Research houses up caution to private credit launches

The rise of private credit funds is giving research houses cause for concern about their viability for retail and wholesale investors, and necessitating changes to their research process.

Earlier this week, it was reported in the Australian Financial Review that advice licensee Count had sent a letter to its advisers recommending they exit their holdings in four private credit funds run by Metrics Credit Partners and MA Financial, noting an increase in the instability in the asset class. 

While the funds are positively rated by research houses, it said it believed the move was appropriate to protect its investors and is undertaking a broad review of the space.

Count has 512 firms on its Australian Financial Services licence (AFSL) and is the second-largest advice licensee in Australia behind Entireti.

A spokesperson for Count said: “I believe the information was sourced from a confidential email that was shared with our adviser network. It’s Count’s policy not to publicly comment on our investment and research decisions.”

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Andrew Lockhart, managing partner at Metrics, said on a webinar that he had not met with Count and was unaware of any due diligence undertaken that may have led to the recommendation. 

"I'm disappointed they have got to a recommendation to redeem and I'm certainly not aware of any reason why that would be an appropriate recommendation for an investor."

The decision by Count comes just weeks after ASIC enacted a private markets review which flagged concerns about the rise of private credit funds. Product failures are likely, it said, and it is increasing its focus on the assets and their risk for retail investors.

ASIC said: “We are currently undertaking work to examine private credit and the risk for retail investors more closely. This includes a thematic surveillance of retail private credit focused funds, reviewing governance and practices relating to disclosure, distribution, conflicts, valuations and credit risk management.

“Retail investors can face significant harm if persons operating businesses that on-lend retail investment monies fail to comply with the law, as evidenced by issues that have arisen in the past in relation to debentures and managed funds.”

Research house ratings

For advice licensees, a key consideration when selecting a fund is the verdict of the respective funds given by a research house. Many licensees will be unlikely to hold a fund on its approved product list (APLs) unless they have a recommended or highly recommended rating which can make a significant difference to the volume of flows a fund manager receives. 

While some houses tend to rely more on quantitative data and models, others prioritise qualitative factors such as the investment teams’ experience and philosophy. A rating is typically based on a fund’s track record, manager experience, available investment resources and research process among others and an APL is updated on an ongoing basis as ratings change.

Metrics' Lockhart specifically referenced this, saying Lonsec and Zenith had positively recommended the funds and that Count's decision to redeem was contrary to these ratings.

Commenting on the news, Louis Christopher, founder and managing director at SQM Research, told Money Management that the research house is becoming increasingly aware of issues with private credit and taking action in the form of a sector watch.

He said: “We are releasing a sector watch on private credit as we are noticing an increase in issuance. There will be more monitoring and more surveillance, and it could result in some funds being downgraded.

“ASIC’s report covered issues with retail investors, but we are seeing issues with wholesale too.”

A downgrade by a ratings house could mean a significant loss of inflows for the fund manager if a licensee subsequently removes it from their APL.

He said SQM had not rated the Metrics funds in question as it did not hear back from the manager, but noted this might have been because the fund was already rated by other research houses. It has rated numerous other private markets funds from firms such as HMC Capital, MLC, Remara and Woodbridge Capital. 

Christopher also questioned whether it will be difficult for Count advisers to exit the positions given the less liquid nature of private credit, which is expected to be held for a long-time horizon. Given the nature of the underlying assets, it would be a negative for funds in that sector to offer daily or weekly liquidity to investors, he said.

Meanwhile, Lonsec said the rise of private credit funds has forced it to change its research process, having rated 28 private credit funds including 20 which are domestically-focused. It particularly noted Australian private credit funds primarily focus on multi-sector approaches and real estate lending whereas global ones are focused on direct corporate lending. 

As such, it has enhanced its private markets model to better capture the additional risk such as illiquidity and governance. There are numerous “areas of heightened risk” for private credit funds compared to other funds, it said, which include governance, start-ups, vertical integration, expertise, resourcing, portfolio diversity and underwriting standards. 

Darrell Clark, deputy head of research and sector manager – alternatives at Lonsec Research and Ratings, said: “Lonsec’s approach to the growth in Australian private credit funds has led to adjustments and an uplift to the seven-factor model and the governance framework overseeing the initiation of coverage.

“While private credit clearly has benefits, it also carries risks related to illiquidity, valuation governance, and leverage among others. Lonsec applies rigour in any review process to ensure these factors are thoroughly captured and integrity is maintained in any rating generated. Moreover, Lonsec seeks to remain adaptable to evolving market dynamics and ASIC’s ongoing reviews of private markets, ensuring our approach aligns with best practices and regulatory expectations.”

Examples of problems with private credit funds which could see a fund rejected by Lonsec included a business in its infancy, a clear equity-debt conflict, small team with lack of resources, a complex asset-based financing structure or a subscale number of loans.

Grant Kennaway, group head of research at Zenith, said the firm does not comment on individual funds but acknowledged the concerns of the private credit space.

“On private credit itself, the sector has a higher risk-reward characteristic given its liquidity profile, so investors need to take this into consideration when investing in the sector,” he told Money Management. 

This is not the first time that alarm bells have been raised by research houses as last July, Christopher told Money Management he was concerned about the number of “fly-by-night” managers coming into the space. 

“There are too many fly-by-night managers, everyone wants to get in on it, and you see this type of thing at the end of a cycle. It rings alarm bells, and we have had to reject some funds. There are some good operators who have previous experience in the space, but it is becoming competitive, and we are concerned some managers are raising funds very quickly.”

How have research houses rated private credit funds?