Understanding Private Credit Fundamentals: Five Rules for Smarter Investing

The decision by the Australian Prudential Regulation Authority (APRA) to phase out bank hybrids may see around $40 billion roll into other forms of investment by 2023.

As a dumb money-lender, I could never get my head around the pricing for an investment that could be converted into equity. In my world, the potential for debt to be converted into equity is a very bad thing  and should be priced accordingly.

The level of capital behind the banks (forget the share value, it’s the real dollars that matter) has always concerned me. It appears that APRA, and financial regulators around the world, shared my view post-GFC and increased capital requirements for the banks. This was the start of hybrids for Australian banks: a cost-effective mechanism for meeting increased prudential requirements.

How the banks replace the hybrids is yet to be seen. There are some smart people at the banks, so it’s sure to be creative and saleable. On the GPS side, I hope it’s more expensive for the banks as that would reduce their market edge of cheap funds. If it comes back to a decision for borrowers based on service levels, then I’m confident GPS will do well.

As there will be a new group of investors looking at private credit, it’s timely to review some fundamentals for investing in the sector.

I’ve been involved in private credit long before it was called private credit. The common definition suggests the asset class began post-GFC. My involvement began around 1994 and I even bought a loan book through the GFC. Hopefully by now, I know what I’m talking about.

Here are five fundamental rules I’ve developed over the years.
I note this isn’t financial advice, I’m not licensed to provide it.

1. Retail AFSL

Raising investment monies is highly regulated. An Australian Financial Services License (AFSL) is required to raise funds from the public. If an operator doesn’t have an AFSL, they’re not regulated. Don’t trust your hard-earned money to someone who doesn’t hold a license.

An AFSL differentiates between whether an operator can raise retail monies (from mums and dads) or only from wholesale (sophisticated) investors.

Many new operators are restricted to raising funds from wholesale investors. It’s much harder to be granted a retail AFSL in terms of experience, transparency, financial resourcing, insurance, and governance.

The ASIC takes a more caveat emptor (“buyer beware”) approach for wholesale investors. The assumption is that these investors are experienced and capable of making their own investment decisions without ASIC needing to play the role of “nanny-state” regulator.

ASIC imposes more onerous obligations on operators with a retail AFSL to protect the interests of these more vulnerable investors.

GPS is licensed to raise funds from both retail and wholesale investors.

There are regulated definitions for who qualifies as a wholesale investor (Note: Bree can cover this as part of her compliance training for staff).

My experience is that wholesale AFSL operators prey on the egos of retail investors and lure them with higher returns. They can pay higher returns because they don’t have the compliance processes designed by ASIC to provide greater protection.

2. What’s the Niche?

The name of the investment game is balancing the risk/return ratio at an acceptable level for the investor.

If you’re investing in traditional asset-backed credit, there’s heavy competition from the banks downward. The better the deal, the lower the risk and the lower the return.

GPS has never tried to be a traditional lender. We’ve always worked in a niche market where there’s less competition — where we can increase investor returns by charging for the service and value we provide to borrowers.

Thirty years ago, most residential development finance was provided by the banks. A niche emerged for projects too large for the local bank manager but too small for the banks’ property divisions. The banks’ risk models also didn’t suit builder–developers. GPS focused on this niche, and it’s proved a good decision: the gap remains today for projects that don’t fit the banks’ lending mandates.

3. No Subordination of Investors’ LVR

GPS offers first-ranking security over the borrower’s assets. Our investors understand this: it’s what banks mostly do. It means that when the secured asset is sold, our investors are paid before all other creditors (except for some statutory charges such as rates and land tax).

Subordination moves investors down the priority ladder so that other creditors are paid before them. This reduces their security position and increases risk. Subordination can take many forms, which is why transparency in disclosure is critical.

A cause of the GFC was lenders borrowing against their loan books - investors’ money. This allowed lenders to access cheap lines of funding and increase their margins. The incoming lender took first security over all loans, meaning they were repaid first. Investors, who’d been told they had first security, were actually demoted to second-ranking.

While it could be argued that those investors technically held first-ranking security, their position was eroded by the borrowings against that same security. All very cute in legal jargon, but the reality is that a lot of investors lost a lot of hard-earned money.

The lessons of the GFC appear to have been forgotten, or never learned, by some lenders who entered private credit post-GFC. This is what ASIC means when it refers to inadequate transparency among wholesale AFSL holders.

GPS doesn’t borrow against its loan book. It’s a clear disclosure in our PDS and a key reason investors should only deal with lenders holding a retail AFSL. We have an obligation to disclose and to be transparent.

GPS does engage in internal subordination within our security structure. This allows us to stretch our LVR in appropriate cases. What we do is true subordination: investors taking higher risk don’t get repaid until after our retail investors are repaid.

It’s worth noting that the Woodhead family is a key participant in this internal subordination. Retail investors like this, they know the Woodhead family doesn’t get paid until after they themselves have been repaid in full. It’s skin in the game and they appreciate it.

4. Avoid Conflicts of Interest

GPS is a sole-purpose operator. Under section 601FC, our obligation is to act in the best interests of investors and to put their interests ahead of our own. It’s part of holding a retail AFSL.

Some operators have competing interests. A common example is a finance broker who decides the grass looks greener as a lender. They’re engaged, and paid — by the borrower to obtain funding. If they determine the best source of funding is themselves, they now also have duties to investors.

When something goes wrong with the project, that’s a conflict.

Another example is professional service providers (accountants, lawyers, etc.) with client bases of both developers and investors. Some decide they can increase revenue by running investments themselves rather than referring to independent operators like GPS. Again — conflict of interest. Who do they act for if a dispute arises?

They’ll talk about “Chinese walls.” My view: it’s best to avoid the conflict in the first place.

5. Strength, Resourcing and Experience Matter

We’ll start this with the required ASIC disclaimer: past performance doesn’t indicate future performance.

That said, GPS has come through every major event of the last 30+ years — the demise of solicitor private lending, the GFC, the Hayne Royal Commission, COVID, and more. We’ve built relationships, learned valuable lessons, and strengthened our financial resourcing — allowing us to finish projects when problems arise or to quietly “take it out the back” after fully repaying our investors.

It comes down to trust.
Do you trust a newbie — or a team that’s been through every cycle and still stands strong?

To learn more about how GPS applies these principles in practice, explore our investment funds