Private Credit Borrower Distress: What AFS Licensees and Fund Operators Should Do

Introduction

Private credit borrowers rarely move from “performing” to “default” overnight. Financial stress often develops gradually through covenant pressure, construction delays, weaker presales, refinancing difficulty, rising costs or repeated requests to change loan terms.

For Australian Financial Services (AFS) licensees involved in private credit, responsible entities and trustees, those warning signs can affect much more than the individual loan. In this article, we explain when borrower stress becomes a governance issue and how funds should approach credit risk, valuations, impairment, loan amendments, liquidity, conflicts, and investor disclosure before formal default occurs.

Interactive Tool: Check If Borrower Stress Triggers Governance Action in Your Fund

When Does Borrower Stress Become a Regulatory Issue?

The Early warning signs

Formal default or insolvency should not be treated as the first point at which borrower deterioration becomes relevant. Warning signs can include:

• covenant breaches or declining interest coverage;
• repeated maturity extensions or capitalised interest;
• construction delays, cost overruns or weaker presales;
• deterioration in collateral values;
• refinancing difficulties or requests for further funding; and
• stress affecting related borrowers, sponsors, or projects.

These are commercial warning indicators, not automatic statutory triggers. The relevant question is whether the new information changes assumptions supporting the fund’s credit assessment, valuation, liquidity, or investor communications.

What obligations can borrower stress engage?

For an AFS licensee to which Section 912A(1)(h) of the Corporations Act 2001 (Cth) (‘Corporations Act‘) applies, borrower deterioration may be relevant to whether its risk-management systems remain adequate. Section 912A(1)(aa) may also become relevant where the circumstances create conflicts of interest.

Registered-scheme responsible entities have additional duties under Section 601FC, including duties concerning care and diligence, members’ interests and regular valuation of scheme property. Their compliance plans must also address valuation under Section 601HA(1)(c).

Australian Securities and Investments Commission‘s (‘ASIC‘) Report 820: Private credit surveillance report: Retail and wholesale surveillance (‘REP 820‘), private credit principles and regulatory guidance provide further detail about the practices ASIC expects to see. They do not, however, create a universal rule that a particular covenant breach, extension, or deterioration event must produce a particular regulatory response.

The governance process should instead be capable of recognising when changing commercial circumstances require the fund to revisit the legal and regulatory obligations that already apply to it, with advice from AFSL lawyers on financial-services governance obligations where needed.

What Should Happen at Loan Level?

Reassess the borrower’s credit risk

The first question is whether the borrower’s credit position has materially changed. For AFS licensees, this forms part of the risk-management systems question under Section 912A(1)(h) of the Corporations Act and may warrant AFSL compliance services for risk-management systems.

The assessment should consider more than whether scheduled payments remain current. Relevant information includes borrower financials, covenant performance, collateral coverage, refinancing prospects, remaining commitments and the expected repayment or exit strategy.

Funds should also consider related exposures. Several loans may appear separate legally while depending economically on the same developer, sponsor, project, or source of repayment.

Revisit the asset valuation

Valuation becomes particularly important once borrower conditions deteriorate because it can affect unit pricing, performance, fees, liquidity, and investor withdrawals.

For registered schemes, Section 601FC(1)(j) of the Corporations Act requires the responsible entity to ensure scheme property is valued at regular intervals appropriate to the nature of the property. This is reinforced by the compliance-plan valuation measures under Section 601HA(1)(c), noted above.

Neither provision mandates a universal monthly or quarterly valuation cycle. However, material new information may mean an existing valuation needs to be revisited before the next scheduled review. That information may include changed borrower financials, collateral deterioration, project delays, revised feasibility, weaker presales, changed refinancing conditions, capitalised interest or reduced recovery prospects.

For unregistered wholesale funds, the Chapter 5C provisions do not automatically apply, but valuation practices may still engage applicable financial reporting, disclosure and contractual AFSL obligations.

