Due Diligence Tips for Private Credit Transactions | GRM LAW

Tips for Effective Due Diligence in Private Credit Transactions (Australia)

Introduction

The Australian private credit market has undergone a remarkable transformation, expanding significantly in recent years to become a vital component of the nation's financial ecosystem. Estimated to be worth nearly AUD 200 billion by the end of 2023, this sector, encompassing direct lending by non-bank institutions, private funds, and family offices, fills crucial funding gaps left by traditional banks, particularly in areas like mid-market corporate lending and property development finance (EY estimates cited in Medium, 2024; Chambers, 2025). This rapid growth, however, has not gone unnoticed. While often described colloquially as "unregulated," the reality is more complex; providers of private credit in Australia operate within a web of existing regulations and are facing increasing scrutiny from bodies like the Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulation Authority (APRA) (Herbert Smith Freehills, 2024; FC Capital, 2024).

Concerns regarding transparency, valuation practices, fee structures, and investor protection have prompted regulators to take a closer look, with ASIC establishing dedicated taskforces and signaling a lower tolerance for opacity (Pinsent Masons, 2024; FC Capital, 2024). This evolving landscape, coupled with the inherent complexities and information asymmetries of private markets, underscores the critical importance of robust due diligence. Simply relying on market hype or superficial assessments is insufficient and potentially hazardous (Pitcher Partners via Money Management, 2024). Effective due diligence is not merely a box-ticking exercise; it is a fundamental process for mitigating diverse risks – credit, regulatory, legal, and operational – and making informed, defensible investment or lending decisions.

This article aims to provide practical tips and highlight key areas for conducting effective due diligence specifically within the context of Australian private credit transactions. Whether you are a direct lender, an investor considering allocating capital to a private credit fund, or a financial advisor guiding clients, understanding and implementing a thorough due diligence process is paramount for navigating this dynamic market successfully and protecting your interests.

Why Due Diligence is Non-Negotiable

In the dynamic and often opaque world of private credit, skipping or short-changing the due diligence process is akin to navigating treacherous waters without a map or compass. While the allure of higher yields compared to traditional fixed income is strong, the potential pitfalls are equally significant. Regulatory bodies like ASIC are increasingly scrutinizing the sector, focusing on transparency and investor protection (Pinsent Masons, 2024; FC Capital, 2024). Furthermore, market commentators caution against letting the "hype" surrounding private credit override fundamental checks and balances (Pitcher Partners via Money Management, 2024).

Why is rigorous due diligence so critical in the Australian private credit context?

• Risk Mitigation: Private credit transactions inherently involve various risks – the borrower defaulting (credit risk), non-compliance with regulations (regulatory risk), flaws in loan documentation (legal risk), and issues with the lender's or manager's operations (operational risk). Thorough due diligence is the primary tool for identifying, assessing, and mitigating these risks before capital is committed.
• Addressing Opacity: Unlike public markets with mandated disclosures and readily available information, private markets are characterized by information asymmetry. Due diligence is the process through which lenders and investors bridge this gap, gathering the necessary data to understand the borrower's true financial health, the collateral's actual value, and the transaction's underlying structure (Medium, 2024).
• Informed Decision-Making: Effective due diligence provides the foundation for sound investment or lending decisions. It allows stakeholders to assess the risk-reward profile accurately, negotiate appropriate terms and covenants, and determine if the transaction aligns with their risk appetite and investment objectives.
• Regulatory Compliance & Defence: Demonstrating a robust due diligence process is increasingly important from a regulatory standpoint. It provides evidence that reasonable steps were taken to assess the transaction and comply with relevant obligations (e.g., AML/CTF, responsible lending if applicable). For financial advisors, it is a crucial part of fulfilling their best interest duty (Medium, 2024; Herbert Smith Freehills, 2024).
• Avoiding Costly Mistakes: The consequences of inadequate due diligence can be severe, ranging from unexpected loan losses and protracted recovery efforts to regulatory penalties and significant reputational damage.

In essence, due diligence moves beyond assumptions and marketing materials to uncover the reality of a transaction. It is an indispensable discipline for anyone participating in the Australian private credit market, ensuring that opportunities are pursued with eyes wide open to the potential risks.

