The outlook for private credit in 2024
The 2024 outlook for the Australian economy is cautiously optimistic, with Gross Domestic Product (GDP) growth to remain positive as inflation comes off its peak and the economy continues to adjust to higher interest rates and cost of credit.
It appears central banks have navigated the challenge of utilising interest rate levers to manage inflation. A soft economic landing now the base case for most investors, and the Reserve Bank of Australia (RBA) is indicating the same, although higher interest rates will be a feature of the investment landscape as inflation pressures remain elevated.
Consumer and corporate performance have been supported by the level of excess savings in the economy, although this has begun to deplete from its highs of the last few years.
Consumer and business confidence figures into Q1 2024 are keenly anticipated, as well as employment growth, as markers for the likelihood of an economic soft-landing eventuating.
Discretionary exposed segments of the economy and businesses with wage-driven margin pressure in competitive sectors (where higher costs can’t be easily passed on through higher prices or revenue) could face some genuine squeeze points by mid-2024. We do not anticipate any systemic issues.
Interest rates at or near their peak
The rate tightening cycle is probably not over everywhere, but more favourable inflation data suggests further rate rises will be limited in Australia.
In the US, where rates were increased earlier and by far more than in Australia, the US Federal Reserve is also predicting a soft landing for the US economy in 2024. If there are signs of emerging stress, the central bank could certainly use their interest rate levers to support the economy. With more leeway to cut rates (compared to the RBA) there are reasonable prospects of a handful of rate cuts in the US by late 2024.
Bond yields in Australia (and the US) rose sharply throughout 2023, peaking at the end of October at just under 5 per cent then declining (suddenly) over the final few months of the year to 3.9 per cent. The Australian stockmarket moved around, finishing the year strongly with the ASX 200 up 12.4 per cent.
Investors are seeking pockets of opportunity and defensive alternatives as they become increasingly comfortable with the diversification benefits of private market assets and the different risk/return, liquidity, and duration characteristics they can deliver. We favour resilient and defensive sectors including alternatives such as private credit and operating real estate.
The asset class of 2023
Private credit was the asset class of 2023. As interest rates rose rapidly, the returns on floating
rate debt trended towards a range of 8 per cent–12 per cent (on a net basis). These are equity-like returns, in an asset class more senior in the capital structure.
Significant credit market dislocation in a higher rate environment did not materialise with consumer and corporate borrowers performing resiliently in the wake of substantial shifts in the interest rate outlook.
The importance of being a fundamental-oriented, broad-based private credit investor was highlighted throughout 2023. In some areas, such as leveraged loans and sponsor-backed debt, there was a dearth of deal activity as higher rates made it harder for private equity to make acquisitions (and hence lower need for financing). For investors with a broader remit, there were significant opportunities to capitalise on a generational opportunity in private credit.
Attractive deal flow in specialty credit arose following the US regional banking crisis and ongoing bank streamlining occurring in Australia (and globally) shifting all types of lending outside the banking system. There were also attractive opportunities to partner with banks in co-lending models.
Avoiding losers in 2024
Private credit in 2024 will be about avoiding the losers, not picking the winners. This will require a sharp focus on strong fundamentals with robust security, asset coverage and downside protection and the rights and controls lenders need to safeguard capital if required.
The best opportunities in private credit over 2024 will likely be in areas where banks have exited for structural or regulatory reasons, or where market forces more generally mean there isn’t a flood of money chasing the same transaction. In larger more highly contested deals, and large syndicated loans, debt terms are likely to continue to progressively weaken further over time.
Smaller, mid-market transactions (lending on a direct or club-basis with real influence over terms and pricing) are likely to be negotiated on attractive terms, earning outsized returns for the level of risk.
In asset-backed and specialty credit, highly diversified portfolios of loans with substantial asset over-collateralisation gives a high degree of downside protection if stress starts to emerge at the underlying borrower level.
When lending to companies, the best opportunities in 2024 will be borrowers with a strong market position in non-cyclical industries, and which are ‘price makers’ and not ‘price takers’ ensuring they can deal with the impact of higher input or wage costs or a period of sustained inflation and supply-chain disruption.
There are also opportunities to partner with banks as they continue to pursue capital optimisation
initiatives or partner, rather than compete with private credit funds.
Strong growth for real estate credit, but a careful approach necessary
Australia’s residential market continues to grapple with acute undersupply in the face of soaring demand. Despite the market imbalance, the forecast for residential prices over 2024 remains relatively benign as several key variables are in play. Record levels of immigration, demographic changes increasing average household size and acute affordability pressures are all impacting both the rental and owner-occupier market. A wide range of outcomes over 2024 is possible depending on location, quality, liquidity, and depth of the market.
The key question for real estate credit investors will be the impact of the increasing affordability crisis on sales and prices, and which pockets of the market will continue to perform and offer opportunity.
Undoubtedly, the opportunities for private lenders to finance the growing demand for real estate credit will continue over 2024 as they work to complement the major lenders in addressing the critical housing shortage. Sound market fundamentals, security through first lien mortgages and an experienced manager to assess underlying value and exit strategies will remain critical to success.
Growth credit opportunities expected in 2024
Valuation resets for private growth businesses occurred during 2023, in line with public market declines. Limited availability of private growth capital resulted in businesses continuing to refocus on profitability at the expense of growth. Several high-profile insolvencies during the year provided evidence of the greater risk of failure for early-stage businesses.
The continued shortage of private growth capital is likely to result in a sustained flow of well-priced investment opportunities for equity investment and growth credit over 2024. Further merger and acquisition activity based on strategic consolidation is likely which in turn should drive private market pricing for exits. Although economic conditions over 2024 are likely to remain broadly muted, the reactivation of the IPO markets would be a positive signal for growth-oriented businesses.
Andrew Martin is head of asset management at MA Financial.
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