Consider impairment separately from formal default

Valuation and impairment are related, but they are not necessarily the same exercise. Where the Australian Accounting Standards Board‘s (‘AASB‘) Accounting Standard AASB 9 Financial Instruments (‘AASB 9‘) applies, impairment is assessed using the expected credit loss model. Lifetime expected credit losses may need to be recognised where credit risk has increased significantly since initial recognition.

That assessment uses reasonable and supportable information and is not confined to whether the borrower has already missed a payment. Changes in the following may be relevant:

• borrower performance
• collateral values
• refinancing conditions
• forward-looking economic information.

A loan can therefore remain technically current under its contractual documents while its impairment assessment requires reconsideration.

Review extensions, restructures and capitalised interest

A stressed loan may remain technically “performing” because its terms have been changed. This can occur through an:

• extension
• covenant waiver
• increased facility
• capitalised interest or
• additional rescue funding.

Those measures may be commercially appropriate, but they do not establish that the borrower’s economic position has improved.

The fund should still consider why the original terms could not be met, whether revised repayment assumptions are realistic, whether collateral coverage has deteriorated and whether expected recoverability has changed.

Where AASB 9 applies, modifying contractual cash flows without derecognising the original asset does not automatically mean the modified loan has lower credit risk. An extension or restructure should therefore not replace a separate credit, valuation, and impairment assessment.

Ensure material decisions receive independent challenge

Borrower stress becomes harder to govern where the same individuals originate the loan, approve changes to it and influence its subsequent valuation. REP 820 found that most funds ASIC reviewed lacked effective separation between those approving loans and those subsequently monitoring performance or overseeing valuations.

ASIC does not prescribe one mandatory structure for every private credit fund. Depending on the nature, scale, and complexity of the business, controls may include:

• separate approval authorities
• valuation or risk committees
• external valuations
• conflict-management procedures or
• escalation to the board or trustee.

The objective is not organisational separation for its own sake. It is to ensure decisions about extending, valuing or impairing a stressed asset receive appropriate independent challenge.

What Should Happen at Fund Level?

Stress-test liquidity and redemptions

Borrower stress can quickly move from an individual credit issue to a fund-level liquidity issue. Delayed repayments may reduce cash available for redemptions, distributions, expenses and undrawn lending commitments. At the same time, reports of borrower problems may increase investor withdrawal requests.

Fund operators should therefore test expected borrower cash flows against expected redemptions, distributions, remaining commitments, liquid assets and realistic asset-realisation timeframes.

For registered schemes, Section 601KA of the Corporations Act provides the statutory test for whether a scheme is liquid, including the 80% liquid-assets threshold. Withdrawals from non-liquid registered schemes are then subject to Sections 601KB–601KE. Those provisions do not automatically govern unregistered wholesale funds.

Identify borrower stress-related conflicts

A deteriorating loan can create new or more acute conflicts for an AFS licensee. These can arise around whether to extend or impair a loan, valuations, performance fees, related-party exposures, allocation of additional funding or situations where multiple managed funds have exposure to the same borrower.

Under Section 912A(1)(aa) of the Corporations Act, an AFS licensee must have adequate arrangements for managing conflicts arising in relation to its financial services business. For registered schemes, Section 601FC, noted above, also requires priority to be given to members’ interests where they conflict with the responsible entity’s own interests.

The governance process should therefore show not merely that a conflict was recorded, but how it was managed and what safeguards influenced the decision. For further practical guidance, see our free Conflicts of Interest Management Guide for AFSL and ACL holders.

Check investor disclosures accuracy

Borrower deterioration may make existing investor communications inaccurate even if those communications were appropriate when first issued. Under Section 1041H of the Corporations Act, misleading or deceptive conduct in relation to financial products or financial services is prohibited. For Product Disclosure Statements (PDS), Section 1013D(1)(c) also requires information about significant risks associated with holding the product to the extent required by that provision.