Key Due Diligence Pillars & Tips

Effective due diligence can be structured around several key pillars. While the emphasis may vary depending on the specific transaction (e.g., direct lending vs. fund investment, asset-backed vs. cash flow), these areas form a comprehensive framework for assessment.

Pillar 1: Borrower & Business Assessment

Thorough due diligence starts with a deep understanding of the entity seeking credit. Simply reviewing headline financials is insufficient; a comprehensive assessment requires delving into the borrower's operational context, financial health, and repayment capacity.

• Tip 1: Go Beyond the Surface Financials: Don't just accept the provided numbers. Critically analyze historical financial statements (P&L, Balance Sheet, Cash Flow) for trends, consistency, and potential red flags. Scrutinize projected financials for realistic assumptions. Assess key ratios (leverage, liquidity, profitability) against industry benchmarks. Crucially, focus on cash flow robustness – can the business consistently generate sufficient cash to cover operating expenses and debt service obligations? Stress-test these projections under various adverse scenarios (e.g., interest rate rises, revenue decline) to gauge resilience.
• Tip 2: Understand the Business Context: A borrower doesn't operate in a vacuum. Evaluate the quality and experience of the management team. Understand the company's business model, its position within its industry, and the competitive landscape. What are its key strengths, weaknesses, opportunities, and threats (SWOT analysis)? Is the company's strategy viable and sustainable in the current and anticipated market conditions?
• Tip 3: Assess Repayment Sources: Clearly identify the primary source of repayment (e.g., operating cash flow). Are there credible secondary sources (e.g., asset sales, refinancing, equity injection)? Evaluate the reliability and timing of these sources. For property development loans, this involves scrutinizing feasibility studies, construction budgets, pre-sales/leasing agreements, and exit strategies (e.g., sale or refinance upon completion).

This fundamental analysis provides the bedrock for understanding the borrower's creditworthiness and the inherent risks associated with the proposed transaction.

Pillar 2: Collateral Evaluation

While understanding the borrower is crucial, in many private credit transactions, particularly asset-backed lending (ABL) which is prominent in Australia, the quality and enforceability of collateral are paramount. As one commentator aptly put it, "If collateral is king, due diligence is queen" (FC Capital, 2024). Diligence on the security package provides a vital fallback position if the primary repayment source fails.

• Tip 4: Scrutinize Collateral Quality & Valuation: Not all collateral is created equal. Differentiate between tangible assets (like real estate, inventory, equipment, receivables) and less concrete forms like cash guarantees or intellectual property. Obtain independent, expert valuations for significant assets, being wary of overly optimistic assumptions, especially in volatile markets like property. Understand the basis of valuation – is it market value, forced sale value? How frequently is it updated? (FC Capital, 2024; Medium, 2024; Perpetual, 2025).
• Tip 5: Master PPSA Perfection: For security over personal property (i.e., anything other than land and certain statutory rights), proficiency with the Personal Property Securities Act 2009 (Cth) (PPSA) is essential. Ensure the security agreement (e.g., General Security Agreement or Specific Security Agreement) correctly identifies the collateral and is properly executed. Critically, perfect the security interest, usually by registering a financing statement on the Personal Property Securities Register (PPSR). Timely registration (typically within 20 business days of the agreement taking effect) is vital to ensure priority against other creditors and to protect against insolvency hardening periods (Chambers, 2025; FC Capital, 2024).
• Tip 6: Don't Forget Real Property Formalities: Security over land falls outside the PPSA. Each Australian state and territory has its own system (primarily Torrens title). Ensure the correct mortgage form is used for the relevant jurisdiction and that it is properly registered on the land title register to be effective against third parties (Chambers, 2025).
• Tip 7: Plan for Enforcement: Due diligence should extend to the practicalities of enforcement. How quickly and easily can the collateral be accessed and realized in a default scenario? Are there potential legal or practical hurdles? What are the likely costs of enforcement? Understanding the downside scenario is a key part of risk assessment.

Thoroughly vetting the collateral package provides crucial downside protection and significantly influences the overall risk profile of the transaction.

