What We’re Watching: Watching the flows

Regulators have been focussed on private credit markets for some time but the pace of action is on the increase and becoming more specific. Investors need to watch fund flows closely to assess who is most at risk from being impacted by the increased scrutiny of the private credit market.

As many of regular readers will know, we have been highlighting the growing need for the private lending sector in Australia to lift its game when it comes to governance issues for many years.

We firmly believe private credit, done the right way, has an important role to play in providing an income producing, capital stable alternative to the traditional 60/40 portfolio. Encouragingly, so does ASIC, “if done well”. However if standards do not improve there is a risk that investors lose confidence in the entire sector due to a fund suspension, an unexpected loss of capital or more likely, a combination of both, resulting in significant losses for investors.

In this piece we share our perspectives on recent events.

ASIC takes action on TMDs

The news last week regarding ASIC’s focus on inappropriate Target Market Determination statements has put the whole industry on notice. A key focus for the regulator appears to be around what constitutes an appropriate product use of a fund comprising significant allocations to private credit/mortgages –guiding to a core allocation 50% or higher is appears to be too high in the view of the regulator. There are also questions regarding distribution conditions, the main thrust of which appears to be whether it is appropriate for investors to invest directly into private credit/mortgage funds without going through a third party distributor (i.e. platform/financial advisor) or having some confirmation that the investor complies with the TMD.

The question around distribution conditions is a critical one where a manager has a large exposure to customers acquired directly rather than via an advisor. All investors will have to consider the implications as second derivative impacts of shutting off a channel of flows could result in large and unpredictable changes in FUM and in the worst case, potential for fund suspensions.

Over the weekend we have reviewed the TMDs of many strategies with significant allocations to private credit/mortgages. While most suggest minor allocations and have more restrictive distribution conditions than the funds already subject to stop orders, there are a minority of funds that have concentrated strategies and suggest allocations of Core (up to 50%) or Major (up to 75%) with some questionable risk banding.

Retail consultants are already acting and requesting that managers review their TMDs for appropriateness.

ASIC Review into Private Markets

On Monday ASIC released a progress update on its investigation into private markets. Positively, they continue to be aligned with our position that private markets have a role to play but only when “done well”. With respect to private credit, ASIC’s release did not include any actions, regulations or requirements but included more specific guidance for managers which seem to be pre-empting future regulation. These include:

Remuneration and fee structures (i.e. including fees paid directly to managers);
Related party transactions including lending to related parties, holding debt and equity in the same entity via the fund and transferring investments between funds managed by the same manager;
Valuation practices including recognition of impairments and the methodology around valuations;
Liquidity reporting as well as detailing how liquidity is facilitated and addressing liquidity mismatch risk;
Definitions and key terms- improving consistent use of terms including investment grade, security, LTV and senior debt; and
Concentration of risk in key sectors particularly in real estate, especially for retail investors.

ASIC also warned that as part of their surveillance of the sector they have found that some of the poorer practices do not align with financial services law and ASIC guidance. They tied this comment back to the stop orders on TMDs for several retail private credit funds but also called out that enforcement investigations were already underway for instances of more egregious conduct. This latter comment is somewhat cryptic and could refer to the ongoing investigations into First Guardian and Shield or to other investigations that are already underway but have not been publicly disclosed.

Next steps

The most immediate focus for investors and managers should be around retail fund TMDs. We will get more information over time including stop orders being potentially lifted and new stop orders being announced. Both will provide more information for investors to assess.

The longer the stop orders stay in place, the more damaging the implications. If rectification is required, it will take time. Changing distribution conditions is not a trivial exercise, nor is ensuring that your existing investors comply with the new TMD conditions (should this be required). Some investors may redeem first and ask questions later, creating liquidity risks within these funds.

The next area of focus should be trying to determine which funds are more impacted by ASIC’s more specific guidance and which funds are most likely to be subject to ASIC investigation. This can be asked directly of the manager (ie. “when was your last contact with ASIC”, “was it part of an industry review or specific to you”, etc.) but also gleaned from mapping the ASIC report to the practices of the manager. Clearly funds with retail investors (especially unadvised), high exposure to real estate and a history of engaging in related party transactions of the type described by ASIC are squarely in the cross hairs.

As above, some investors may redeem first and ask questions later. Consultants of course will be asking the same questions of managers and the challenge for all investors will be assessing new information as it emerges but also predicting the actions of other investors in the funds and the consultants themselves.

This is the real risk we think investors should be watching. If funds with poor governance practices start to receive outflows this limits their ability to manage problem assets and in more stressed cases may force them to liquidate assets at valuations well below where those investments are being carried. Ongoing issues such as stop orders can even limit the ability of the manager to originate quality assets as borrowers will become more discerning about which private lending platforms they choose to deal with. ASIC scrutiny on real estate construction lending could exacerbate the significant existing challenges the sector is already facing.

In short – watch the flows

These recent actions are not thegame changers some may be hoping for but nor is it the final step in the road. We expect more stop orders and more specific guidance from ASIC in November. Further enforcement actions could be coming as well.

Regulators are walking a fine line. They clearly have observed practices which are not appropriate but if they are too forward in calling these out, they risk a disorderly unwind which will surely lead to losses for investors. But to date investors have been arguably too sanguine about these risks, comforted by the consistency of performance numbers reported by private credit managers.

Nothing that has been released over the past week will immediately impact performance so there is an argument to say that ASIC’s report and the stop orders will be much ado about nothing. Managers will change their practices to adapt to ASICs expectations around better governance practices and the show will go on.

This will necessitate more direct action by regulators who are surely hoping that industry practices shift before they have to force them to. The flows will tell the story. Managers in outflow will be forced to address problem credits, will see good credits refinance and good borrowers go elsewhere, exacerbating performance issues. And if performance starts to suffer, the dam will surely break.

Regulators have been focussed on private credit markets for some time but the pace of action is on the increase and becoming more specific. Investors need to watch fund flows closely to assess who is most at risk from being impacted by the increased scrutiny of the private credit market.

ASIC takes action on TMDs

ASIC Review into Private Markets

Next steps

In short – watch the flows

Further reading