For several years, I’ve had an interesting conversation repeated to me by high-net-worth investors and family offices. They love private credit. And I understand why.
The proposition has been compelling: attractive income, first-mortgage security, professional fund management and returns that traditional fixed income hasn’t always been able to provide.
For much of the past decade, it has worked exceptionally well. Capital has poured into the sector. Fund managers have grown rapidly. Developers have found an increasingly important source of capital outside the traditional banking system, while investors have enjoyed attractive distributions.
But every investment strategy ultimately needs to experience a difficult market before we really understand its risks. Australia’s private credit industry may now be encountering that moment.
Following the collapse of Bathla Group, the bankruptcy of Jon Adgemis and liquidity restrictions across a number of funds, ASIC has described what is occurring as the first significant cracks appearing in an industry facing its first real test.
That doesn’t mean private credit is broken. Far from it. Private credit performs an enormously important function in the Australian economy and many of its best managers have built excellent businesses.
But it does mean investors should be asking more questions.
THE REGULATOR WAS ASKING QUESTIONS BEFORE BATHLA
What makes the current situation particularly interesting is that regulatory concerns about private credit didn’t begin with Bathla. ASIC had already identified opacity, valuation uncertainty, conflicts of interest, illiquidity and leverage among the key risks requiring attention in private markets. Its detailed review of Australian private credit subsequently raised questions around transparency, valuations, liquidity, conflicts and investor understanding.
One observation deserves particular attention:
“Their fee structures also have potential to create conflicts of interest for managers.”
That is an important statement from Australia’s corporate regulator.
Because one of the questions investors should now be asking isn’t simply: How much am I earning? It is:
How is everyone involved in originating and managing my investment being paid?
If a manager receives establishment fees, management fees, interest margins or other transaction-related income, investors should understand whether those incentives could encourage capital deployment.
Does the manager primarily benefit from protecting capital?
Does the manager also benefit from writing more loans?
And how does that influence decision-making when competition amongst lenders becomes intense?
None of that implies misconduct. But incentives matter in every investment market. And since Bathla entered administration, ASIC’s language has become even more direct.
Appearing before Federal Parliament on 4 September, ASIC Chair Sarah Court said there had been several “troubling developments” in private credit, most notably the collapse of Bathla.
She also made an extraordinary observation: “Currently there is a lack of information and insight into wholesale private credit funds.” ASIC says the level of information available in Australia is well below that available in comparable jurisdictions such as the United States and United Kingdom. The regulator says recent developments reinforce the need for strong governance, effective oversight, accurate valuations and clearer disclosure. That should matter to investors. You cannot properly price a risk you cannot properly see.
WHAT DOES “FIRST MORTGAGE” REALLY TELL US?
I’ve heard the phrase repeatedly from sophisticated private investors: “We’re comfortable because we’re in a first mortgage position.”
A first mortgage is undoubtedly an important protection. But it isn’t a guarantee against losing money. ASIC itself has highlighted the need for clearer and more consistent use of terms including “security”, “loan to value ratio”, “senior debt” and “investment grade”.
Ultimately, security is only as valuable as the asset sitting underneath it. A 60 per cent LVR based upon an independent valuation of an established, income-producing asset can represent something very different from a 60 per cent LVR calculated against assumptions surrounding the future value of a development.
Valuations move. Construction costs move. Presales disappear. Interest capitalises. Projects are delayed. And equity cushions can erode.
The words “first mortgage” therefore shouldn’t end an investor’s due diligence. They should begin it.
THE RBA IDENTIFIES THE ELEPHANT IN THE ROOM: VISIBILITY
Reserve Bank Governor Michele Bullock recently summarised one of the fundamental challenges beautifully: “People don’t know where the leverage is.” She continued: “They don’t know who is exposed.”
And that may be the most important issue of all.
Private credit isn’t inherently dangerous because it is private. But the less visible a market becomes, the harder it is for investors and regulators to understand where risk is accumulating. The RBA itself has said that limited visibility of activity in private markets restricts regulators’ ability to assess and respond to emerging risks in a timely way. Interestingly, the RBA remains measured about the systemic implications. That position hasn’t changed following Bathla. Asked directly at the AFR Property Summit on 8 September whether the Bathla situation could snowball into something larger, RBA Assistant Governor Sarah Hunter said the Bank was monitoring private credit closely because of its rapid growth. But she also said: “We don’t at the moment see systemic signs of stress.” And, more specifically in relation to Bathla: “Right now, from our perspective, we don’t see a systemic risk.”
That distinction matters enormously.
A problem doesn’t need to threaten Australia’s financial system to cause significant losses for individual investors. Systemic risk and investment risk are two very different things.
