Private Credit in Australia: The ‘Wild West’ of Finance

The private credit market in Australia has surged in recent years, as non-bank lenders fill the gaps left by traditional banks, especially in riskier sectors like commercial property and small to medium-sized businesses. However, with the boom has come rising concerns about poor governance, lax regulation, and potential risks for investors. One project in particular, the ambitious Halo tower in Sydney’s CBD, highlights the growing troubles in the sector.

The Halo Project: A Cautionary Tale

The Halo development, a proposed 55-storey tower in Sydney’s bustling Hunter and Pitt Streets, was meant to be a high-profile success. Backed by a loan worth nearly half a billion dollars arranged by Merricks Capital, it had all the makings of a winner. Located in Sydney’s commercial heart, close to a transport hub, with a sustainable timber design and an environmentally-conscious focus, it seemed like a sound investment.

But over a year later, construction has yet to begin. Developer Milligan has struggled to secure investors, and the project’s $1.8 billion valuation is now under scrutiny. Even Lendlease, previously mentioned as a potential owner, has distanced itself from the project. Factors like depressed commercial property values, working-from-home trends, and skyrocketing construction costs have exposed cracks in what once seemed like a prime investment opportunity.

Merricks Capital, which loaned a significant portion of the funds for the project, has had to mark down its loan and extend its terms. As a result, Merricks' flagship $1.2 billion fund posted its first monthly negative return in nearly five years. Despite reassurances from Merricks, including claims that demolition would begin soon, doubts continue to hang over the project.

A Market Rife with Risk

Private credit has flourished in the wake of the 2018 banking royal commission, which saw Australian banks retreat from lending to more speculative or risky ventures. The market quickly expanded, with non-bank lenders filling the void. Sectors such as commercial real estate, hospitality, and small businesses – areas banks deemed too high-risk – became the target customers of private credit firms.

However, the rapid growth has exposed deep flaws in the industry. Many of the players entering the market have limited experience in managing distressed loans. As a result, problems are becoming more frequent. According to Mark Robinson, a liquidator with Fort Restructuring, there has been a noticeable uptick in distressed loans recently, with many lenders scrambling to extend loan terms rather than face potential losses.

Conflicts and Lack of Oversight

Private credit firms like Property Investory, led by Tyronne Shum, illustrate the challenges facing the sector. Shum, a popular YouTuber and podcaster, has used his platform to arrange loans and pitch them to investors. However, concerns have emerged about the quality of vetting for borrowers and the lack of financial exposure for firms like Property Investory, which merely act as intermediaries between investors and loan opportunities. One investor, a blue-collar worker who invested in a hospitality property deal, voiced frustration over a lack of transparency about the borrower’s financial issues. In such cases, investors are left in the dark with little recourse to recover their money.

This situation is emblematic of a larger corporate governance problem in the private credit sector. With minimal regulation and oversight, there’s no certainty about the true size of the market. While the Reserve Bank estimates the private credit sector at $40 billion, other estimates place it anywhere between $1.8 billion and $188 billion. The lack of transparency and poor governance practices raise alarms, especially with retail investors increasingly exposed to these high-risk investments via their superannuation.

The 'Pretend and Extend' Problem

A troubling trend among private credit firms is the practice of “pretend and extend.” This refers to lenders offering extensions on loans instead of reporting losses, essentially pushing the issue down the road. While some firms are adept at refinancing loans, others are simply looking for someone else to take on the risk. This practice, combined with rising fees and complex structures, leaves many investors in the dark about the true financial health of their investments.

Chris Selby, vice chairman of wealth management firm Escala Partners, warns that the lack of regulation, poor asset valuations, and hidden risks are reminiscent of the prelude to the Global Financial Crisis (GFC). In both cases, investors may be exposed to riskier assets than they realise, with potentially disastrous consequences if the market turns.

High Fees and Conflicts of Interest

One of the more controversial aspects of private credit is the high fees charged by many firms. These fees are often hidden within complex loan structures, meaning investors don’t always see how much the firms are profiting. Some firms charge exorbitant fees for loan origination, while others profit from refinancing deals rather than ensuring loans are repaid.

Conflicts of interest are also common. For example, at Melbourne-based Millbrook Group, Colin Robinson, head of credit, also serves as a broker through his other business, Lugero Property. He has been involved in bringing loan opportunities to Millbrook, raising questions about potential conflicts in the decision-making process. While Millbrook has denied any wrongdoing, claiming a clear policy on such matters, concerns about transparency persist.

Looking Ahead: Increased Scrutiny and Regulation

In response to these growing concerns, the Australian Securities and Investments Commission (ASIC) has signalled its intention to increase scrutiny of the private credit sector. ASIC’s recent report on private markets highlighted the lack of reliable data on the size of the market and warned of the growing risks to retail investors. ASIC has committed to examining governance, valuation practices, and credit risk management more closely.

The regulator’s involvement is timely, as there is growing recognition that the private credit market is operating in an unregulated environment reminiscent of the pre-GFC era. The sector’s rapid growth, coupled with its lack of oversight, has left many investors vulnerable to the whims of unaccountable firms and ill-managed risks.

Conclusion: The Wild West of Finance

As the private credit market in Australia continues to boom, investors are urged to be cautious. The sector is rife with risks—poor governance, lack of transparency, rising fees, and potential conflicts of interest. While private credit offers high returns, it also carries substantial risks, especially as distressed loans and troubled projects, like the Halo tower, continue to emerge. With ASIC stepping up its scrutiny of the sector, the future of private credit in Australia may depend on tighter regulation and more transparency.

For now, though, many in the sector are still operating in what can only be described as the ‘Wild West’ of finance—where high rewards are often tempered by equally high risks. Investors must tread carefully and ensure they have a clear understanding of the risks involved before diving in.

Source: Commercialrealestate