The Real Risks in Private Credit – and How Smart Lenders Control Them

INSIGHTS

The Real Risks in Private Credit – and How Smart Lenders Control Them

Insight #6

Private credit has become one of Australia’s fastest-growing investment categories, offering contracted income, real-asset backing, and welcome stability in volatile markets. But it isn’t risk-free – and investors shouldn’t expect it to be.

Like any form of lending, private credit carries risks tied to borrowers, assets, market conditions, liquidity, governance, and portfolio construction. The difference lies in how those risks are identified, priced, managed, and monitored.

High-quality lenders treat risk as a discipline, not an afterthought. They build frameworks designed to protect capital first – so returns can follow.

Here are the key risks in private credit, and how responsible managers mitigate them.

Borrower risk – and why disciplined assessment matters

Every loan ultimately hinges on one thing: the borrower’s ability to repay. Strong lenders dig deep into a borrower’s track record, financials, project feasibility, and experience before committing capital. They maintain clear visibility of the underlying borrower – not just the intermediary or project vehicle – and continue monitoring through covenants, milestones, and regular reporting. Managers who prioritise conservative loan selection, verifiable cash flow, and robust due diligence set the foundation for capital protection.

Security risk – and the importance of first-mortgage protection

Security structure is one of the biggest drivers of risk in private credit. Two loans may offer similar returns, but their risk profiles can differ dramatically depending on what they’re secured against. First-mortgage, senior-secured loans sit at the top of the capital stack, giving lenders priority rights and a clear path to recovery if something goes wrong.

Risk increases significantly in structures such as:

Second mortgages
Preferred equity
Corporate loans secured only by cash flow
Distressed or special-situations lending

Disciplined managers anchor portfolios in registered first mortgages, supported by independent external valuations and clear enforcement rights. This ensures loans are backed by tangible, saleable assets – not assumptions or internal assessments.

Market and valuation risk – and why LVRs matter

Even with strong security, asset values can move. Rising rates, market sentiment, or project delays can all shift valuations.

The strongest safeguard is a conservative loan-to-value ratio (LVR). A low LVR creates:

Substantial equity buffer if values fall
A clear path to full capital recovery in stressed scenarios
Built-in discipline around borrower and asset selection

For example, a $60 million loan secured against a $100 million asset has a 60% LVR – giving investors a 40% protection buffer. Low LVRs, combined with external valuation providers, are hallmarks of institutional-grade lending.

Liquidity risk – and why transparency is critical

Private credit isn’t designed for daily trading – and that’s part of its appeal. But it does mean investors rely on the investment manager’s discipline around loan duration, cash-flow timing, construction milestones, and redemption planning.

Leading lenders manage liquidity proactively. They run monthly or quarterly stress tests, maintain conservative cash reserves, avoid leverage or rehypothecation, and communicate clearly on lockups and exit terms.

Good liquidity management isn’t reactive. It’s engineered into the fund, so redemptions and cash flows remain orderly, predictable, and fully transparent – a point increasingly emphasised by ASIC.

Operational and governance risk – and why oversight matters

Governance is one of the biggest differentiators in private credit – and often one of the least visible. Weak governance can lead to hidden risks such as related-party lending, internal valuations, poor reporting, or unclear enforcement processes.

Strong funds are structured to eliminate these issues. That includes:

Independent responsible entity oversight
External fund administration
Third-party valuations from tier-1 providers
Separate loan administration
Documented credit and ESG committees
No related-party or internal lending

This layered oversight creates transparency by design – ensuring decisions, valuations, and processes are independently verified, not internally controlled.

Concentration risk – and what diversification really means

Diversification in private credit isn’t about sectors or market indices. It’s about balancing exposure across the real components of lending: borrower type, loan type, asset type, region, loan duration, and project stage.

Too much exposure in any one of these areas elevates risk. A disciplined lender structures the portfolio intentionally – staggering loan maturities, lending across multiple asset types, and avoiding concentrated exposure that could magnify downturns.

Diversification becomes a form of risk engineering, ensuring no single loan dictates the performance of the fund.

Key learning

Private credit provides stable, asset-backed income – but only when risks are understood and actively managed. The most resilient strategies are built on: