SQM places private credit on watch amid mounting risks

SQM Research has placed the private credit sector on watch amid growing concerns over governance and transparency issues, as well as recent regulatory scrutiny from ASIC and APRA.

SQM Research has put the private credit sector on watch – essentially flagging that it will increase its ongoing monitoring of the sector and has “made adjustments to its ratings scoresheet to place a greater weighting towards governance factors”.

While SQM Research expects most existing ratings to remain unaffected by the watch, it said that some funds may still face downgrades or discontinuation over the next 12 months.

SQM Research managing director Louis Christopher said the ratings house was taking a “precautionary measure”, which it views as a “necessary step” to ensure “appropriate oversight” of an asset class that has been growing in relevance and size over recent years.

Christopher, however, said SQM Research sees no imminent risk of fund failures and expects the sector to withstand current challenges, with strong future opportunities for investors.

“It must be stated there is no imminent event that SQM Research is aware of that may trigger a series of fund failures and that overall, SQM Research expects the sector to weather current challenges,” Christopher said.

“The private markets sector has a positive future in front of it as there are genuine opportunities for investors.

“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.”

According to SQM, the change in stance was driven by an increase in issues that it has observed and recent statements from both the corporate and prudential regulators.

Namely, ASIC last month published a paper ​raising concerns about the rapid growth and opacity of private markets, emphasising the need for enhanced oversight as superannuation funds increasingly allocate capital to this sector.

On private credit in particular, the regulator said that while it currently makes up a small part of the Australian economy, speculation suggests it could be the source of the next financial crisis.

“We, at ASIC, anticipate more failures in some private credit investments and Australian investors will lose money, that’s why ASIC is increasing its focus on private credit,” said ASIC commissioner Simone Constant at the time.

Constant said that as part of its ongoing private credit surveillance, ASIC is focusing on “fund governance, valuation practices, accuracy of statements, management of conflicts of interest and fair treatment of investors”, with an update due later this year.

Interestingly, SQM’s move comes just days after reports that Count Financial had recommended its advisers to exit three Metrics Credit Partners funds. The $22 billion non-bank lender subsequently pushed back on the news, saying it does not understand the reasoning behind the decision.

However, the decision raised eyebrows, given Lonsec’s Highly Recommended rating on the Metrics Direct Income Fund and claims that Count made the call without meeting with Metrics.

In a comment to Super Review sister brand InvestorDaily, Count said the information published by The Australian Financial Review was sourced from a confidential email that was shared with its adviser network. Count’s policy, however, is not to publicly comment on its investment and research decisions.

SQM flags multiple issues

SQM currently has ratings on about 70 private credit funds across both the wholesale and retail space that represent around $33 billion in funds under management, which it said makes it the “largest researcher of private credit funds” in Australia.

According to the ratings house, the issues it has observed are “not endemic within the sector”; however, they are more frequent within wholesale funds and newer fund products offered to the market.

In fact, over the past 12 months, SQM Research has screened out around 20 private credit fund offerings, mostly in the wholesale sector.

Among the issues the research house said it has observed are:

- Lack of transparency on who borrowers actually are, on sub-fund holdings and on group financials.

- Questionable categorisation of asset holdings (illiquid/liquid/fixed income/convertible equity/equity).

- 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.

- 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 onto 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.

“We have an expectation that wholesale funds provide the same transparency as retail funds,” Christopher said.

“On that front, there is no question there has been a rapid increase on wholesale fund offerings which we think has been driven, in part, by a rapid increase in the number of Australians who now qualify as a sophisticated wholesale investor/high-net-worth individual; the threshold of which is still set at $2.5 million in net assets or a gross income of $250,000 per annum.

“As our financial regulators have stated in recent months, there is a clear link between weak governance and poor outcomes for investors.”

This, the MD said, has led to SQM to put an even greater emphasis on reducing the risks for investors through an increasingly “cautious approach to potential governance issues”.