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  2. INDUSTRY VOICES
June 22, 2021 08:00 AM

Commentary: Private asset-backed finance is attracting investor interest

Daniel Pietrzak
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    Daniel Pietrzak
    Daniel Pietrzak

    Just as direct lending has become a mainstay of private credit portfolios over the past decade, private asset-based finance is the latest strategy to capture widespread attention. With nominal interest rates near record lows, investors are taking notice of the above-average yields and downside protection offered from a diversified portfolio of assets.

    Today, asset-based finance, or non-corporate lending against financial and hard assets, represents a $4.5 trillion market, which is forecast to grow to $7 trillion in the next five years, according to estimates based on shadow banking data from the Financial Stability Board. With favorable secular and cyclical tailwinds and an investible universe 10 times larger than corporate direct lending, ABF is still in its early innings as an asset class.

    While ABF has long been a ubiquitous source of financing for millions of global businesses and consumers, the market has evolved for the better since the global financial crisis. As securitization declined and banks pulled back, well-capitalized private lenders stepped in to fill the funding gap. They have in turn created more appealing — and dependable — ways for institutional investors to access the ABF asset class.

    For borrowers accessing credit types as diverse as fix-and-flip lending, point of sale consumer credit, equipment leasing and used auto financing, the benefits are clear. As more investors enter the market and fill the funding gap, businesses and consumer borrowers can access more options and competitive rates.

    The appeal to investors is easy to understand. By pursuing underserved and mispriced lending opportunities, ABF offers attractive yields and exposure to large, diversified pools of assets. Private credit investors are creating scaled exposures to a diverse set of lending opportunities, often through platforms that combine underwriting and servicing expertise with deep sector experience.

    ABF is a strategy well suited to these times, owing to the downside protection of collateral-based loans, diversity of borrowers, and customized investment structures.

    The opportunity to invest in ABF has grown as structures have evolved to include locked-up capital and increasingly permanent capital vehicles (such as interval funds) that can foster added stability and longer-term growth strategies. ABF also can get exposure from prime and near-prime borrowers across multiple industry sectors, population demographics and geographies.

    Private asset-based finance market focuses on areas of the lending market that are underserved by traditional lenders, secured by collateral ranging from homes and vehicles in consumer lending to inventory and equipment in the small and midsize enterprise market. It also lends against hard assets such as aviation leasing and contractual cash flows like royalty financing.

    The strong performance of diversified ABF portfolios during the pandemic is a testament to the resiliency of the asset class. Though there is no benchmark, each investment being idiosyncratic, ABF did not experience massive volatility like public equities and traded credit (loans, bonds, CLO liabilities, ABS), nor were there widespread reports of leverage providers seizing and liquidating assets due to margin calls. Many managers took measures such as turning off new loan origination and offering payment holidays and cancellations to increase the odds of ultimate repayment. The vast majority have rebounded well — to pre-pandemic levels or above.

    Still there are also risks. The fundamental one is credit risk. Investors must examine how the underlying loans will behave in different scenarios through granular, bottom-up modeling that can involve millions of lines of data. Another is negotiating optimal structures to withstand macroeconomic and financial cycles, as well as adequately scaling and deploying of assets.

    Private lenders have become more sophisticated thanks to financial technology innovations and artificial intelligence. Big data helps providers make better loans, faster.

    New cadres of fintechs reliant on funding from private capital, such as marketplace and point-of-purchase lenders, are streamlining credit consumption. They are leveraging e-commerce, using algorithms for underwriting and risk assessment in novel ways that revolutionize origination and the customer experience. Forward-thinking legacy lenders are also driving innovation.

    Powerful machine-learning models can analyze broad datasets to qualify new customers for credit services, score risk and determine loan limits and pricing. These platforms can help providers offer competitive rates and increase the availability of financing in niche sectors, while keeping risk costs low and reducing fraud.

    ABF also can offer investment exposure in interesting and often proprietary investments, such as music intellectual property rights.

    Some have valuations over $100 million, and the biggest names could reach $500 million, or more. With substantial cash flows and low correlation to other asset classes, music IP can present compelling value in a world with high equity multiples and record low interest rates.

    Goldman Sachs and Morgan Stanley project annual streaming growth for the next few years around 13%. In addition, music rights owners can further leverage their investments by partnering with musicians and pursuing sync placements in movies, TV shows and video games. Investors can own pieces of their favorite music with the potential for meaningful diversification and double-digit returns on invested capital.

    Another area with substantial opportunities is auto loan markets, specifically in the United Kingdom. In 2015, the U.K. used-car market was a £50 billion ($71 billion) industry, yet only £12 billion was financed at the point of sale with dealers. Multiple finance companies targeted different demographics.

    For global investors seeking potentially high yields, downside protection and portfolio diversification, ABF can be an appealing option.

    Daniel Pietrzak is partner and co-head of private credit at KKR & Co. Inc., New York. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.

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