The Bathla failure and the reset of Australian real estate private credit

Disclosure: Corval Avenue does not have any exposure to Bathla Group.  Historically, Corval Avenue has been a lender, however it exited its last loan position over twelve months ago.

The collapse of the Bathla Group is a serious event for the people directly caught up in the failure and has also heralded a day of reckoning for Australia’s rapidly expanding private credit industry.  

The first priority should be the human and economic consequences.  The uncertainty facing Bathla’s 350 employees is profound with their household income thrown into doubt.  For purchasers of Bathla homes and units, the consequences are potentially even more dire. Thousands of buyers have committed deposits and are waiting for homes to be completed. Around 2,000 homes were reportedly under construction when the administrators were appointed, while the wider pipeline runs into the tens of thousands of dwellings.  The ultimate outcome will vary project by project, depending on ownership, financing, construction status and security arrangements, but the immediate problem is the same: families who thought they were buying a home are now caught inside a complex insolvency process.

Then there is the Western Sydney housing pipeline. Bathla has been one of the significant suppliers of relatively affordable homes, townhouses and apartments in the region. A disorderly unwinding of its projects could remove a meaningful amount of future housing supply at precisely the time Sydney needs more, not less.

Another key stakeholder group are the investors – the super funds and individuals who have lent to Bathla through loans secured against their projects, many of whom are retirees and some of whom had no idea they had taken on an exposure to a group that may have been teetering on the brink of insolvency for some time.  The Bathla collapse may well be the day of reckoning that Australian real estate lending needs to usher in more disciplined lending and better investor disclosure and transparency.

Credit selection and portfolio construction

The immediate lesson for private credit investors is not that property lending is inherently dangerous. Properly structured senior secured commercial real estate loans can be an attractive asset class, especially for those looking to add income to their portfolios.  However, in much the same way as dividends on a listed stock are only maintainable when earnings are robust, income payments on a loan portfolio are only maintainable when the loans perform.  Credit selection and portfolio construction are key.

More than 40 lenders reportedly had exposure to Bathla, illustrating just how widely the developer’s funding requirements had spread across the private credit ecosystem.  Some lenders reportedly had very material exposures. CVS Lane, for example, disclosed nine Bathla loans and subsequently suspended applications and redemptions in two funds.  Centuria Bass had already paused redemptions in two funds following the ratings agency SQM downgrading the funds to non-investment grade amid concerns about their significant exposure to Bathla.  

The uncomfortable feature of the episode is that investors in pooled private credit funds may not necessarily know that they had Bathla exposure.  Investors may have understood they were investing in a diversified income fund with a target yield and perhaps a reassuring description of senior secured lending, without necessarily knowing the identity, concentration or changing risk profile of the underlying borrowers.

Incentives drive behaviours

The pooled-fund model can create a dangerous separation between the investor and the individual credit decision. At the manager level, there are powerful commercial incentives to keep deploying capital. Holding substantial cash is unattractive, investors expect the fund to deliver its target return, and the manager needs to continue originating loans to generate management and performance fees. In a competitive lending market, that can create pressure to deploy capital even as attractive opportunities become harder to find. The danger is that the imperative to keep capital working can begin to outweigh the discipline required to say no. 

The terms on which capital was deployed to Bathla included attractive interest rates, but those returns needed to be weighed against the underlying credit risk and the warning signs that emerged. Some of those warning signs appear, in hindsight, to have been difficult to ignore. Bathla was operating with a significant and growing debt burden against a backdrop of softer sales and escalating construction costs. There were also increasingly complex questions around lender protections, project funding and buyer deposits. Recent reporting has alleged that substantial homebuyer deposits have been released to Bathla for projects still under construction, without the knowledge of some lenders..

This is where performance fees deserve scrutiny. If a manager earns fees based on investment performance, there can be an asymmetry: the commercial reward for deploying capital is immediate, while the consequences of a bad loan may emerge years later. That does not mean performance fees caused the Bathla exposure, or that any manager behaved improperly. It does mean investors should ask whether fee structures genuinely reward risk-adjusted returns, rather than simply the volume of money put to work and the headline yield generated.

The liquidity illusion

Private credit loans to property developers are, by their nature, illiquid. A $20 million development loan cannot necessarily be converted into cash tomorrow simply because an investor presses a redemption button.

Yet pooled funds can create an appearance of liquidity around inherently illiquid assets. Access through investment platforms like Netwealth and Hub 24 that enable financial advisors to invest in the products on behalf of their clients can reinforce that perception. Investors seeing a unit price updated regularly may give them a false sense of liquidity when the underlying loan may have a three-year maturity, require a sale or refinance to repay, and depend upon a development completing successfully.

Bathla has exposed that mismatch and has demonstrated how quickly apparent liquidity can disappear when investors simultaneously want their money back.

This is something platform providers will need to examine closely for all their alternative investments including direct real estate, infrastructure and private equity – not just private credit.  The issue is whether the architecture and presentation of private credit through products designed for platforms can inadvertently reinforce a liquidity illusion, making a long-dated, difficult-to-value loan portfolio feel more liquid and transparent than it really is.

The answer should be better disclosure, more granular exposure reporting and a much clearer distinction between fund liquidity and asset liquidity.

A necessary rationalisation – always darkest just before dawn

Investments are cyclical.  Debt has down cycles in the same way that equity bear markets exist and economies experience recessions.  This next phase will likely be painful for the industry. Some lenders will have to stop or materially reduce new lending while they assess their existing books, strengthen controls and work through impaired assets. Some managers will discover that their funding model was too dependent on continuous inflows. Others may simply decide that the risk-reward equation is no longer attractive and exit the market altogether.  That would not necessarily be a bad outcome.

A period of rationalisation could ultimately make Australian real estate private credit better and more disciplined.  This was seen in previous cycles, most recently in the 2008 / 2009 global financial crisis.  Managers that survive should have to compete on the quality of their underwriting rather than simply on the yield they can advertise. For investors, greater transparency around underwriting and portfolio risk, robust reporting, genuine diversification and clearer liquidity terms can provide important protections.

And this is where the opportunity lies…

If capital retreats from the sector, good borrowers will still need funding. For lenders with capital available to deploy, reduced competition can create opportunities to lend on stronger terms: lower LVRs, stronger security, tighter covenants, greater equity buffers and materially more attractive credit risk margins.

Bathla may therefore prove to be a watershed moment. The immediate consequences are serious and painful for employees, homebuyers, contractors, current investors with Bathla exposure and Western Sydney’s housing pipeline. For investors, however, the longer-term lesson is an important one: private credit has an important role to play in providing capital, but that capital still needs to be priced appropriately for risk, supported by structures that protect the lender and provided through funds where investor liquidity matches the liquidity of the underlying assets.

Looking beyond the final quarter of this year, Corval Avenue sees opportunity for enhanced risk-adjusted returns, particularly in the commercial sectors and lower to middle priced housing outside of Western Sydney.