Pillar 3: Legal & Regulatory Compliance Check

Navigating the legal and regulatory landscape is a critical, yet often complex, aspect of due diligence in Australian private credit. While sometimes perceived as "unregulated," the sector is subject to numerous obligations that lenders and investors must understand and verify compliance with (Herbert Smith Freehills, 2024).

• Tip 8: Dissect the Loan Agreement: The loan agreement is the cornerstone of the transaction. Scrutinize all terms, paying particular attention to representations and warranties, information and financial reporting requirements, positive and negative covenants (including financial covenants like LVR or ICR, which provide early warning signs), and events of default. Ensure the terms align with the assessed risk and provide adequate protections.
• Tip 9: Verify AML/CTF Compliance: Australia has a robust Anti-Money Laundering and Counter-Terrorism Financing (AML/CTF) regime. Lenders operating within its scope must be enrolled with AUSTRAC, have a risk-based AML/CTF Program, and conduct appropriate customer due diligence (CDD) on borrowers. Verify that the lender (and potentially the borrower, depending on the transaction structure and your own obligations) meets these requirements. Non-compliance carries significant penalties (Herbert Smith Freehills, 2024).
• Tip 10: Check Other Regulatory Boxes: Depending on the lender, borrower, and transaction structure, other regulations may apply:
  • FSCODA: Lenders exceeding AUD 50 million in assets may need to be registered with APRA and submit regular data under the Financial Sector (Collection of Data) Act 2001 (Herbert Smith Freehills, 2024).
  • AFSL: While direct lending generally doesn't require an Australian Financial Services Licence (AFSL), structures involving credit funds (issuing interests, managing assets, custody) typically do. Ensure relevant parties hold the necessary licenses or exemptions (Herbert Smith Freehills, 2024).
  • Consumer Credit: If lending to individuals or strata corporations for personal, domestic, or household purposes, or for residential property investment, the National Consumer Credit Protection Act (NCCP) may apply, imposing significant additional obligations.
  • FIRB: If foreign entities are involved in lending or taking security over certain Australian assets (particularly land), Foreign Investment Review Board (FIRB) approval might be required (Herbert Smith Freehills, 2024).
  • Financial Assistance: If the loan facilitates the acquisition of shares in the borrower or its holding company, ensure the strict rules in section 260A of the Corporations Act are met, often via a shareholder "whitewash" procedure (Chambers, 2025).
• Tip 11: Beware Voidable Transactions: Be mindful of insolvency "hardening periods." Security granted or transactions entered into shortly before insolvency may be challenged by a liquidator as unfair preferences (up to 6 months, or 4 years for related parties) or uncommercial transactions (up to 2 years, or 4 years for related parties) if the company was insolvent at the time (Chambers, 2025). Perfecting security promptly helps mitigate preference risk.

Legal and regulatory due diligence requires specialist expertise but is essential to ensure the transaction is valid, enforceable, and compliant, avoiding potentially significant legal and financial repercussions.

Pillar 4: Fund/Manager Scrutiny (If Applicable)

For investors accessing private credit indirectly through a managed fund, or for lenders co-investing alongside a fund manager, an additional layer of due diligence is required – scrutinizing the fund manager themselves. The manager acts as the gatekeeper and steward of capital, and their competence, integrity, and processes are paramount.

• Tip 12: Demand Transparency: The opaque nature of private markets can extend to fund structures. Push for clarity on the fund's underlying portfolio holdings – what specific loans or assets does it hold? How diverse is the portfolio? Critically examine the valuation methodology used for assets, especially illiquid ones. Is it performed independently? How often? Also, dissect the fee structure – understand management fees, performance fees (and their hurdles), and any other potential costs or charges. Lack of transparency in these areas is a major red flag (Medium, 2024; Perpetual, 2025).
• Tip 13: Assess Manager Capability & Process: Evaluate the fund manager's experience and track record in the specific private credit strategy they employ. What is their underwriting process? How robust is their credit assessment and risk management framework? Do they have adequate resources and infrastructure, particularly for ongoing monitoring and potential workout scenarios? Understand how the manager's interests are aligned with investors – are incentives structured appropriately? (Perpetual, 2025; FC Capital, 2024; Pitcher Partners via Money Management, 2024).

