Asset-backed finance is starting to garner serious amounts of attention. Yet getting the right exposure requires LPs to really get under the hood of what they are backing.
Private credit has undergone a series of transformations over its relatively short life. Where once, mezzanine, non-performing loans and distressed strategies were dominant in what was a much smaller space, regulatory pressure that came to bear following the financial crisis ushered in a flourishing direct lending market. Today, we’re witnessing a further evolution as LPs look beyond plain vanilla direct lending to find some of the different private credit flavour profiles, with asset-backed finance (ABF) a major beneficiary of this trend.
Direct lending has driven the growth of private credit to date. But we’re now entering a new phase of growth as LPs expand into other areas. There is only so much more that direct lending can grow, it is becoming harder to separate the different players, and alpha has now gone from some parts of the market. LPs therefore need to find something else to generate returns and gain adequate diversification – and they are turning to ABF, venture and growth lending, and sponsor finance.
Reji Vettasseri, Lead Portfolio Manager at DECALIA
Direct lending is now the mainstay of investors’ portfolios, but investors are looking beyond this for attractive opportunities, where capital supply is more scarce. There is far less competition in ABF, less pressure on documentation and terms and this space is set for material growth.”
That growth is coming as banks retreat further from lending activities, in particular as regulations such as Basel III Endgame increase the capital cost for them providing ABF.
The 2023 collapse of some US banks that used to provide ABF, such as First Republic and Silicon Valley Bank, also left funding gaps waiting to be filled.
And while the banks may remain in some parts of the market, there is clear white space for private credit to expand into. "Banks are not providing finance in more complex areas," says David Aidi, Senior Managing Director at Blue Owl. "Private credit is stepping in here as it can be more flexible, more patient and can take a partnership-first approach with the users of capital."
Spanning a wide range of assets, from shipping and aviation finance, infrastructure and real estate debt, and residential, consumer and commercial loans, through to more esoteric and niche areas, such as royalties, litigation finance and insurance premium finance, there is a wealth of options that LPs can choose from.
While some of these private credit flavours have long been on the table, it’s only as LPs have become comfortable with direct lending that they have started to taste some of the different ABF strategies.
"Investors have gone up the learning curve quickly in ABF in the past two or three years," says the head of credit at an asset manager. "It is no longer a niche strategy and, as it provides funding to the real economy, LPs see a lot of value in ABF. It’s also far less commoditised than other areas of private credit and barriers to entry are high."
Yet, given ABF’s broad range, LPs need to look closely at the different dynamics present in each sub-segment. Indeed, these are so varied that some now talk of ABF being a range of sub-asset classes.
"This space is large and diverse," says the head of credit. "Managers target different assets, sectors and positions in the capital structure. It’s really important for investors to assess each on its individual risk and return profile, looking at what is driving returns and value."
A portfolio manager at a European investment manager explains how LPs can cut through some of this complexity. "In ABF, where you have large, granular collateral pools, you can do desktop analysis," she says. Yet not all ABF is like this – infrastructure lending, for example, can involve financing one large asset.
"If you have single assets, you can’t reliably do desktop modelling," she adds. "You need to conduct field trips. As an LP, you need to start with the fundamentals of the collateral and determine which risks will affect it. Then, it’s a case of manager due diligence to assess the GP’s expertise and relationships with, for example, servicers – do they have back-ups?"
"This space is large and diverse. Managers target different assets, sectors and positions in the capital structure. It’s really important for investors to assess each on its individual risk and return profile, looking at what is driving returns and value."
For ABF portfolios containing SME or consumer loans, for instance, robust technology and the capacity to slice and dice vast quantities of data are vital.
"Data-driven underwriting is at the heart of our ABF programme," says Udai Bishnoi, Global Head of Asset Based Finance at Sculptor Capital Management.
