The rise, risks and realities of investing in private credit

Our first speaker today is Frances McDonald, co-founder and director at Capstone Funds.

She's responsible for sourcing, evaluating, and executing investment opportunities, as well as managing the fund's operations compliance and risk.

Now today, she'll be taking us through the rise, risks, and realities of investing in private credit.

Welcome, Frances.

Thank you for having me.

All right, so kicking into about private credit, it has been the talk of the town.

And the reason for that is it has absolutely had a meteoric rise in popularity.

What you can see here is globally since the GFC private credit has grown tenfold.

And just in the last five to six years, it's had a K go over 15%.

investors have been flocking to this asset class.

And that has been true to in Australia.

And in Australia, private

credit penetration of the total debt market is actually far behind our comparators in Europe and the US.

We're about 10% of the total market compared to over 50% in those markets.

So there's a lot of room to grow in Australia.

It has been analysed as the best performing and fastest growing alternative asset class.

And the reason for why that has happened is since the GFC, there's been a raft of new regulators that has made lending criteria

are tighter for banks, and has meant that they've rid certain segments of the market, particularly in Australia, that's been the small to medium sized businesses and develop a market.

Now up to 25% of small businesses get their lending from private credit lenders, and nearly three quarters of developers stated that they use private credit to fund projects.

So that's a dramatic shift to just a few years ago.

and private credit in Australia has been growing at double the rate of traditional lending.

It does mean now that private credit has been estimated to be valued at up to $200 billion in Australia, but it's got a lot of room to grow and pipeline.

There's a huge funding gap in Australia, particularly in those markets I've just mentioned, with up to $40 to $80 billion of funding needed that's not currently there.

From an investor perspective, investors have really been flocking to this asset class for its stability, its security, and its yield.

From a selective, private credit's been really attractive because it has low correlation to public markets.

So it's a very good diversifier.

And it's been resilient throughout market cycles.

And that's been really attractive in the context of the last few years where traditional fixed income has broken down as a reliable diversifier in the context of high inflation and high interest rates.

And also its yield has declined.

And actually diversification has been, investors say have been the number one reason that for investing in private credit.

The second key reason for investing in private credit is the security that you get on your investment is often secured against tangible assets.

For example, we lend against Australian established property, and there's often a buffer on your investment, which is determined by the loan to value ratio, which means you've got multiple lines of defence on your investment.

And the third category for reasons is about the yield, you can get a double digit return in private credit with less risk than other

asset class and that is extremely attractive in the context of the volatility we've had over the last few years.

But not all private credit is the same.

I think that's really important to understand because private credit has been tasked a lower risk asset class where you can get equity style returns without equity style risk but it's an incredibly diverse landscape.

So if I take you into where risk and return

sticks at a very high level in private credit.

Some of the key factors to consider is the capital structure and what is the underlying asset.

So from a capital structure point of view, what you can see on the left hand side is the more senior the debt, the lower the risk, the lower the return.

So if you're a first mortgage, you're

have less risk than a second mortgage because you are repaid first.

Equity in comparison is normally repaid at last which means the risk but your upside is uncapped whereas in debt your downside is minimized but your upside is capped.

In terms of the lending category this is what I really encourage people to look at when they are investing into private

credit.

And the way I like to think about the risk to returns is according to the complexity of the recovery, if a loan goes into default, and according to the uncertainty of the realisation of the value.

So if I look at this spectrum here, at the bottom end, you've got established real estate that's valued on an as is basis.

If you need to go into recovery on that, you can take over an asset and sell it as is.

You can see returns in the landscape of six to 10% in that category.

Then you can go into business lending, which is incredibly diverse, it may be secured or unsecured.

In terms of recovery, you may have a situation where a lender needs to take on and actually take over the operations of a business.

We've seen that recently with metrics taking over a string of high profile restaurants, and suddenly they're an operator of a restaurant business, which adds complexity to the recovery.

and you can see returns, I've seen returns in the area of 10 to 12% or higher in business lending depend on the underlying business.

Then in construction lending, construction lending is based on a realizable value at the end of the project.

So if a lender needs to step in to a loan and default midway through a project or a builder goes bust, they need to

for example, a point to receiver or a point to new builder, and then manage that project to completion, which takes time and money, which means that in construction lending, you should be looking at higher returns, certainly seeing funds that offer up to 15% in that category and then higher than that you've got distressed opportunistic debt, where the underlying business or asset might be in trouble where you can get returns over 20%.

So I think that is a key takeaway I really encourage people to think about is what is your risk return appetite?

Where do you want to sit on that spectrum?

And what's the capability of your fund manager to manage the underlying assets if they need to?

In terms of what to watch out for, I think that's a important thing to spend a minute on.

And there has been rising scrutiny on private credit and private markets in general, as it's been exploding as asset classes from the regulators to make sure that they're the right safeguards in place that it's sustainable, and that investors have the right protections.