Investing through a fund involves delegating key decisions. Therefore, thorough due diligence on the manager is essential to ensure they are capable, transparent, and acting in the best interests of their investors.

Integrating Due Diligence into the Process

Effective due diligence isn't just about knowing *what* to check; it's also about embedding the process systematically into your transaction workflow.

• Establish a Framework: Develop a clear due diligence checklist or framework tailored to the types of transactions you typically undertake (e.g., real estate finance, corporate lending, fund investments). This ensures consistency and helps prevent oversight of critical areas. The framework should cover all key pillars: borrower, collateral, legal/regulatory, and manager (if applicable).
• Leverage Expertise: Recognize that comprehensive due diligence often requires diverse expertise. Don't hesitate to engage internal specialists or external advisors (legal counsel, financial analysts, valuers, industry experts) where necessary. For instance, navigating PPSA intricacies or complex regulatory issues often demands specialist legal advice.
• Documentation is Key: Maintain thorough records of the due diligence performed, findings, supporting documents, and any decisions made based on those findings. This documentation is vital for internal governance, potential regulatory review, and defending decisions if issues arise later.
• Ongoing Monitoring: Due diligence shouldn't cease once the deal closes. Implement processes for ongoing monitoring of the borrower's financial health, collateral value (where relevant), and covenant compliance throughout the life of the loan or investment. Early detection of potential issues allows for proactive management.

Integrating these practices ensures that due diligence becomes a robust, repeatable, and value-adding part of the investment or lending lifecycle, rather than an ad-hoc exercise.

Conclusion

The Australian private credit market offers significant opportunities for lenders and investors seeking yield and diversification. However, its rapid growth, inherent opacity, and evolving regulatory landscape necessitate a disciplined and comprehensive approach to due diligence. Effective due diligence is not optional; it is the cornerstone of prudent risk management and informed decision-making in this sector.

By systematically assessing the borrower and their business, rigorously evaluating the collateral package, ensuring legal and regulatory compliance, and scrutinizing fund managers where applicable, participants can navigate the complexities of the market with greater confidence. Integrating these checks into a consistent process, leveraging appropriate expertise, and maintaining ongoing monitoring further strengthens resilience.

Ultimately, thorough, tailored due diligence allows lenders and investors to look beyond the hype, understand the true risks and rewards of a transaction, and build sustainable, successful portfolios in the dynamic Australian private credit environment. Proactive engagement with due diligence principles is key to thriving in a market that, while offering potential, demands careful navigation.

References

• Chambers and Partners. (2025). Private Credit 2025 - Australia. Retrieved from https://practiceguides.chambers.com/practice-guides/private-credit-2025/australia
• FC Capital. (2024, November 4). Private Credit under scrutiny. But the proof is in the backing. Retrieved from https://fccapital.com.au/news/private-credit-under-scrutiny-but-the-proof-is-in-the-backing.html
• Finexia. (n.d.). Private Debt Funds Australia. Retrieved from https://www.finexia.com.au/blog/private-debt-funds-australia
• Herbert Smith Freehills. (2024, September 6). Private credit in Australia – the regulated "unregulated". Retrieved from https://www.herbertsmithfreehills.com/insights/2024-09/private-credit-in-australia-the-regulated-unregulated
• Money Management. (2024, February 21). Don’t let private credit hype override due diligence: Pitcher Partners. Retrieved from https://www.moneymanagement.com.au/news/funds-management/dont-let-private-credit-hype-override-due-diligence-pitcher-partners
• Murphy, M. (2025, January 15). The questions you should ask your private credit fund. Perpetual. Retrieved from https://www.perpetual.com.au/insights/michael-murphy-the-questions-you-should-ask-your-private-credit-fund/
• Pinsent Masons. (2024, February 29). ASIC ramps up scrutiny of Australian private credit market. [URL Placeholder - Verify if available]
• Walsh, B. (2024, September 7). Private Credit in Australia: Opportunities, Challenges, and Implications for Financial Advice. Medium. Retrieved from https://medium.com/@walshbenjamin007/private-credit-in-australia-opportunities-challenges-and-implications-for-financial-advice-0520e8cc6247

Disclaimer: This article provides general information only and does not constitute legal advice. You should seek professional legal advice tailored to your specific circumstances.