This article first appeared in Wealth, The Edge Malaysia Weekly on December 25, 2023 - January 7, 2024

Private credit investments that yield investors up to double-digit returns each year are growing in popularity. They are accessible through various platforms, including peer-to-peer financing (P2P), wholesale funds and structured products. The underlying assets are usually preference shares issued by private companies.

Such a trend is fuelled by the widening financing gap in the market as banks pull back on lending to preserve capital in challenging times, especially when US regional banks such as Silicon Valley Bank, Signature Bank and Silvergate Bank collapsed on the back of the Federal Reserve’s aggressive interest rate hikes.

Industry players agree that private credit has provided asset managers and investors with an opening to extract better returns in the market. But dabbling in such an investment asset class is not without its risks.

The most direct way for retail investors to gain exposure to private credit is through licensed P2P platforms such as CapBay, operated by Bay Group Holdings Sdn Bhd, which raise funds from the public for small and medium enterprises (SMEs).

In an interview with Wealth, CapBay CEO Ang Xing Xian says its investors earn an average net return of 8.2% after deducting service fees and experience a default rate of less than 0.1% (lower than the P2P industry’s default rate of 2%).

As at Oct 31, 2023, its P2P investors had enjoyed a net return of 8.07% per annum, with a three-year annualised net return of 7.79%. Ang says it is evident that the P2P platform provides great returns.

Several fund houses have been providing private credit investments to sophisticated investors through private mandates and structured products. The notable ones are Areca Capital Sdn Bhd and Kenanga Investors Bhd (KIB).

Areca Capital CEO Danny Wong says the firm’s structured products invest in private companies or subsidiaries of a listed entity, sometimes through the acquisition of preference shares and with collateral of up to two times the amount of funds provided. With an investment tenure of a year or two, the net return these generate for investors is about 7% per annum.

The investee companies of Areca Capital are asset-rich with healthy balance sheets but are facing cash flow challenges over the short term. This is where the firm comes in, by helping them to “bridge” the gap.

Wong says the firm also deploys its investors’ money into start-ups that are venturing into new businesses and are unable to get financing from traditional banks as they are unable to properly assess the risks.

Have there been any default cases since Areca Capital started offering private credit to sophisticated investors in 2015? Wong says there have been a few, including one during the pandemic when the tourism sector took a blow from the lockdowns. However, the firm managed to restructure the deal, allowing the investee company to fulfil its repayments over an extended period.

“If the worst comes to the worst, we have the collateral. But we didn’t want to force a liquidation event as the owners of the company would lose all their assets. Ideally, we also don’t want to take over and operate the assets,” he says.

Meanwhile, KIB offers private credit products through its non-discretionary private mandate, which is an investment solution available only to sophisticated and high-net-worth investors.

Its CEO and executive director Datuk Wira Ismitz Matthew De Alwis says these products are offered to clients in the private wealth segment who want to preserve capital, yet target returns higher than fixed deposit rates. They are less inclined to generate better returns by taking equity market risks.

He says these private credit products can invest in credit-linked securities, such as redeemable preference shares (RPS) and redeemable convertible preference shares (RCPS). These are issued mainly for business acquisition, transformation or to fund working capital.

In general, preference shares provide investors with a fixed return each year, similar to bonds, but without conferring on them voting rights. These shares can come with specific features such as redemption and/or conversion.

In the case of redemption, the company can redeem preference shares from holders at a predetermined amount when certain conditions are met. As for conversion, the holders of preference shares are allowed to convert the shares into ordinary shares for better liquidity, among other reasons.

“We do not provide recommendations to investors on private credit products. However, we add value by screening the issuer [of RPS and RCPS] through a comprehensive due diligence process. This covers the company’s registration, assets being used as collateral and other credit-related criteria,” says De Alwis.

“We also screen the stakeholders of the issuers if they are providing certain guarantees, such as a personal guarantee. This is to ensure they can meet their obligations and investors have a robust avenue of recourse should the worst occur. All this is to minimise the credit risk and ensure the information provided to our clients is accurate and up-to-date.”

The demand for private credit from companies has been particularly strong in recent years, according to industry players. The key reason is that banks underwent a contraction period during the pandemic in 2020. Technology adoption and the emergence of new types of businesses have also made it challenging for traditional banks to assess risks and give out loans.

Private credit is defined as lending to companies by institutions other than banks.

According to Morgan Stanley, the size of the private credit market at the start of 2023 was about US$1.4 trillion, representing a 60% growth from US$875 billion in 2020. The market is expected to grow to US$2.3 trillion by 2027.

On the local scene, private credit has been gaining momentum, not just among SMEs but also listed companies for short-term funding.

According to the Securities Commission Malaysia, the country’s P2P financing industry raised RM1.58 billion in 2022, a year-on-year increase of 38%. The industry raised RM852.86 million in the first half of this year (1H2023) through 12,861 campaigns, which appears to be well on track to achieve another record-breaking year.

The overall financing gap in the local SME sector amounted to RM90 billion in 2021, exceeding more than RM80 billion in 2016, according to the SC.

The growth of the private credit market this year is also evident in the number of applications received by CapBay from SMEs seeking funds. For instance, Ang says the funds disbursed by the firm for supply chain finance this year is expected to reach RM800 million, a 14-fold increase from RM51 million in 2019.

