Singapore family office turns wary about private credit

Concerns are mounting for private credit as economic uncertainty and the market’s rapid growth in size, to now over $2.1 trillion globally, have begun to pressure spreads and loosen underwriting standards.

Some investors say alarm bells are ringing over credit quality, liquidity risks, and asset revaluation.

“Adverse selection and moral hazard are the key risks that will be thrown aside by the pressure to deploy capital by private credit managers,” Kah Ken Kam, investment manager at Singapore-based single-family office Wellco Capital, told AsianInvestor.

The family office invests in multi-asset strategies to obtain endowment-like returns over the long term.

“To appreciate the problem of competition in private lending, we only need to look back to 2005 to 2007 in the US housing mortgage problem. Too much money and limited regulations led to excessive risk-taking,” he said.

In April, Fitch Ratings observed the continuing growth of private credit: “While the prospect of increased regulation kept banks largely on the sidelines last year, they have become more active in recent months as seen with several bank/non-bank partnerships of late. Competition is likely to intensify, particularly in the upper middle market.”

Also earlier this year, the International Monetary Fund warned: “The rapid growth of private credit has recently spurred increased competition from banks on large transactions. This in turn has put pressure on private credit providers to deploy capital, leading to weaker underwriting standards and looser loan covenants—some signs of which have already been noted by supervisory authorities.”

Loan covenants have become weaker or sometimes do not exist at all as investors seek to win mandates, according to Wellco’s Kam.

However, the level of risk also depends on the depth of the particular market segment and the relationships fund managers rely on to secure deals.

For example, in a well-developed market like the US, the success of a private credit fund can transcend market conditions if managers have sufficiently strong relationships with key players in the financial ecosystem, which can facilitate access to lucrative lending opportunities.

He suggests avoiding first-time mangers under current conditions.

MANAGER SELECTION

Manager selection has become even more important as risks rise.

Kam’s due diligence includes checking if the fund manager is focused on making high-quality, profitable investments or is merely looking to deploy capital.

He also checks if the funds have experienced teams to manage and recover value from troubled investments.

Overall, while additional collateral or guarantees can make private credit seem safer, the real value exists in the fund manager's ability and experience to handle scenarios that turn sour.

“Additional collateral protection or other guarantees need to be weighed against the fund manager’s willingness and experience at debt collection and asset foreclosures,” noted Kam.

ASIA CREDIT

Risks in private credit have re-surfaced this month as US-based private credit lender Prospect Capital Corp came under fire for its frequent use of payment-in-kind arrangements, where borrowers pay interest by taking on more debt, a practice some see as risky.

Additionally, concerns have been raised about Prospect's heavy reliance on individual retail investors for its funding, which could expose the company to vulnerabilities during market downturns.

"It's natural for regulators to worry when an asset class grows quickly and is more opaque than public markets," said Eddie Ong, deputy chief investment officer and managing director of private investments at SeaTown Holdings International.

Singapore-based SeaTown is owned by Temasek’s asset management group, Seviora, and specialises in alternative investments.

Ong believes that private credit in Asia, where there are more highly customised deal structures, investment assessments go beyond simple leverage or debt service coverage ratios.

Downside protection mechanisms and third-party guarantees can be instrumental in determining credit worthiness.

Ong also highlighted that emerging Asia Pacific private credit generally offers a return premium of 300-500 basis points over the US or Europe on average.

“This return premium is warranted given that Asia is a heterogeneous market with idiosyncrasies in each market. Deal structures are more bespoke and varied. Access to private debt managers with a strong track record will generally be more difficult compared to US or Europe,” he noted.

Distressed and special-situations private credit strategies typically offer the highest returns due to their equity-like risk profiles.

At times, returns from such strategies are comparable to private equity returns, which may attract investors, Ong said.

However, “the range of realised returns among funds in this category can vary widely,” he said.

“We are seeing increasing interest in a performing Asian private credit strategy from global investors who have traditionally deployed in developed market credit strategies."