes with no risk.

You know, what our job is as the investment manager on this fund is to minimise the risk where we can.

So we do that by layering protection.

Now, the first piece is ensuring you've got a quality borrower or obligor at the front end of a transaction.

So we're looking at a business that has strong cash flows, a strong balance sheet that essentially needs money to grow and increase their profits.

We do not do any distressed lending as an example.

So I mean, we are seeing a number of funds that do that.

That is something we do not do.

So the first layer for us is quality.

One measure of quality can be the actual risk score.

There's a bureau called Equifax who looks at rating SMEs in the Australian market.

And if you're looking at Equifax scores north of 600, you'll see that probability is a default around 1.2%.

And this is over a significant data set.

So if you're going for those higher scores, you've got a reduced probability of default.

Now, default does not mean you have a loss necessarily.

There's a second piece that you can obviously go in and that's going into the borrower's security that they provide as backup for the loan.

So that's the collateral layer.

So if a borrower defaulted,

and they've provided collateral, you then collect the collateral if they don't end up paying.

That's correct.

And recover the loan that way.

The collateral's collected, sold, and those funds are used to repay the loan.

So what we're doing as an assessment, so the lenders that we're funding are looking at the underlying borrowers, looking at the quality of those borrowers, looking at their balance sheets, looking at their previous track record, and then they're looking at what collateral can be pledged to back that loan.

And what types of collateral are available?

We have multiple types.

And if you look at what the banks have traditionally done, it's against residential properties of the owners of that business.

Now we do do some of that lending, but we also take securities such as invoices.

So receivables, ledgers, we lend against livestock equipment.

There's guarantees, you know, director's guarantees and general security agreements.

So a general security agreement is a fixed and floating charge over the business's asset and the director's guarantees of personal

guarantee provided by those directors.

OK, so that's two layers.

And then there's the third layer as well.

The third one.

And this is a bit of a differentiating point for our fund.

We are providing capital for lenders who are specialists in their respective market.

We're providing that capital in.

Now, the lenders that we're providing the capital to will put in an equity layer that sits below us.

So they're putting up some of their money into the loan book.

How does that protect investors?

So that is what's known as the first loss piece.

So if there are defaults in the pool and if the collateral does not back the value of those loans, then you're looking to tap into the lender's equity or their net interest margin as a layer of protection.

So they will cover

they will lose some of their income.

And then if the losses are greater, some of their capital before there are any losses experienced by investors in the fund.

That's correct.

That's correct.

And I think that's a very important point of differentiation in what we do versus direct lending.

Understand.

So Brett, another concern investors may or may not have, if they don't know this space or haven't heard about this space before, they won't know the difference between your fund and other funds.

Talk a little bit about liquidity.

How is your fund different to other funds and how easy is it for investors to get their money out if they decide to?

If you look at the private credit space, there's two common structures.

One will be funding or capital is provided by the investors for a specific purpose and those funds will be locked for a duration whilst that purpose is met.

That's a lockup.

That's a lockup and you'll have a defined period whereby you cannot get your capital out.

So how do investors find out whether the fund they're considering has a lockup or not?

That should be in all the author documents.

Okay great.

So what we do, we have monthly liquidity windows across all of our private credit funds that our team are managing.

So that gives the investor an opportunity to request capital back on at least that monthly basis

And look, if there was a run on the fund as an exam, so if every investor wanted to get out their money all at the same time, then you move into a gating procedure.

So that would be sort of an orderly unwind of the fund and people get let out on a pari-pursuit basis.

And that makes sense because you've lent that money out and so you're waiting for the borrowers to pay that money back before paying the investors.

But presumably that is an extreme event.

Correct.

You'd be talking about a GFC or worse type event before

you'd see something like that happen.

That's right.

And the way we manage that, we look at running a very short duration portfolio.

So the underlying loans within our portfolio are relatively short.

So as an example, 46% of the loans in the Aura High Yield SME fund have a maturity date of three months or under.

Right.

OK, so that also means that you can reprice the book with changes to interest rates.

That's correct.

For those loans every three months.

That's correct.

