Private credit under pressure – growth, risks and regulatory challenges shaping the landscape in Australia

Under the spotlight

Since non-bank lending emerged after the global financial crisis of 2008, the sector has grown from an alternative source of capital for smaller businesses and startups who may be under-served by traditional banks, to providing capital solutions for corporate businesses, real estate and infrastructure projects.

Regulation has struggled to keep pace with the rapid growth of the sector. While non-bank lenders are subject to financial services licensing, anti-money laundering and consumer protection laws, they are not as closely regulated as the traditional banking sector.

This is now changing with regulatory scrutiny of private credit increasing globally, including in Australia where ASIC said it will be addressing the build-up of risks and would pursue private credit funds who it suspects are breaking the law.

A previous ASIC report, published in September, concedes that private credit has “a valuable role to play in the Australian economy” and notes that funds backed by pension firms, institutional investors and the most reputable private credit managers operating in Australia, typically demonstrate sound governance and transparent valuation and fee practices.

However, it also highlights concerns about “segments of the market targeting wholesale investors” who, it says, “have practices that do not compare favourably against international practice”.

Specifically, the report identifies practices in four main areas, which will require significant improvement if trust and confidence in the sector is to be maintained:

• Conflicts of interest across fee structures, valuations, related party transactions and loan structuring
• Opaque and unquantified fee and remuneration structures
• Inconsistent valuation practices and portfolio disclosures
• Inconsistent definitions of key terms, including rating methodologies and the basis for loan-to-value ratios (LVRs)

Following both ASIC reports on the Australian private credit sector, market participants should anticipate increased regulatory oversight. They should therefore re-consider the scope of existing insurance protection in place for professional indemnity (PI) and directors’ and officers’ (D&O) risks.

Risks associated with private credit

The Australian financial services sector is one of the most highly regulated territories globally. And now with closer scrutiny, private credit fund managers, trustees, auditors, advisers, valuers, and research and fund rating providers operating in Australia should anticipate increased regulatory and litigation risks.

Lack of transparency around potential conflicts of interest, valuation practices, and definitions of key terms could ultimately result in costly litigation for market participants.

An investment managers insurance (IMI) policy, which typically provides cover for PI, D&O liability and crime, will protect funds against many of the risks arising from regulatory enforcement and litigation.

While PI insurance is mandatory for lenders in Australia, private credit firms don’t always invest in the full IMI product suite, despite having significant D&O exposures in the event of insolvency and subsequent investor litigation.

Indeed, there have already been instances of Australian IMI policies responding to investor claims involving misleading LVR representations, flawed valuations and conflicts of interest, highlighting the value of the cover and the importance of precise policy wordings.

They can also help to interpret policy wordings in light of emerging risks and regulatory developments and offer clear guidance on scope of coverage, exclusions, suitable limits and claims processes.

For example, with the historically high insolvency risk in Australia’s construction sector, funds need clarity on whether insolvency risks are covered or not, as they are commonly excluded from IMI policies.

Similarly, while regulatory compliance in Australia requires a minimum AUD2 million of PI coverage for private credit lenders, companies sticking to the statutory minimum are unlikely to have policy limits commensurate with the size of their business and risk exposures and may require advice on buying additional limit.

While buyers can currently benefit from a highly competitive market for PI and D&O cover, simply pursuing rate to reduce premium spend may not be the most effective strategy.

Brokers and insurance buyers would do well to explore the scope of coverage available and the potential for increasing limits in line with their exposures.