THEN CAME BATHLA
The Bathla situation provides a fascinating case study. When the group initially entered administration, reports suggested approximately 40 private-credit lenders and funds had exposure, with individual exposures ranging from relatively modest amounts to hundreds of millions of dollars.
But as the administration has progressed, the scale has become considerably clearer. At Bathla’s first creditors’ meeting on 4 September, administrators Teneo disclosed approximately $3.4 billion of known liabilities. Around $3.1 billion was owed to secured lenders.
The group also reportedly owed approximately $145 million to the Australian Taxation Office, $42 million in land tax and around $130 million to other unsecured creditors.
Think about that for a moment.
Dozens of professional lenders can independently conduct their own due diligence and still end up exposed to the same underlying borrower group. Perhaps one of the confronting lessons from Bathla is that 40 independent lending decisions do not necessarily result in diversification.
They can still produce an enormous concentration of capital around the same underlying economic risk. That doesn’t necessarily mean those individual lending decisions were wrong. Different lenders may hold security over different projects, at different LVRs, with different guarantees and vastly different recovery prospects. Some may recover every dollar. Others may not.
But it raises a legitimate question: How did such enormous aggregate leverage build across one group without the wider market having a clearer understanding of the total exposure?
Problems involving billions of dollars rarely materialise overnight. They generally accumulate. Which brings us back to transparency. $4.9 billion of property against $3.4 billion of debt sounds comfortable. But is it?
This is where the Bathla situation gets particularly interesting.
Administrators have reportedly identified preliminary stated values of approximately $4.9 billion across Bathla’s property holdings. Against approximately $3.4 billion of known liabilities, that might initially sound reassuring. But property investors should immediately understand the problem with looking at those two numbers in isolation.
A valuation is not cash. It is not necessarily a sale price. And it isn’t necessarily equity available to every creditor. The underlying properties are financed through different entities, against different projects, by different lenders.
A lender secured against one Bathla development doesn’t necessarily have access to equity sitting inside another. There may be construction costs required to complete projects. There may be selling costs. There may be senior and subordinated claims. There may be taxes, outstanding contractors and other creditors. And importantly, the valuations themselves need to be tested in the market.
This is almost a live demonstration of why an LVR viewed in isolation never tells the entire story. Value is important. But so is where that value sits, who controls it, what sits ahead of you and how readily it can be realised.
BATHLA IS ALSO TEACHING US SOMETHING ABOUT SECURITY
Another fascinating development occurred this week. Bathla’s administrators secured a temporary funding arrangement of approximately $3 million to $5 million from five lenders to allow limited operations to continue. But the money was not simply provided to Bathla generally.
Construction could continue on projects associated with the participating lenders. Projects associated with lenders who did not participate were suspended. Approximately 213 employees were subsequently stood down, with construction reportedly continuing on only around 14 sites.
That distinction matters.
Bathla isn’t simply one borrower with one pool of assets and 40 lenders sitting neatly alongside one another. It is an enormously complicated collection of projects, special-purpose entities, lenders, securities and priorities. And this brings us back to the phrase: “first mortgage secured.”
First mortgage over what? What is the property worth today? What will it cost to finish? What other liabilities exist within that project? How much capitalised interest is accumulating? How quickly could the asset actually be sold? And what happens to its value if dozens of similar projects need to be sold at the same time?
Those questions matter considerably more than the label sitting on the investment memorandum.
LIQUIDITY IS EASY UNTIL EVERYBODY WANTS IT
The other lesson now emerging involves liquidity. CVS Lane recently temporarily suspended applications and redemptions across two funds while it assessed uncertainty surrounding the Bathla administration.
Its explanation was reasonable: “The funds’ redemption provisions are designed to balance investor liquidity with the interests of all investors in the funds.” The trustee said the temporary suspension was in investors’ collective best interests while it obtained better information.
MA Financial, which said the relevant action was unrelated to any Bathla exposure, introduced temporary redemption limits. Joint chief executive Chris Wyke described this as: “a proactive measure in response to the potential for increased redemption activity”.
Again, there can be entirely legitimate reasons for gating redemptions. If a fund holds illiquid loans and investors suddenly demand their capital simultaneously, forcing the manager to rapidly realise assets could materially disadvantage the investors who remain.
But it reveals something investors should never forget: Liquidity at the fund level ultimately depends upon liquidity underneath the fund.
A development loan secured against land, a half-completed apartment project or an asset requiring a workout cannot necessarily be converted into cash because an investor would like their money returned next Tuesday.
And perhaps the most interesting aspect of the current situation is that liquidity pressure doesn’t necessarily remain confined to funds directly exposed to a troubled borrower.
