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A ratings agency has identified 14 issues in private credit and indicated it will increase its monitoring of the sector.
Ratings agency SQM Research has put the private credit sector ‘on watch’, in response to “increased instances of issues observed” as well as recent scrutiny from the financial services regulators.
SQM Research has covered the private sector since 2007 and has credit ratings on around 70 private credit funds – both retail and wholesale – representing approximately $33 billion of funds under management.
Fund managers use the ratings issued by SQM Research to attract interest and raise money from investors.
This new status will see the agency increase active monitoring of the sector. SQM Research also said it would adjust its rating scoresheet to place a greater emphasis on governance and increase the initial due diligence screening prior to a formal review.
The agency said it expects the bulk of its ratings to be unaffected by the change in status, but it wouldn’t rule out some funds being downgraded or discontinued over the next 12 months.
Louis Christopher, SQM Research managing director, said: “We are taking this precautionary measure in response to increased issues observed in the sector and in response to recent announcements by our financial sector regulators.
“This action doesn’t necessarily mean that a fund rated by SQM will be automatically downgraded or placed on hold. However, it is viewed as a necessary step to ensure appropriate oversight of an asset class that has been growing in relevance and size over recent years.”
Observed issues
In explaining its decision to put the sector on watch, SQM outlined 14 issues it had observed “with increasing frequency”.
These issues are as follows:
- Questionable categorisation of asset holdings (illiquid/liquid/fixed income/convertible equity/equity).
- Lack of transparency on sub-fund holdings.
- Lack of transparency on group financials.
- Highly leveraged balance sheets.
- Overall inadequate disclosure within information memorandums.
- Information memorandums that give too much latitude to the manager in terms of asset allocation weights.
- Elevated loan-to-value ratios, calculated on end-of-completion developments.
- Vertical and horizontal-related party structures (same trustee, responsible entity, custodian, development/real estate agency divisions attached) that may give rise to a conflict of interest.
- Increased loan arrears and an increasing frequency of refinancing of existing loans that were scheduled to be exited.
- Sizeable interest rate margins not being passed on to investors.
- Lack of independence at board/investment committee level.
- Dubious marketing strategies involving advisers.
- An increasing number of products being offered with a mismatch between stated liquidity and the underlying liquidity of the loan assets.
Christopher also highlighted regulator criticism of the private credit sector in recent months.
“As our financial regulators have stated in recent months, there is a clear link between weak governance and poor outcomes for investors,” Christopher said.
“And so, while we have throughout our ratings research history, placed an emphasis on fund governance, we are determined more than ever to reduce the risks for investors by taking an increasingly cautious approach to potential governance issues.”
However, Christopher also said SQM Research was not aware of any “imminent event” that may trigger fund failures and that the expectation was that the sector would weather current challenges.
“The private markets sector has a positive future in front of it as there are genuine opportunities for investors,” Christopher said.
“What we are observing to date is nothing like what was experienced back in 2008 when a large number of mortgage trusts were forced into redemption suspensions. However, I think the risks within the sector have increased in recent times and so increased diligence is required.”
Sector under scrutiny
SQM Research’s update follows warnings from the Australian Securities and Investments Commission (ASIC) issued earlier this year.
In a discussion paper, the watchdog warned failures are on the horizon and at current volumes, it is untested by prior crises.
ASIC said that growth in private credit has been an area of particular interest globally and is at historically high levels in Australia but subject to less regulatory oversight compared to private equity and leveraged loans.
The regulatory body said: “This combination of risk factors is untested in historic stress scenarios making it critical that regulators and participants understand the associated risks.”
[Related links: ASIC warns ‘failures are on the horizon’ for private credit market]
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