Does a slowing economy increase the risk of loan defaults in private debt?

Well-run private debt funds use rigorous scenario testing and real-time monitoring to mitigate risks. Historical net write-offs by banks peaked at just 0.68% during the GFC and were 0.04% in September 2024, demonstrating strong resilience across economic cycles.

Does a loan default always result in a credit loss?

No. Private debt investors are protected by their seniority in the capital structure. Senior debt holders get repaid first, before subordinated debt, preferred equity, and common shareholders. Covenants and controls act as early warning signals allowing lenders to engage with borrowers to mitigate financial loss.

Are all private debt managers the same?

No. Private debt managers differ significantly in scale, credit skills, and experience. Quality managers need sizable assets under management, bank-level credit skills, extensive networks, and the ability to directly originate and diversify loans across borrowers to achieve optimal outcomes.

Does commercial real estate debt put capital at risk in a property downturn?

Property owners face greater risk than lenders. With typical loan-to-value ratios of 60%, owners' equity acts as a buffer. Even if property values fall significantly, lenders can compel borrowers to restore their position or pursue asset sales to maximize recovery without necessarily incurring losses.

Are non-bank lenders lenders of last resort?

No. Competent private debt managers lend to quality companies and often compete with banks or work alongside them in lending syndicates. Post-GFC regulations requiring banks to hold more capital have created financing gaps that private debt fills for established companies with sound fundamentals.

Why private debt can still grow at 5-6% pa even in an economic slowdown

Portfolio holdings that can continue to grow even during down times? Metrics’ Andrew Lockhart explains.

Economic slowdowns, let alone recessions, rarely get a positive reaction from most investors. But one asset class does find a way to grow its returns even during a downturn. Better yet, it’s available in Australia and it works just as well during the good times.

That asset class is private debt, and the largest player in the Australian market is Metrics Credit Partners. For founding partner Andrew Lockhart, a slowing economy provides a chance for lenders such as Metrics to cherry-pick the investments in which it wants to participate. While doing so in the knowledge that credit growth will still increase in Australia even during a downturn.

“When business or economic conditions deteriorate, what you tend to find is that top-line revenue becomes more challenging. Companies need to respond in terms of aggressively attacking their cost base, but also, as a result of rising interest rates, alternative asset classes become more interesting or compelling from a valuation perspective,” Lockhart said recently.

In this edition of Expert Insights, you’ll learn just how the Metrics team navigates a downturn.

Edited Transcript

Does a slowing economy have an impact on your opportunity set?

Lockhart: At the end of it, any business or economic slowdown can have an impact in terms of the demand for credit. Recognising that in Australia, though that most credit is provided by the banks, it’s still a very large market. So for us, we’re the largest non-bank private debt provider in the Australian market at around $15 billion. That’s dwarfed in comparison to the size of the market, which is around about 1.1 trillion.

So certainly, we have the opportunity to be very selective in terms of the kinds of companies and projects that we agree to finance, but we believe that credit growth will still grow at 5% to 6% per annum, providing opportunities for us to originate good-quality opportunities.

But importantly, when you get a situation where business or economic conditions deteriorate, all of the protections associated with appropriate covenants, appropriate controls, ensuring that equity bears that risk of first loss, ensuring you’ve got appropriate security to mitigate your risk of loss, and giving you multiple ways in which you might exit your exposure are all designed to mitigate the risk of loss.

So again, as a lender, what you’re looking to do is not take the risk that the company’s going to generate a huge increase in value or earnings. That’s an equity opportunity.

So, when business or economic conditions deteriorate, what you tend to find is that top-line revenue becomes more challenging. Companies need to respond in terms of aggressively attacking their cost base, but also, as a result of rising interest rates, alternative asset classes become more interesting or compelling from a valuation perspective. So, in an environment where equity upside looks less appealing, investors tend to focus in on, “How can I generate an acceptable income while preserving my capital?”

I believe that private credit does provide that opportunity. With a team that has a strong skillset in corporate restructuring and workout, you can manage through the cycle. Our team have a strong track record with many decades of experience in terms of different cycles, and the risks that may present to a lender.

Livewire Markets | 27 September 2023

Metrics Credit Partners Pty Ltd ABN 27 159 646 996 AFSL 416 146 (Metrics) makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and is not intended to provide you with financial advice. It has been prepared without taking into account your objectives, financial situation or needs. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, Metrics excludes all liability for any loss or damage arising in any way due to or in connection with the publication of this content, including by way of negligence.

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