Nick Bruining: What truth really lies behind those promises of mega private credit investment returns?

The La Trobe Financial stop orders by the Australian Securities and Investments Commission coincided with the release of a report showing the corporate regulator is troubled by the rise of fixed income investments which fail to adequately disclose risk.

The executive summary of ASIC’s recently released Private Credit in Australia report includes a sentence which perfectly summarises the issues at heart.

“Investors in private credit are, in most cases, appropriately rewarded for taking sub-investment grade credit risk and maturity/liquidity risk; however, these risks are not always adequately described in offer documents and subsequent performance reporting.”

These products are inevitably targeted at those with big pots of money to invest. In many cases, it’s people with large superannuation balances or hefty inheritances who naturally seek out the best return possible, at the lowest possible risk.

The issue is that most don’t properly understand the very real risks and the tricks used by some in the industry to effectively fool people into thinking an investment is completely safe.

Let’s start with the fundamental issue — the rates of return on offer. It’s worth repeating a simple example of how the income investment game works, starting with a bank deposit.

When you invest your $100,000 in an Australian bank term deposit paying 4 per cent, the bank essentially takes that money and on-sells it to, perhaps, your grandkids at 6 per cent to buy their first house, making a 2 per cent per year profit along the way.

Using that example, if someone is offering you 6.2 per cent, with a similar 2 per cent margin, they’re probably lending that money out at 8.2 per cent.

It’s just common sense and good business to pay the lowest interest rate possible when you are the borrower. Your grandkids — even though they’re living on the edge, driving around in an old bomb of a car and scrimping and scratching to save their deposit — can still secure finance from a bank at 6 per cent a year.

It goes without saying that anyone forced to pay 2.2 per cent more than your grandkids is someone the banks don’t want to do business with. Putting it bluntly, someone that’s potentially high risk, or sometimes has a track record.

Let’s be perfectly clear, that’s the type of customer who your invested money is lent to when you invest in this stuff.

The promoters will usually crow about the security offered to support the loans. “First mortgage-backed security over high quality assets”.

That’s usually alongside a beautifully photographed picture of a resort-like building.

Lenders take security over fixed assets so that if the borrower defaults, the lender can sell the underlying assets to recover the outstanding debt.

The question here is what valuations are being accepted to advance the loan? This is particularly relevant when dealing with property developers. Large amounts of the money in these funds usually ends up with property developers.

The reports often don’t spell out the nitty gritty details that good financial planners and other researchers would want.

Valuations used to advance the loan are sometimes based on the value of a fully completed project, with all properties sold. The valuation might not be based on the block of land or the actual realisable value if the security assets needed to be sold right now, or in a fire-sale.

Supply problems for builders, a change in demand for property, interest rates — all can be factors that determine the outcome and the ability for the loan to be repaid in full.

We just need to remember how many builders and developers have gone broke recently, and that’s in a surging market. All of them borrowed money from somewhere.

So before you click the link on Facebook or call the 1800 number, remember the lessons learned by tens of thousands of investors before you. Risk-averse people just like you, who invested in Black Burn and Dixon, Teachers Credit Society, the Pyramid Building Society, Rothwells, Mayfair 101 and Westpoint. All convinced that their money was safe.

These investors learned the hard way that the return on your invested capital is nowhere near as important as the return of your invested capital.

All of it. When you want it, or expect it to be paid.

Nick Bruining is an independent financial adviser and a member of the Certified Independent Financial Advisers Association