ROADNIGHT MUSING – AUGUST 2024

IT FEELS GOOD TO BE LOVED!
ROADNIGHT’S OBSERVATIONS ON PRIVATE CREDIT

It feels good to be loved! After years of explaining to anyone and everyone who would listen to what private credit is, it seems like now, everywhere you look, someone is commenting on private credit. Not wanting to be left out now that we have an audience, we wanted to provide our observations on where private credit sits and how we see it developing. 

WHERE DOES PRIVATE CREDIT SIT TODAY IN AUSTRALIA?

Private credit in Australia is a relatively new investment class that non-institutional investors can access that is seeking to show that it should be treated as a real investment class, like fixed income or bonds, where non-institutional investors should have an allocation of their capital.

For that to be the case, private credit needs to show investors that:

> It is a permanent opportunity that is not going away

> Those managing investors’ capital are “good stewards”. To Roadnight, this means:

• Do managers have a strong, robust investment process?; and

• Will investors ultimately receive strong risk-adjusted returns after all costs?

PRIVATE CREDIT IN AUSTRALIA IS AN INCREASING PART OF THE CREDIT MARKETS

In this initial phase, investors are focused on whether the market is big enough and the returns sufficient to deploy capital.

Roadnight believes this phase has been established in Australia generally and across various subsegments of private credit (such as property, corporate, securitisation, and the like). Australia is simply following the taillights of the US, which has a well-established and deep private credit market. The evidence of the rise of private credit is seen from the growth in credit generally relative to the increase in the credit provided by banks over the last decade. APRA’s continuing tightening of solvency requirements means that this trend towards more private credit is unlikely to change.

As private credit is generally not geared, while the banks are leveraged more than 8x, private credit growth paradoxically reduces the total system leverage.

INVESTORS FOCUS IS SHIFTING TO WHO THEY SHOULD INVEST WITH

As a result, investors are increasingly focused on assessing whether private credit managers are “good stewards”. The challenge here is investors' lack of experience in understanding what differentiates a good or great private credit manager from an inadequate manager. 

You can see this in the commentary about private credit as it is focused on highlighting the potential red flags associated with private credit managers including:

• Limited experience

• Unclear investment process

• Lack of transparency on fees and effective fee take

• Limited reporting

• Investment valuation

This shift in focus is good for both the Australian private credit industry and investors, as it will result in market participants lifting their game or being forced to merge or close.

SO, WHAT IS ROADNIGHT’S APPROACH TO PRIVATE CREDIT INVESTING?

The Roadnight team primarily has a family office / direct investing background. As a result, our philosophy is that we partner with our investors in seeking strong risk-adjusted returns when deploying capital.

In practice, this means:

• We risk rate all our investments: We risk rate every investment we assess using our internal risk rating model. Our risk rating is our version of a credit rating provided by S&P or Moody’s. The risk rating does not determine if an investment should be made. Rather, using objective criteria, it is used to assess the level of risk and compare the potential investment to similar risks in the public markets and to assess if it generates a superior return to similar risks elsewhere. Very simply, if we can’t get a substantial excess return for a given level of risk, we won’t invest. This approach is very different from other private credit managers who don’t risk rate their investments. We estimate that after fees, we are generating 350 basis points in excess spread compared to returns available on equivalent risk elsewhere.

• We are invested in our funds on the same terms as everyone else: The advisory board and executives of Roadnight have  their own money invested in our funds, and we pay the same fees (with no rebates) as all other investors.

• Our fees are set for alignment of interests: We do this by:

  • All fees related to a transaction are passed onto the Fund

  • No double dipping on fees. If an investment in which the Fund holds a stake is held in an SPV we do not charge fees at both the Fund and SPV level

  • Clearly detail what fees we take. In our main fund, the Roadnight Capital Diversified Income Fund (DIF) we take:

    • Flat management fee of 1.50% p.a. of gross assets. We do not believe including an incentive fee is appropriate for an open ended fund

    • Where there is a specific loan monitoring fee that fee is passed on

    • In the rare case where a fund gets warrants as part of a transaction, it shares the warrants with Roadnight, which vest only once the investment is fully repaid. To date, only one loan out of 60 loans has had warrants attached.

• Valuation of Fund investments: Like other private asset classes (property, private equity, and the like), our valuation approach follows a similar path—determining cash flows, capital value, recoverability, and potential impairment and reviewing it with an auditor.

  Where we are different from other funds in that, as part of our approach to valuation, we have built up a general loss provision, which reduces the value of DIF’s investments. As a result, our approach (while probably less sophisticated) is similar to how banks value their directly originated loans. At the end of July, the provision was more than 3.5% of DIF’s investments.

  Including a provision is very unusual for a private credit fund and recognises that while we don’t seek to write loans where capital is impaired in an uncertain world this can occur, so we aim to build up a safety net to allow for this possibility.

WHAT DOES THIS MEAN GOING FORWARD?

Roadnight believes that over the next couple of years, we will see a standardisation of private credit fund terms, reporting, and other similar elements, which will align with our approach. 

This does not mean that our approach or the information reported will remain static or unchanged. For instance, two years ago we implemented a loan management system on which all investments are maintained. This system allows us to provide more detailed information and reporting than previously available. As the portfolio grows and the number of loans exceeds 40 (currently 28), we expect to use this information to provide investors with a more detailed snapshot of DIF.