Private Credit – a smart choice for retirees

Our first speaker today is Roger Montgomery, founder and chairman of Montgomery Investment Management, an Australian boutique investment manager which he established in 2010.

Roger has over three decades of experience in funds management, cemented his status as an industry expert with his best-selling investment book, Value Able.

He's a well-known media personality with regular appearances on television, radio and in the press, including the ABC, The Australian and Auspice.

Today, Roger's presentation topic is private credit, a smart choice for retirees.

Welcome to the stage, Roger.

Thanks, Angelina.

Great to be with you and thanks for having me, everyone.

I'm hoping you'll get some brilliant insights from today's presentation, and I'm looking forward to sharing my experiences with you on this particular subject.

Before we go forward,

Just note that nothing that I'm sharing with you is specific advice.

If you have any questions about this particular sector, funds in this particular space, then you should seek personal professional advice.

Everything that I'm going to share with you is general in nature.

And if you do,

If you are considering investing, make sure you read the target market determination, as well as the product disclosure statement.

Okay, with that, a quick background on Montgomery.

Montgomery is a distributor of funds.

We're the exclusive distributor of a number of funds in Australia, both that cover, I should say, large Australian equities, small cap Australian equities,

long short funds, global large and small funds, as well as private credit, which is the topic we're going to be talking about today.

If we go back in time to 1955, which is really just the, you know,

the edge or the beginning of 10 years into the baby boom, you can see the bulge for girls and boys.

On the left-hand chart down the bottom there, you can see that

very large increase in the population.

And that's the children of the generation that came before them that were all born at the end of World War II.

A serviceman came back to Australia and peace returned to the world.

Everyone had babies.

And you can see that baby boom right there.

And as you move forward over on the

right-hand side.

Towards the right you can see in 1970 that boom has shifted up along the chart.

And then over on the right-hand side it's shifted forward again.

And as those baby boomers had children, the population remained larger as a consequence of that second wave, which is the Generation X.

And if we look at today or

very recently, 2023, we can see that there is a significant, significant increase in the population.

Now, a very large portion

of that increase in the population is heading towards retirement.

You can see the people over the age of 60 over the next five years and 10 years is going to be very, very different or the number of people over the age of 60 in five and 10 years is going to be very different to where it was five and 10 years ago.

At the same time that this is happening, what we know is that lending to businesses hasn't, or the requirement of business lending hasn't been met by banking.

The large banks, particularly lending to small businesses, they haven't increased how much they're willing to lend.

And that's a function of the fact that after the GFC,

regulation was put on the banks that required them to have larger amounts of capital for certain types of loans and that included lending to small and medium-sized corporates in Australia.

And the result of that gap, the result of that rather, produced a gap

So the amount of money that small and medium-sized corporates in Australia would like to borrow for growth versus how much banks are willing to lend, that gap is somewhere between $350 and $400 billion.

So we've got these two dynamics happening.

We've got an older cohort of Australians moving to retirement who want income

And we've got all of these small and medium sized corporates who wanted to borrow money, but the banks haven't been able to lend to them.

So what's happened is that private lenders have stepped into that space.

Non-bank lenders have moved into that space.

Now, this is all very new in Australia.

In fact, private lending in Australia to small and medium sized businesses is only about 9% of all lending.

But if you look at the United States, private credit or private loans

to businesses is about 91% of their funding, whereas in Europe it's about 65%.

So in Europe and the United States, this private credit space has been around for longer.

And it's also grown more significantly, partly because there's been more high net worth, ultra high net worth and family offices that are more sophisticated and have decided that this is a space where they want exposure.

Why?

Number one,

high and attractive returns.

Number two, low volatility and low correlation or no correlation to public markets like equities and the bond market.

Now, how do private credit funds work?

Well, in Australia, Montgomery distributes the AURA private credit income fund and the AURA core income funds.

And we're gonna be talking more about the AURA private credit income fund.

Essentially what happens is you as an investor invest into a fund that is managed by a gentleman named Brett Craig and his team.

Brett Craig's ex Macquarie Bank, he was there for 11 years.

By the way, this fund that I'm talking about right now has been around for seven and a half years already.

It's invested through COVID and you'll see that track record in just a moment.

So this isn't a overnight success.

This isn't something that is a Johnny come lately fund.

it's been around for quite a while and it's invested through some disruption to markets and financial systems and economies and you'll see the results of that in just a moment.

But you as an investor invest in that particular fund and then Brett and his team

will then spread that money if you like or allocate that money to non-bank lenders.

Those non-bank lenders are also called originators and the reason why they're called originators is because they're originating the loans.

They're out there marketing

lending.

They're looking for borrowers.

