There’s lots to like about Australia's fast growing private credit – aka non-bank lender - market, especially the commercial real estate (CRE) sub-sector which accounts for the lion’s share of the Australian market.
There are covenants requiring minimum performance and maintenance standards, whilst borrowers pay monthly interest, which should ensure minimum future cash flows are maintained.
As a result, yields can be attractive given that they should incorporate what’s called the illiquidity premium. This is simply a fancy way of describing the additional return investors require for holding assets that are not easily tradeable or sold on the market.
Trouble is when there’s plenty of liquidity, the illiquidity premium often declines as investors reach for yield.
However, as investors in the Regal Partners-backed Merricks Capital Partners Fund recently discovered, letting liquidity take a backseat can come back to bite you.
No redemption for now
Investors in Merrick's $1.2 billion flagship fund were recently advised that redemptions would be delayed because there was no ‘unallocated cash’ to distribute to them.
Instead, investors who want to redeem funds will be offered a new class of unit and aren’t forced to back any new loans.
While they will continue to receive distributions, redemptions are unlikely to start being processed until December 2025 and then in six-monthly increments.
“Historically, the Fund has processed redemption requests ahead of schedule, utilising excess unallocated cash available in the portfolio,” Merricks told its investors earlier this month.
“However, at present, the Fund is fully deployed in senior-secured loans across its core sectors.”
Troubled loans
What appears to have previously weighed down the fund is its exposure to troubled loans. In January the fund posted its first monthly negative return in almost five years.
One of these troubled loans related to Halo, a quirky 55-storey office tower made partly of timber in the Sydney CBD.
After facing serious financing difficulties, Merricks had little choice but to tip in even more debt into what’s being marketed as the world's tallest hybrid timber tower.
The woes facing the tower underscore some of the challenges confronting the private credit sector as developers straddle both high cost of construction and weaker office building valuations.
What happens next?
If a CRE private credit fund becomes illiquid, the portfolio managers have a few possible remedies.
According to Liz Moran an independent expert on fixed income, the most obvious solution is to either try and sell the debt, and typically at a deep discount if a project is in mid-completion.
However, she suspects that the more likely outcome is to defer redemption and hold out for completion and sale of the building.
“There are other avenues, like raising debt, which would be expensive or additional equity, which isn’t always an option,” Moran told Azzet.
“In any case, it’s a good reminder that things don’t always go to plan, and capital may be tied up for longer than expected, particularly in an open-ended credit fund.”
In light of the Merricks example, it’s clearly a good idea to consider how capital will be returned to you before you invest in private credit.
Similarly, Moran suggests checking to see there if there are any penalties to borrowers if the issue resides with them, and if investors are compensated or additional fees go back to the fund manager.
Equally important for future investors, Moran also recommends assessing the additional margin needed over public debt to successfully jump the illiquidity hurdle.
“Merricks’ move to defer redemptions should raise questions over management and performance of underlying loans and construction timetables,” she says.
“It’ll be interesting to see if the company has done enough to placate the current investors, or whether they’ve decided to join the exit queue.”
ASIC has waded in
It might be cold comfort for Merricks Capital Partners Fund investors, but the seemingly murky way some funds value the assets they lend against has also captured the attention of corporate regulator ASIC.
What’s also raising a red flag for ASIC is the rising fascination the growing numbers of smaller investors have with the PC sector as it posts outsized returns.
While ASIC remains unclear on how big the largely unregulated the private credit market is, EY estimates suggest $188 billion in private credit loans will be written by the end of 2023 – with $79 billion linked to commercial real estate.
What may also raise ASIC’s eyebrows is Merricks Capital Partners Fund’s letter to investors this month - promoting its prospects for this year - despite the redemptions.
“We highlight that the [2025-26] vintage of private credit loans is presenting in our view as a particularly attractive opportunity set, supported by improving asset liquidity, sustained borrower demand, and compelling credit spreads,” the letter noted, adding it was “confident” of its performance.
Road to redemption
Depending on loan repayments, redemptions are expected to start being processed in six monthly increments starting in December and finalising in June 2027.
However, Merrick has made it clear that a paltry 30% of an investor’s redemption requests were likely to be fulfilled in December.
“It is our intention, depending on underlying loan repayment timing, to expedite the repayment schedule where possible and appropriate,” the note to investors stated.
Meanwhile, Merricks suggested investors could choose to have their redemption requests reclassified as Class R units - meaning they would receive income distributions but not participate in new loans.
In 2024, Merricks was acquired by Regal for $235 million, adding to the company’s growing portfolio of asset managers.
Within a June performance update, the fund’s performance says it had returned 0.7% in that month and expects to pay a 4% distribution in August.
“The Fund is fully deployed and holds no unallocated cash, reflecting a strong environment for deploying new-vintage credit,” the report noted.