"Different segments have a different way of presenting their information and so we have built proprietary systems to collect and analyse that data. Frequency is also important – credit performance is reported monthly, but it’s a massive dataset that could include more than 30 million US borrowers. That’s why we employ data scientists and we’ve built and refined our system over the past 16 years."
Recent technological developments have helped spur more finely-tuned investment decisions among these types of ABF provider.
"Data enables you to pick your spot with more accuracy than was previously the case," says Dean Atkins Managing Director of 400 Capital Management Europe. "It helps you mitigate risk. We can gather granular data on each borrower in a way that wasn’t possible before, and that means you can be much smarter about what you do and don’t underwrite."
Different segments have a different way of presenting their information and so we have built proprietary systems to collect and analyse that data. Frequency is also important – credit performance is reported monthly, but it’s a massive dataset that could include more than 30 million US borrowers. That’s why we employ data scientists and we’ve built and refined our system over the past 16 years.
Meanwhile, in infrastructure lending, investment decision-making and portfolio management is markedly different – and far more akin to direct lending. "It’s a very competitive market," says Darryl Murphy, Managing Director and Head of Infrastructure Debt at Aviva Investors. "Unlike other forms of ABF, it’s not just about the desktop research and analysis; it’s about the relationships you have built. We have to be the people that sponsors call first. And it’s not just about doing deals – it’s about how we act during asset management and how responsive we are to sponsors’ needs. It’s all about people."
Yet the fact that some ABF sub-asset classes are relatively new does present risks for the uninitiated. In the rush to find ever more esoteric assets to back, some may well be overstepping the mark, as Bishnoi explains. "The assets are evolving as corporates are looking at what they own and finding ways to maximise value using ABF as opposed to arranging a corporate loan," he says. "And this will continue. But there are pitfalls as people start calling finance ABF that doesn’t fit the label. I’ve seen air miles as an asset in ABF, for example. But that’s not ABF because it relies on the airline’s profitability or existence."
The other issue LPs face is which bucket they allocate capital from – and the answer may well depend on the type of ABF, the asset involved and individual investor policies. Real estate debt is a case in point. "We are seeing more LPs allocate to real estate debt from their private credit portfolios," says Rupert Gill, Head of European Real Estate Debt, Portfolio Management, at Barings. "The real estate private credit market now offers investors in Europe a greater variety of investment strategies, and the ability to add bond-like investments to their portfolio."
Some investors are coming into real estate debt from the private credit space, adds George Cotterell, Managing Director, Real Estate Debt, at ESR Europe. But historically, more have allocated from the real estate space. Part of the issue is that there is a lack of reliable long-term data on the performance of real estate debt as an asset class. Across the industry, real estate debt managers need to make a better case for private credit allocations.
Despite these challenges, ABF’s flexibility and optionality can make it an attractive addition to LPs’ portfolios. For example, Munawer Shafi, Managing Director at Aviva Investors, explains the importance of asset duration, particularly in the current economic cycle. He suggests that investors might consider opting for shorter-duration assets and wait for the normalisation of medium and long-term duration spreads.
ABF’s correlation with the broader private credit market is another key factor. Strategies backed by hard assets, such as music royalties, are expected to have low correlation, whereas those backed by financial assets, such as fund finance of corporate loans, are likely to have high correlation, especially in a challenging economic environment.
Finally, investors can be flexible about where they sit in the capital structure. Even if ABF facilities are backed by highly correlated financial assets, they can still achieve a low credit risk outcome by positioning themselves in the senior part of the capital structure. It's clear that LPs are warming to the opportunities that ABF presents as they expand their exposures beyond plain vanilla direct lending.
They are attracted to the potential to access a wide variety of underlying assets and risk-reward characteristics that can help them manage and fine tune their portfolios. But as with any expanding asset class, investors will need to do their homework to ensure they get the exposure and protections and, ultimately, the returns they expect.
Investors might consider opting for shorter-duration assets and wait for the normalisation of medium and long-term duration spreads.