I think the key things to watch out for and to do your homework on when you're investing is understanding that security, what is the underlying asset?

what is the loan to value ratio, the lower the LVR, the lower the risk you're taking on, but importantly, is that backed by an independent valuation and the strength of the collateral and the borrower who would be servicing the interest payments.

I think that security is number one, then also looking at what are the key terms around your investment?

What is the level of oversight on the fund?

For example, if there's related party transactions, or if they have an independent custodian,

very much look at who you're putting your money with in terms of the management.

What is their track record?

Do they have experience in managing tricky situations?

And do they have skin in the game?

And then risk management is very important in this field about having a proactive manager who is also diversifies the portfolio to manage risk across the book.

So I just want to change tracks a little bit to where who is Capstone and where do we sit in that whole spectrum.

So we're an Australian property debt fund, we specialise in short term loans, with no major construction exposure in the sub $5 million market.

And what that means is that allows us to achieve an outsized return relative to the underlying risk, because we don't have any construction exposure.

We are not exposed to multi-year market fluctuations.

Our loans generally have a very clear exit and we get a premium because they are short term.

What that looks like in terms of what we offer to the market, what was really important to us when we set up our offer was that it's consistent, reliable, the same amount of money in the bank account every month had strong protection and inner structure when management took on more risk than investors.

What that looks like is a 10% per annum return, monthly payments, flexible redemptions with multiple layers of security.

Our portfolio LBR at the moment is under 60%, we're mainly first mortgages and management is invested as a first loss investor, which means our capital is at rate at risk first.

That's our way of standing behind our product.

We're also not paid until we meet the 10% return.

put more meat on the bones of what that actually looks like day to day and what we invest in.

Broadly the categories of loans that we do you can see on the left hand side here about 30% of our historic lending has been bridging loans.

That is when an asset is for sale or has been sold.

The example given here is a

lovely property in Mosman, New South Wales that actually had an executed contract for sale with a deposit paid when we did the loan, so the risk on that loan is very low.

The second key category we do is residual stock loans, that's when a developer has actually finished the construction of say an apartment, they want to come off their higher interest rate construction loan and they need a loan for the sale and settlement of those apartment units.

and they are for sale so there's a very clear exit there.

The third category we do is land and subdivision when a developer is going through the DA planning or subdividing of a lot with the exit being either refinance to construction facility or to sale.

On these categories, we look to have lower LVRs given they are land assets.

Overall, we have a diversified portfolio across these different assets.

by both location and category.

And now talking to performance so this slide really does demonstrate the earlier points around people have kind of been coming into private credit what you can see here and I'll just call out the equities comparison ASX200 the yearly return over the last five years has just been above seven percent capstone income fund as an example

has had a 10% per annum return.

So you can see on the right hand side how that, the important thing to really note here is the comparison to the volatility in the equities market.

Certainly equities market since the beginning of COVID has had a lot of recovery, but it is a volatile investment.

Whereas private credit is a consistent passive income stream that compounds over time, which is very attractive as a complimentary to an equity strategy.

So just some takeaways from who we are and what we do, we offer a 10% per annum return, monthly payments, flexible redemptions in a portfolio with under 60% OVR, majority of the first mortgages.

We are invested as first loss.

We have a strong track record in place.

We've done well over $100 million worth of loans.

We've never had a capital loss.

We've always met returns.

And that's kind of where we sit across the risk return spectrum of private

Great.

I might pause now because I believe there's some questions that have come in.

For instance, you excluded construction funding from your mandate.

What's the reason behind this decision?

So capstone, it doesn't fit in the mandate of Capstone Income Fund.

Capstone Income Fund is focused on very strong capital preservation with stable, reliable returns.

Construction lending, we would absolutely go into in a different mandate fund with a higher risk appetite.

because in construction lending there is more risk and particularly in the last few years we've seen the highest number of insolvencies in construction ever and we've seen cost increases of 30 to 40 percent in just a few years as well.

There are very good opportunities in construction lending is critical for us to meet some of the housing shortage in Australia but it's not in this mandate of this fund structure.

Now why would an investor choose to invest in property debt rather than property directly?

Property debt is a great alternative or complementary to investing directly in property.

We've actually had a really big influx of property investors into the fund as they started to see the weighing of the property market and they are still looking to profit from a tangible asset that they know and love.

but they can't bank on that capital appreciation that we've certainly seen of previous years in the Australian real estate market.

Property credit has less risk than property debt.

You're not taking on that equity risk.

It has a stable, consistent, passive income.

It doesn't have the effort and management of managing rental property.

And it has a lower entry cost because for example, in our fund you can enter

from a hundred grand as well as being able to more flexibly redeem compared to selling.

Thank you for your time Francis.

No problem.