When they find someone who's interested in borrowing, they'll assess their application and ultimately either reject or approve that application based on the credit quality of that particular borrower.

and then that money is extended to those corporates and those corporates might be in the legal profession, they might be doctors, they might be pet shops, they could be agricultural producers, they could be blueberry growers, they could be across 40 different sub-sectors of the economy for this particular fund.

And then what happens is those borrowers then pay back those loans monthly

Those loans are eventually paid back and when those loans are paid back, the manager of the fund will then reallocate that money to either the same non-bank lender or to a different non-bank lender and that money will be recycled.

and reinvested into new loans.

Now, the difference between the AURA private credit income fund and many other funds is that the average term of those loans is quite short.

In fact, the average term of those loans is three to four months

and the average size of the loans is somewhere between 100 and $150,000.

Now there's some advantages to that and we will talk about that briefly in just a moment.

The other thing that I'll say is that the fund doesn't lend to distressed companies.

The loan portfolio has a very high rating for this particular fund.

It's investment grade, it's double B, that's been independently assessed by a credit agency

And so it is investment grade.

These are relatively high quality loans or the quality of the book of loans is relatively high quality.

And then the other thing that I'll say is that all the loans are underpinned by security or collateral.

So that could be a director's guarantee.

It could be a loan, sorry, a guarantee or security

over the cashflow of the business.

It could be property backed, but there is no lending, I should say, to property developers, but the loans could be asset backed.

It could be invoice financing.

So there's always security that's behind these loans so that if there was a default that led to a loss, the loss could be recovered through the collection of those covenants.

So there are various levels of security.

At the borrower level, there is very careful loan selection.

So extensive due diligence is done not only on the lender or the non-bank lender and their performance over time, but the non-bank lender's due diligence then on the corporate borrower.

That's the first level of security or protection, if you like.

And then as I said a moment ago, all the loans have collateral underpinning them.

And so in the rare event of a default,

there is recourse to collect on that security.

And then the short duration, the loans are very short.

And what that means is that let's say worst case scenario, you worried about a very deep recession in Australia, and you decided you wanted to get your money out because something bad could be happening to the economy, or it may not happen by the way, you're just worried about that.

And if you were concerned about that,

And let's say every investor was concerned about that, so they rushed to the fund to try and get all their money out at the same time.

What the manager would do is they would gate the fund.

Now, if the average term of the loan is two or three years, you have to wait until the loans are paid back before you see all of your funds returned.

And that could take two or three years.

But in the AURA private credit income fund, the average term is about four months.

And that means a very large proportion of your investment is going to be paid back in a very short period of time, all else being equal.

I should also say that the loans are structured with a floating rate and that means that if interest rates go up, there's the option for interest rates that you're receiving to also rise.

That's at the borrower level.

Then at the deal level, what I will say is that

Those non-bank lenders are sharing in the risk.

In fact, they have to put some equity into the loan portfolio as a first loss piece.

That way they're aligned with your risk.

If any of the loans go bad, it affects their income first and then their equity contribution second before there's any impact on the investor in the funds.

What I'll also remind everyone is that credit ranks above equity.

So if something tough happened to a business, well, all of the equity would be wiped out first.

And a lot of people in the share market don't realise that, that they own equity and equity is lost first before credit.

And remember, this is secured credit that we're talking about, which ranks even higher.

in what's called the capital stack.

And then there's bankruptcy protection as well.

The loans are held in a bankruptcy remote trust.

So that means if any of those non-bank lenders, the originators were to go bankrupt, the manager could then allocate the loans to another non-bank lender or collect the loans, continue to collect the loan themselves.

Those loans are protected from the business operations of the non-bank lender.

And another level of protection is in the fact that there are

a very substantial number of loans, about 13,000 loans, as I said earlier, across 40 different sectors or sub-sectors of the economy.

If we have a look at this final slide, we can see on the bottom a credit rating and we can see over on the left-hand side the total return.

And if we look at the AURA private credit income fund that you can see highlighted there or bolded there at the top,

You can see it ranks at BB in terms of its credit rating.

And that risk statistic was calculated by a third party risk consultant.

And you can see that you can compare that to other BB credit ratings.

So for example, you might look at Credibles ABS, which is an asset backed security.

So that's also BB or BBB around that zone.

but it's generating a slightly lower return.

What you can also do is run a line horizontally to the left, and you can see that in order to get a 10 percent return or anything better than that, you would have to accept higher risk

in other securities.

So, you know, it's a good blend of, or it's an acceptable or attractive, relatively speaking to these other examples, an attractive blend of credit rating and return.

By the way, these funds, unlike other funds, they don't pay the interest to their investors monthly or, sorry, quarterly or annually or biannually, they pay income monthly.

If we look at the final, sorry, this slide here, you can see the returns on the bottom part of the slide there.

You can see the monthly returns.