Areca Capital’s Wong resonates with Ang’s view. He says the firm received more than 20 private credit proposals this year, which is higher than usual, showing that many companies are cash-strapped.

KIB’s De Alwis points out that the private credit market has continued to grow in tandem with the country’s economic growth. But the factors underpinning its rapid growth recently are different from the past.

“What was structurally different in the lending pattern during the pandemic was the use of funds. In a lot of cases, the funds were not utilised for [business] growth but to make wholesale changes to business operations to adapt to the new environment caused by the pandemic,” he says.

Technology plays a key role in fuelling the private financing trend, as various processes can be done quickly and funds channelled to individuals easily through smartphones. Take the buy now, pay later (BNPL) scheme, through which buyers can make purchases and slowly pay for them in instalments. The interest on such loans is imposed on the merchants.

“It was with the introduction of new technology, coupled with financial innovation, that we started to see the emergence of P2P financing and BNPL schemes,” says De Alwis.

It was also during this period that Touch n’ Go Group launched GoPinjam, which extends personal loans to millions of individuals through the mobile application. However, these investment opportunities are being tapped by asset management firms and companies instead of retail investors.

As for CapBay, it utilises technology to provide SMEs with invoice financing solutions, allowing the companies to efficiently convert their receivables into cash through a transparent online bidding process. “This offers businesses competitive financing rates and it reduces the risk of fraud associated with multiple financing deals generated from the same invoice,” says Ang.

Yet, all this is still not enough to address the broader market’s funding needs, which in part fuelled the popularity of RPS and RCPS in the market. De Alwis says more companies approached the firm to subscribe to RPS and RCPS recently.

Wong says the emergence of new types of businesses, which banks are not able to finance, is another factor that has made private credit popular. He cites the example of Areca Capital providing an investment to a start-up that cultivates algae.

One appeal of the business is that it fits well under the environmental, social and governance investment theme. Also, algae can be turned into biofuel and used as an alternative to fossil fuel to power vehicles. It is a developing trend globally that some may not know about.

As algae is good at absorbing greenhouse gas, it allows the cultivator to apply for carbon credits, which can be sold at an attractive price in the market. “It has been proven that the amount of carbon dioxide absorbed by algae is 10 times more than that by normal plants,” says Wong.

It is companies like these that banks find hard to finance. So, Areca Capital steps in to provide them with funds after conducting a proper risk assessment and putting in risk management structures.

“There are risks — water contamination, weather or diseases and other things can wipe out all the algae that is being cultivated. But what the company does is that it cultivates these plants in several hundred tanks. If anything goes wrong with a tank, the others survive,” he says.

Wong says the funds provided by Areca Capital are collateralised by three times their value with land owned by the investee company. “The company is done with its proof of concept. It is being executed. And we are funding it. There is risk, but we see the potential and we manage the risk.”

According to industry players, private credit is preferred by businesses because it can be arranged at a faster pace and with more flexibility. For instance, Areca Capital can provide businesses with the necessary funds in as fast as two weeks to a month.

Meanwhile, P2P financing platforms can provide funding to SMEs and underserved businesses without collateral. “Unlike most bank loans, private credit solutions can be tailored to meet borrowers’ needs in terms of size, type or timing of transactions,” says Ang.

In an earlier interview with Wealth, Ang said local investors like private credit as it is not marked-to-market, which means the value of the underlying assets doesn’t fluctuate daily based on market conditions, such as during a rising interest rate environment.

However, investors should know that private credit comes with risks. Jason Lee and Heng Wui Leng, co-founders of boutique fund house Cross Light Capital, opine that private credit investors who don’t diversify their bets can take a huge loss when a default happens. It could wipe out all of their gains or push them into huge losses.

“The thing about private credit is that it is all good until it is not. It can provide a steady return of 10% every year, right? But when something blows up, you can basically take a haircut of 30% to 40% [that could wipe out all your gains or more],” says Heng.

“The issue is that investors don’t really see what’s underlying sometimes. Even if you do, you need to be able to assess the risk. The general advice is don’t put all your money in this space.”

It is worth noting that private credit deals offered by fund houses, including Areca and Kenanga, are usually backed by collateral, but investments provided by some P2P financing platforms are unsecured, which means the funds channelled to SMEs are not backed by real assets.

De Alwis emphasises that private credit investments are generally categorised as lower risk than equities, but they are not risk-free, which is why risk management is vital.

“There is still a risk in private credit, which is compensated by higher fixed returns compared with fixed deposit rates. There has been a relatively small percentage of credit events on which we have worked closely with the issuer to manage repayments and prevent a default,” he says.

After all, should investors take on more risk for higher returns when interest rates have been relatively high in recent years? Areca Capital’s Wong says it is about how well investors understand the underlying business and risks involved.

He adds that some of Areca Capital’s high-net-worth clients moved part of their funds from fixed deposits to private credit, provided that they understood the companies, the businesses and the risks of the products very well.

“Many people forget about the ability to assess the risks when talking about private credit. Ultimately, it is about risk-adjusted returns, not just returns,” says Wong.

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