Private credit funds need good design, not just good loans

Private credit has become one of the most-debated asset classes in financial markets.

Yet many investor outcomes are most often determined less by the asset class itself than by the structure through which it is accessed.

Headlines have focused on defaults, redemption pressures, valuation practices and whether the asset class has become too crowded.

Yet much of the discussion conflates different issues and often very different segments of the market. A US middle-market direct lending portfolio has little in common with an Australian property development loan book, a retail income fund or a highly leveraged credit vehicle - but they are often discussed as though they are the same thing.

As a result, investors can end up focused on the wrong risks. Many of the most publicised issues in recent years have been liquidity events, governance failures or product design shortcomings rather than evidence of widespread deterioration in underlying corporate loan performance.

The question for investors is no longer simply whether private credit belongs in portfolios, but whether they are accessing it in the right way.

That distinction is becoming increasingly important. The way a private credit allocation is built and implemented - including manager selection, deployment speed, fee structures, benchmarking, currency management and liquidity terms - can materially influence investor outcomes.

In many cases, the difference between a well-designed private credit allocation and a poor one has as much to do with implementation as it does with the underlying loans themselves.

In core middle market corporate direct lending, particularly across large and developed markets such as the US and Europe, investors can access a deep opportunity set. For investors, this sector can offer high levels of transparency, attractive risk-adjusted returns and exposure to a mature underlying market.

But access alone is not enough. Available products often carry persistent design flaws: slow deployment, cash drag, fee leakage during ramp-up, cash benchmarks, unhedged currency, weak diversification controls and liquidity terms that promise more than the underlying assets can deliver.

Deployment profile

An investor committing capital to a typical closed-end private credit fund can wait months for the first capital call and often two years or more for full deployment. Where possible, capital should be invested in credit from day one, with meaningful exposure to private credit economics immediately and the balance rotating into underlying strategies over time.

The warehouse exposure required to make this possible is one many investors simply cannot access on their own.

It is the kind of implementation detail that can materially affect the investor experience but is often overlooked when private credit products are assessed only by headline manager names or target returns.

Preventing fee leakage

Fee structures deserve greater scrutiny than they often receive. Management fees in core middle-market direct lending have fallen substantially over recent years, yet some investors continue to pay performance fees, surrender origination fees and bear private credit fee levels before their capital is fully deployed.

In our view, performance fees have little place in core middle-market direct lending. Borrower origination fees should accrue to investors, not managers, and fees during any ramp-up period should reflect the assets actually held.

Investors should pay private credit fees for private credit exposure, not for temporary liquid credit deployment solutions.

Benchmarking and liquidity

Benchmarking has long been another weak point of private credit product design in Australia.

Measuring a private credit portfolio against cash tells investors very little about portfolio and manager performance. A genuine private credit index, hedged into Australian dollars, is a better barometer.

Liquidity also needs to be properly accounted for in product design. Redemption terms should reflect the long-term, illiquid nature of the underlying loans, with staggered, long-dated windows and an investment horizon measured in years, not months.

Recent headlines around the "gating" of private credit funds in the US are a reminder that liquidity mismatches matter. Many of these issues stemmed from investor expectations being inconsistent with the illiquid nature of the underlying assets.

A well-structured fund should be deliberate on liquidity. Private credit is a long-term asset class, and investors should not expect to redeem a significant portion of their capital at short notice. Fund terms should reflect the illiquid nature of the underlying loans.

Investors are compensated for that illiquidity through higher expected returns but should enter the asset class with clear expectations around illiquidity.

Conclusion

Headlines about private credit often focus on borrower quality and lender rights in the event of default.

These are central to achieving targeted returns, but they are not the only considerations when choosing a private credit fund. In private credit, the quality of access matters as much as the quality of the underlying loans.

Investors should be confident that every design decision - from manager selection and customised mandate guidelines to diversification, currency hedging, benchmark selection and redemption structure - has been tested against the same standards applied to institutional-grade investments.