Funds should therefore reconsider statements about:

• arrears
• restructures
• borrower concentration
• asset values
• liquidity
• distributions
• performance and
• claims such as capital preservation.

This does not mean every covenant breach requires a replacement PDS. The appropriate response depends on whether the existing disclosure or communication remains accurate and on the specific disclosure requirements applying to the fund.

Reconsider retail product governance

For products subject to the design and distribution obligations, material portfolio deterioration may also affect assumptions supporting the target market determination (TMD).

Under Section 994C of the Corporations Act, a TMD must be reviewed in the circumstances specified by the statutory framework.

Borrower deterioration does not automatically invalidate the TMD. However, the issuer should consider whether the resulting change in the product’s characteristics engages a review trigger or otherwise requires reassessment under Section 994C. This is particularly relevant where deterioration materially changes the level or nature of risk investors are exposed to.

How Should Borrower Stress Be Escalated?

Stage 1 – Early warning

Early warning indicators may include covenant deterioration, project delays, weaker sales or emerging refinancing concerns. At this stage, the fund should generally increase monitoring, obtain current information and reassess the borrower’s credit position.

The key governance question is whether the issue remains capable of being managed within ordinary credit monitoring or has become sufficiently significant to require escalation.

Stage 2 – Material deterioration

Material deterioration may involve significantly reduced collateral coverage, capitalised interest, material delays, worsening financial performance or a proposed loan amendment. At this stage, the issue should generally move beyond credit monitoring alone. The fund may need to reconsider valuation, impairment, liquidity and any emerging conflicts.

Relevant committees or decision-makers should also receive sufficient information to understand how the borrower’s deterioration affects the wider fund.

Stage 3 – Restructure

A significant extension, covenant waiver, rescue funding or materially revised repayment arrangement may indicate that the borrower has moved into a restructuring phase. The commercial decision to restructure should be separated from the questions of how the asset should be valued, whether impairment has changed and whether investor communications remain appropriate.

Material restructures should also receive the level of independent challenge and approval required by the fund’s governance framework.

Stage 4 – Default or enforcement

Formal default, insolvency, or enforcement requires the fund to reassess its expected recovery and determine its enforcement strategy. At the same time, the fund should reconsider the resulting valuation and liquidity consequences and whether investors require updated information.

The precise thresholds between these stages will differ between funds. This framework is a practical governance model, not a process prescribed by legislation.

What Should AFS Licensees, Responsible Entities and Trustees Do Now?

The objective is not to create a separate compliance framework for every stressed borrower. It is to ensure the fund’s existing governance arrangements respond when economic circumstances change.

As a practical starting point:

1. Define escalation triggers: Identify the events that require a borrower to move beyond routine credit monitoring.
2. Connect governance functions: Ensure credit information reaches valuation, impairment, liquidity, conflicts, and disclosure processes.
3. Build in independent challenge: Material amendments, valuations, and impairment decisions should be appropriately reviewed.
4. Test fund-level consequences: Consider concentration, liquidity, investor withdrawals and related exposures.
5. Document the decision: Record the information considered, competing views, conflicts, approvals, and reasons for the outcome.

There is no standalone statutory requirement to maintain a particular “borrower-stress file”. Documentation is instead an important way for an AFS licensee, responsible entity or trustee to demonstrate how its existing legal obligations and governance processes were applied.

AFS licensees can also use our free AFSL Compliance Checklist to review the broader systems and controls supporting their licence obligations.

Conclusion

Private credit governance should respond to a borrower’s changing economic position rather than simply wait for formal default.

A covenant breach, extension, or request for additional funding may not automatically require impairment or another prescribed response. It may, however, require an AFS licensee, responsible entity or trustee to reconsider credit risk, valuation, liquidity, conflicts, and investor disclosure under its existing governance framework, making it important to contact Click Legal’s AFSL lawyers for private credit governance compliance services.

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