For investors that care about credit quality, the insights into the loan book of Australia’s largest corporate lender, NAB, can provide invaluable insights. Furthermore, the way this lender assesses credit risk sets a benchmark when considering a private credit investment according to Epsilon Direct Lending, a non-bank lender and alternative asset manager, specialising in providing loans.
Last week, NAB, as the largest corporate lender in Australia, revealed that approximately 49% of their $236bn corporate and SME loan portfolio falls within the B+ to BB+ credit rating range, giving investors a glimpse into the credit quality landscape of a regulated bank’s portfolio.
“In the competitive world of private credit funds, loan quality can be a complex puzzle for investors to solve,” says Joe Millward, Founding Partner at Epsilon Direct Lending.
“The distinction between bank loan portfolios and those of private credit funds is a common area of questioning. Given many credit funds frequently note that banks are supposedly withdrawing from corporate lending, investors might draw the conclusion that the credit quality within these funds will be similar to the banks that are departing. The reality is somewhat different, with banks actually continuing to grow their corporate loan portfolios as has been highlighted by NAB’s recent results,” he notes.
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“For the regulated banking giants such as NAB who operate under the watchful eye of the Australian Prudential Regulation Authority (APRA), the use of credit models is highly regulated with meticulous oversight and auditing to ensure accuracy and reliability in assessing credit quality.
“Thankfully for investors, the results of these credit models is summarised each reporting season in their Pillar 3 reports.
“However, private credit funds operate in a different realm, unrestricted by the regulatory requirements that govern banks’ use of credit models.
“In this sector, practices diverge, with some funds crafting their proprietary credit models or even using a simple ‘finger in the air’ approach, while others turn to third-party models from leading rating agencies. This diversity of practices raises an important question for investors: how can they effectively navigate the unique landscape of private credit?
“While the methodologies of credit rating agencies may not perfectly align with each other or with those used by regulated banks, they serve as proxies for credit quality.
“So as an investor, if you’re investing in private credit because you’re seeking more defensive characteristics with a focus on capital preservation rather than return maximisation as your key priority, then the gap between both the credit quality of the loans and also the spread between bank interest margins and those captured by a particular credit fund, will offer invaluable insights.”
Millward adds: “Investors should have a checklist of questions for their private credit managers that include:
- Do you use a third-party ratings tool?
- Have you fully adopted the third-party tool or made changes to the models purchased? If changes have been made, how accurate are the ratings versus public ratings?
- If third-party tools are used, how many overrides of the ratings outputs have been made when adopting ratings for investor reporting? What is the ratio of downgrades to upgrades for those overrides?
- Are the ratings inputs quantitative, qualitative or both?
- Does your manager provide you with portfolio reporting showing underlying credit ratings?”
“The message remains clear: credit quality assessment tools empower private credit fund investors, allowing them to draw their own conclusions. While the regulatory landscape for banks and private credit funds differs, the use of credit ratings serves as a bridge to transparency and responsible investing,” says Millward.