Well, OK, so my next question is,

Investors are worried about recession.

They're always worried about recession, even though, you know, last year they were worried about recession.

I wrote in The Australian there wouldn't be one and we haven't had one.

And even if there is a recession, my personal view for what it's worth is that it would be a technical recession, not a recession of the sort that we saw in the early 1990s, the recession that we had to have.

Back then we had 11% unemployment.

We had every second or third shot was boarded up and closed down.

No one is expecting that.

No one is forecasting that.

But if there's a recession, what does it mean for your investing?

What does it mean for investors in the fund?

Yeah, I think this last four year period has been very interesting for us.

Obviously, we ran through a pandemic and

I think what investors should look for is a manager that's actually managed these exposures through an interesting time.

So we're seeing a lot of funds coming into the market now where they haven't developed that track record throughout the pandemic and obviously that small technical recession in 2022.

So if you look at how our fund has performed, we have maintained a $1 NAV, we have maintained distribution.

An NAV being an asset value?

Correct.

So what you're saying is that

through the pandemic, through all of the disruption that that caused to the economy, the fund's net asset value stayed at $1 per unit through the entirety of that.

You haven't experienced a month with a loss.

That's correct.

We've distributed every month and we value the portfolio on a monthly basis and get it audited annually.

So, you know, I think valuation is also a very important consideration for investors in all private markets.

So I think it's worth

just emphasising this point that funds that are exposed to a single industry, the investor, and there are funds exposed, for example, to property development, they might be exposed just to retail or whatever it is, the investor needs to consider what the likely outlook is for that particular industry.

The AURA High Yield SME Fund takes a different approach to investing in industries.

Talk a little bit about the diversification.

Yeah, diversification is an important piece of our process.

So if you're looking at our High Yield SME Fund, we have exposure to over 12,000 loans in that particular strategy.

And we've got those spread across a number of industries.

whether that be agriculture, manufacturing, we do have exposure to the construction sector, but more subcontractors, et cetera.

We don't do development finances, as you noted.

The services sector is something that we were seeing a significant ramp up in our portfolio, but we really want our portfolio to look like a representation of the Australian business, you know, the Australian economy, not into a single sector.

And we want a spread across

geography as well as industry.

So if there is a specific event in a certain area, it doesn't necessarily impact the entire portfolio that we have.

So Brett, there's a lot to think about for investors, which is why it's not appropriate for everyone and it's also important that they seek advice.

You've talked a lot about, we've talked about returns, we've talked about risk and how you mitigate some of those risks.

And we've talked about lockups.

We've also talked about diversification.

They're the things that investors need to understand when they're choosing a private credit fund, which by the way, is an asset class, I think will become much more important for investors over the next few years.

Angelina, over to you.

We before we run out of time, happy to receive your questions.

Thank you for your presentation, Roger and Brett.

I have two questions for two of you.

The first question is directed to Brett.

Many investors might think all private credit funds are the same.

Is that true?

No, there is a significant number of ways you can gain exposure to the private credit market.

Different managers will have different areas of expertise, which they will lean on.

They might have different industries that they're looking to target.

So you might see funds that are focused on providing debt to infrastructure projects or leverage buyouts within the private equity space or to construction.

What we really focus on is business lending in the Australian market.

And we're trying to do that through securitized vehicles as opposed to direct lending.

So there are a significant number of ways you can gain exposure to that private credit market.

The second question is for you, Roger.

What should investors need to look for when choosing a private credit fund?

Well, I think it's those things we've talked about today.

I really do think that

private credit is going to be a very, very important part of people's portfolios.

You're going to hear a lot more about it simply because the demographic is changing.

You know, the baby boomers are now heading towards their 70s or they're already in their 70s.

And if they don't like volatility, private credit is going to have a lot of appeal with attractive potential returns without that stock market volatility.

So I think the things you want to look for is security.

You wanna make sure that there's great security in place.

You wanna make sure you're not locked up for any period of time.

And I think it's really important to have that diversification that Brett's been talking about today.

Thank you, Roger and Brett.

Pleasure, Angelina.

Thanks for having us.