And what you'll notice is that from inception in August, 2017, every month has been positive, including through COVID, including through the stock market sell-off in 2022.

This is not exposed to equities.

It's not exposed to the stock market.

and it's paid income monthly and it's not had a negative month since it's in inception.

So that's extremely attractive or it's been very beneficial rather for existing investors.

And while we can't guarantee the future, in terms of the portfolio management, the types of loans that are being made, that's not changing in the future.

And I think this is the final slide.

And if you look at the blue, the brightest blue line at the top of the chart there, you can see the inception of the AURA private credit income fund.

and you can see its returns.

It's roughly returned the same amount as the ASX200 accumulation index, and this by the way is with the income reinvested, but you'll notice that it's done it with none of the volatility of the stock market.

So while the stock market rises and falls, the AURA private credit income fund

has generated to date a similar return overall since inception but without any of that volatility.

And that could be the reason why these funds are growing in popularity because they're generating attractive returns but without any of the volatility that pension investors, so retirees who are in pension phase, and retirees might not like.

They might not like that volatility.

And this is the core income fund, which is a retail fund.

And if you're thinking about investing in this particular fund, you would need to seek personal professional advice from a financial planner who knows and understands your present circumstances and your financial needs.

This is a younger fund.

It invests in a higher quality section of loans that the other fund invests in.

So its returns are slightly lower.

And

its quality is slightly higher.

So this ranks at the AA spectrum in terms of risk rather than BB.

And it's been returning compounded about 7.5% per annum since its inception in October 22-23.

So we'll finish up there.

I've gone a little bit over time.

Forgive me for that.

And we'll probably put less slides in next time.

And there's more that I could talk about, but we'll hand over to questions now.

Roger, we're seeing more high net worth investors, especially retirees turning to private credit as an alternative to shares and property.

Now what's driving this shift and what key benefits are they seeing?

Well I think as I said in the presentation one of the benefits is the low volatility.

So for the AURA private credit income fund and the core income fund since inception up until today they've never had a negative month.

Every month

has produced positive income at an attractive rate.

And I think number one, that's been very, very popular because retirees require income to fund their lifestyle as well as health requirements down the track.

Or for example, helping the grandkids or helping the children with a deposit on a home or helping with school fees for grandkids.

So there's lots of reasons why retirees

are looking at these funds as attractive, but perhaps more importantly, it's the lack of correlation or the low relationship to public markets like equities, that low volatility is really, really attractive.

If you're a retiree, you're worried about what's called sequencing risk.

You don't want to invest your money and then find that the stock market falls

you know, 3% overnight as it did last night from the date, last night from the date that we're recording this particular video.

And so investors who are concerned about sequencing risk and they're worried about volatility of public markets might be more inclined to think about this for some aspect of their portfolio.

I should say, Angelina, this is not, this is not for all of your money.

It's not for all of your cash.

It's for a proportion of your portfolio that you want to enhance your income, use it to enhance your income and note the historical track record of low volatility.

Since we last spoke, private credit is gaining more traction as an asset class, but they asked you some common misconceptions.

So what are some of the more common myths investors have and is there truth to them?

If someone says to you, and we still hear this and it's not frustrating at all, it's a great opportunity for investors who do a little bit more digging, but you hear from people who don't understand the private credit space saying, oh yeah, private credit, very risky.

Now, 15 years ago, Angelina, if you'd said, Roger, I'm going to lend money to small and medium sized businesses in Australia, I would have said, you've got rocks in your head, Angelina, don't do it.

And the reason why is because the banks had that market completely sewn up.

They were lending.

So the only businesses you could have lent to were the ones the banks had rejected.

That would have been an incredibly risky thing to do.

But the space has transformed.

The banks have reduced their lending to that space, not because they want to, but because the capital requirements needed means it's less profitable business for them.

It's not in their interest.

And so the space has opened up, you and I can now lend to

higher quality corporate borrowers in Australia, the sort of borrowers that the banks used to lend to.

So from that perspective, there's a different risk profile.

And then across private credit, there are lots and lots of different funds.

Some of the funds lend to property developers.

I personally think that's a much riskier thing to do.

So I don't personally want to invest in a private credit fund that lends to property developers.

In fact, all the headlines in the press over the last 12 months

about private credit and defaults have been related to property developers collapsing.

So I don't want to do that.

And then if you're investing in a private credit fund that has, for example, a few very large loans that are long dated loans,

That's a very different risk profile to a fund that invests in thousands of smaller loans with a shorter term.

So when someone says to you, oh, private credit, it's risky, drill down a little bit more, dig a little bit deeper, and you'll find that just like the stock market, there are different risk profiles within the funds that are offered in this space.

Thank you for your time, Roger.

Thanks, Angelina.