History and background
Australian private debt is not a new asset class, nor is it a small one. At over A$2.8 trillion, it is actually larger than each of the Bloomberg AusBond Composite Index, the S&P/ASX200 Index and the Australian superannuation savings pool and has been growing at a compound annual growth rate (CAGR) of 7.6% since 2003. The new and evolving aspect of Australian and New Zealand private debt is the ability for institutional investors and high net worth individuals to access a larger portion of this market that historically has been the domain of banks.
The Australian opportunity
The opportunity in Australian and New Zealand private debt is being driven by a number of macro-economic tailwinds, the most substantial of which relates to recent changes to bank regulations. These changes have resulted in the local big four Australian banks being required to hold additional capital against mortgages, derivatives (such as interest rate and cross currency swaps) and securitisation assets, which is resulting in capital being rationed amongst internal business units within the banks. This has created an opportunity for non-bank lenders (such as private debt funds/investment managers) to fill the gap left by the banks as they withdraw from certain sub-sectors of the domestic lending market. Other factors supporting the opportunity include the current low interest rate environment resulting in low absolute yields, and recent increases in public market volatility. Coupled with these factors is a general acknowledgement that fixed income return drivers have changed, with interest rate duration no longer being a tailwind and inflation concerns increasing. These factors combine to create a compelling backdrop for investors to consider allocations to the Australian private debt sector.
Key attributes of private debt
Private debt also affords portfolios a number of attractive structural protections through seniority, security and covenants, which combine to mitigate the risk of the investment and is particularly important given the stage in the current credit cycle. Being largely illiquid, private debt also exhibits lower volatility than other major asset classes, and stable returns. Additional diversification benefits are achieved by private markets offering access to companies and industries that may not be available in public markets, whilst also offering exposure away from the Australian financial sector, which is an existing material component of investors’ Australian equity and fixed income portfolios. Importantly, quarterly or monthly contracted coupons provide portfolios with regular income streams, while their floating rate nature provides protection from inflation and future interest rate increases. In private debt there is a contractual loan agreement for the life of the investment that stipulates the interest rate to be paid by the borrower to the lender and the frequency of the payments (these are based on a floating rate plus a credit margin). As such, private debt has a very attractive attribute of a steady income stream rather than relying on capital gains as is the case in other asset classes.
The role of private debt within portfolio construction
From a portfolio construction perspective, Australian and New Zealand private debt exhibits several compelling characteristics. The Revolution Private Debt Reference Benchmark exhibits a low negative (-0.26) correlation to the S&P/ASX200 Accumulation Index and a low positive (+0.34) correlation to the Australian Ausbond Composite Index over the most recent 10 years ending April 2018. This provides an important portfolio building block which offers diversification, high income, low volatility and a floating interest rate. Additionally, adding Australian and New Zealand private debt to a balanced portfolio may increase returns, without additional volatility, resulting in a higher Sharpe ratio.
Size of the investable market & attractive sub-sectors
In looking at the spectrum of what is included in the private debt universe, the most attractive sub-sectors have been identified (against the current market backdrop), which include leveraged buyout and private company debt, private and public Asset-Backed Securities (ABS) and loans to stabilised commercial real estate assets. The relative attraction of these sub-sectors is driven by numerous factors, such as their size and the relative value on offer.
While the total Australian private debt market is very large, at over A$2.8 trillion, the above mentioned key sub-sectors that are the most attractive are also importantly large in their own right. In aggregate, the annual issuance across the three key sub-sectors (leveraged buyout and private company debt, private and public ABS and loans to stabilised commercial real estate assets) totals A$180-195 billion. Accordingly, manager selection is critical to ensure deep and wide origination networks to take advantage of transactions that display the best risk-adjusted returns, while maintaining credit discipline.
Relative value vs global equivalents
It is beneficial to have a large investable universe in asset classes that exhibit low correlation to other major asset classes, however the real question is whether the asset class offers compelling relative value. The relative value in the Australian private debt market is evidenced through the current wide (and stable) spreads on offer in the Australian leveraged loan market, which is also echoed in Australian ABS. The Australian leveraged loan market currently prices transactions circa 200 basis points wider than an equivalent-rated US leveraged loan transaction. When compared to US Collateralised Loan Obligations (CLO’s) (which offer the greatest credit margin for global ABS), Australian public market ABS are currently trading 50-125 basis points wider, with Australian private ABS being another 100 basis points wider again (150-225 basis points wider than US BBB-rated CLOs) with a much shorter maturity.
One may wonder why such a large asset class offering such strong relative value has not been inundated with institutional participants (i.e. private debt funds and investment managers), and this is largely due to a number of barriers to entry. These barriers include the requirement to hold a mandate to invest in illiquid and unrated instruments, while establishing and maintaining relationships with sponsors, banks and advisory firms. Expertise is a key barrier, with participants requiring specialist expertise in negotiating and documenting transactions, as well as the ability to analyse industries, businesses and financial statements and create detailed financial models for scenario analysis. Local knowledge is also critical – i.e. local knowledge of regulations, industries, the political landscape and market dynamics. Lastly, offshore participants would most likely seek to hedge the exposure to an Australian dollar position, which is made difficult by Australian private debt typically being callable in nature and incorporating both unscheduled amortisation and cash flow sweeps, which make the variable nature of the foreign currency cash flow difficult to hedge.
The role in a ‘late cycle’ phase
Being late in the cycle, a number of factors combine to make Australian private debt a relatively attractive asset class when compared to domestic and offshore, investment grade and high yield bonds and US leveraged loans. Australian private debt offers seniority, security, covenants, protection from M&A activity and cash flow leakage, as well as demonstrating attractive relative value. These key characteristics help to provide capital stability and protection in this late cycle phase.
This paper presents empirical evidence on the relative value of the Australian private debt market versus notable offshore markets and makes a case as to why this asset class is worthy of consideration within a diversified portfolio construction framework. Furthermore, a rationale supporting an allocation to the private debt asset class at this late phase of an unprecedented period of economic growth in Australia spanning 26 years is also discussed.
This is a summary only. For a full copy of the whitepaper, contact Channel Capital at email@example.com
 Reserve Bank of Australia (RBA).
 Reserve Bank of Australia (RBA).
 The Revolution Private Debt Reference Benchmark is based on 1-month BBSW plus a gross credit spread of 450 basis points, less 50 points of modelled credit losses (consistent with bank loan books) and is provided for illustrative purposes only.
 APRA, Macquarie Group, Westpac, RBA, Thompson Reuters LPC, Revolution Asset Management.