Investor psychology can change across an entire asset class. The Financial Times reported that Bathla’s collapse had begun affecting investor sentiment more broadly, including funds without direct Bathla exposure, as investors reassessed the risks surrounding Australian private credit.
That is when the difference between the liquidity investors believe they possess and the liquidity embedded in the underlying assets becomes visible.
EVEN THE INDUSTRY ACKNOWLEDGES STANDARDS NEED TO IMPROVE
Perhaps one of the most telling developments has come from the Financial Services Council itself. The FSC has introduced new standards for private markets and private credit. Its CEO Blake Briggs acknowledged that: “rapid growth in the private markets sector has created inconsistent practices”.
That’s important. It demonstrates that scrutiny of private credit isn’t simply coming from critics of the industry. The industry itself recognises that rapid growth requires stronger and more consistent practices. And that is probably healthy.
Private credit has an important role to play in Australia’s economy. The best managers may actually emerge from this period considerably stronger. Investors may become more discerning. Managers may become more transparent. Underwriting disciplines may improve. Weak structures may disappear.
And capital may increasingly move toward the managers who can demonstrate genuine experience managing loans through difficult markets rather than simply originating them during good ones.
AND PERHAPS “BORING” DESERVES ANOTHER LOOK
Which brings me back to something I’ve spent most of my working life around. Bricks and mortar.
Direct commercial property isn’t fashionable. It doesn’t sound particularly innovative.
It’s illiquid. Buying it properly requires considerable due diligence, active management and patience. But perhaps those characteristics are precisely why certain investors may start looking at it differently again.
Consider the simplicity of owning an established commercial property.
There is a physical asset.
You know what you paid.
You can walk through it.
You know who occupies it.
You can investigate the tenant’s business.
You know the rent.
You know the lease expiry.
You know the rent-review mechanism.
You can see surrounding supply.
You can monitor competing properties.
And every month, you know whether the rent arrived.
That doesn’t eliminate risk.
Property values fall.
Tenants fail.
Buildings become obsolete.
Debt can destroy equity in direct property just as effectively as anywhere else.
And buying the wrong property at the wrong price can produce disastrous outcomes.
But there is a fundamental distinction: You can see what you own.
VISIBILITY MAY BECOME INCREASINGLY VALUABLE
Maybe the debate shouldn’t therefore be framed as private credit versus commercial property. Perhaps it is about something more fundamental: Complexity versus visibility.
There is something incredibly powerful about owning a quality piece of real estate occupied by a sustainable business capable of paying sustainable rent. If that business grows, the rent can grow. If the rent compounds over many years, the income stream compounds with it.
Consider an asset generating $1 million of annual rent.
At 3.5 per cent annual rental growth, that income becomes approximately $1.41 million after ten years.
Nothing revolutionary happened.
There wasn’t a new financial product.
There wasn’t financial engineering.
The tenant continued operating.
The rent continued increasing.
And time did the heavy lifting.
That is both the beauty and the boredom of quality commercial property.
Perhaps the premium investors have been prepared to place on liquidity and financial sophistication also deserves to be considered alongside something much harder to quantify: the value of transparency.
THIS ISN’T THE END OF PRIVATE CREDIT
I don’t believe private credit is disappearing. Nor should it.
It provides capital where traditional lenders sometimes can’t or won’t. It facilitates development, business investment and economic activity. And Australia’s strongest private-credit managers will probably use the lessons from this period to improve their businesses.
The RBA itself isn’t predicting systemic disaster. But investor psychology can change remarkably quickly. For years, many private investors and family offices have been attracted by the combination of double-digit returns, mortgage security and periodic liquidity.
Now they may start asking harder questions.
Not simply: What is my return? But:
Who is my borrower?
What exactly is my security?
What is the real LVR?
How was the valuation determined?
What other debt exists?
How much exposure does the manager have to the same borrower?
How much exposure exists across the wider market?
What fees is the manager earning?
What happens if the loan isn’t repaid on time?
And what happens if I want my money back at exactly the same time as everybody else?
Those aren’t arguments against private credit. They are arguments for understanding it.
And alongside changing tax settings and increasing regulatory scrutiny, that could cause investors to reconsider how they allocate capital. Not necessarily out of private credit. But perhaps back towards direct ownership of assets they can see and understand.
A quality physical asset.
A quality tenant.
A sustainable rent.
Sensible leverage.
And time.
Perhaps the lesson from the first real test of Australian private credit isn’t that investors should avoid illiquidity.
It’s that if you’re going to own something illiquid, you should understand exactly what you own.
Until next time,
Mark Wizel