The asset-backed finance market is growing at a rapid rate, but has investor understanding caught up at the same pace? Jon Yarker reports…
Asset-backed finance (ABF) is a rapidly growing area of private credit, with an increasing number of firms now creating dedicated strategies. This has seen competition intensify between private credit firms, eager to outmanoeuvre the others and seize market share, which is putting ABF at an interesting point in its development. One of the drivers behind ABF’s growth is its appeal for numerous investor bases.
“In our experience the increasing interest in ABF stems from investors who are either fully allocated to traditional cashflow lending and are looking to diversify their credit exposure, or do not want to allocate to traditional cashflow lending as they have enough exposure to those borrowers elsewhere in their portfolio,” explains Luke Chan, partner and head of private credit at HighVista Strategies.
This has seen ABF come in from the margins to be a core holding in some portfolios, as its qualities become recognised beyond diversification and increasingly towards the yield it can offer.
“ABF is increasingly becoming a core component of private credit portfolios, as it offers more stable and predictable cashflows,” says Albane Poulin, head of private credit at Gravis Capital. “Investors expanding their presence in the private markets are drawn to this asset class for its potential to enhance portfolio diversification while generating consistent yield.
“However, investing effectively in this space requires access to specialised resources, expertise in structuring and valuation, and deep sector knowledge.”
CJ Wei, managing director of private credit at Northleaf Capital Partners, is also seeing ABF becoming a core holding and highlights the potential it can offer beyond simple yield enhancement.
“Asset-based lending can provide strong downside-protection to investments when you combine highly diversified portfolios with conservative structures, significant asset coverage, borrower alignment and lender-protective covenant protection,” says Wei. He also points to the asset class’s performance and valuations as typically being “very stable” as unlike public fixed income, these investments are not traded and therefore less vulnerable to market volatility.
Read more: ABF an “evolutionary step” for private debt investors
ABF’s relative ‘newness’ is also helping it to increasingly command larger parts of investors’ portfolios. Wei says that ABF’s “emerging nature” can benefit early adopters.
“Given its emerging nature, there is still an imbalance of private lender demand versus specialty finance borrower origination supply,” he says. “This dynamic provides attractive yields and the ability for ABF to generate strong risk-adjusted returns and structures.”
Getting to grips with ABF
Like with any asset class that finds itself coming into favour, a rush of allocations gives way to scepticism and questions about hype. For instance, to what extent are investors committing to ABF simply because their peers are? This is true, to some extent, in some areas which could be suffering from hype according to Stephen Plagemann, chief financial officer at Mount Street. He points to new and innovative types of infrastructure projects, for example carbon capture and battery storage, as falling into this category.
“We are also seeing some interest from retail investors, due to the increased visibility of the asset class,” adds Plagemann. “However the long-term and illiquid nature of the asset class creates difficulties in terms of getting the structure right.”
This has created a need to approach ABF with some distinction, especially given the wide range of assets ABF can give investors exposure to. Here, Gravis’s Poulin argues for the need to distinguish between these different assets. Describing property, vehicles, equipment and energy infrastructure as “traditional” assets for ABF, as well as financial assets like consumer loans, she points out how these are different to “unconventional assets.” With the latter likely to include assets like art, music royalties or litigation claims, Poulin highlights their tendency to have lower liquidity and less transparency.
“At Gravis, our focus is on “hard” assets, particularly infrastructure and real estate,” she explains. “We believe these sectors are more widely recognised, better understood and offer greater investment clarity.
“The core advantage of asset-backed lending lies in the presence of strong collateral, which enhances visibility on recovery value if a deal does not perform as expected. The use of well-understood and widely accepted assets as collateral improves loan liquidity and facilitates asset liquidation when necessary.”
Approaching ABF correctly
The importance of the assets behind the ABF debt itself cannot be overstated, and this is an area which investors are having to spend more time trying to understand. As such, HighVista’s Chan argues that investors should be fully aware of the actual assets they are lending against.
“The idea behind ABF is that lenders will gain exposure to collateral that can be liquidated in an enforcement scenario,” he adds. “However, if collateral is low quality, lenders may sustain losses.”
Therefore, Chan says that investors tackling ABF need to be ready to trade around a wider range of assets given the flexibility ABF affords. In particular, he warns against newcomers taking false comparisons with other similar areas of private debt: “Unlike EBITDA-based lending, which can be executed upon by a generalist team, ABF requires specialised teams able to underwrite and work with each underlying collateral type.”
Asset class specific considerations for ABF extend beyond the collateral supporting the debt. ABF investments are highly structured and can be more difficult to source than other asset classes in private credit. According to Northleaf’s Wei, there are several other aspects of ABF loans investors should be mindful of.
“ABF debt investments include a number of key structural benefits from significant asset coverage and wide ranging financial and asset covenants,” he says. “Embedded in the structures for ABF investments include a handful of financial and a range of eligibility criteria and concentration limits that govern a facility’s borrowing base, while ensuring a high level of collateral diversification.
“It’s worth noting that ABF lenders are generally successful in securing call protections and granular reporting packages that allow for real time monitoring and a high degree of information access.”
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This means not just any firm can get involved in ABF, if they want to do it correctly. Some may assume there are strong enough similarities with cashflow lending, but the wide variety of assets being used in ABF can only complicate the due diligence required. Here, Gravis’s Poulin argues that “deep expertise” in assessing the quality and enforceability of these assets is needed, and the ability to delve deeper if needed.
“It’s not just about understanding the asset’s intrinsic value, but also about knowing the legal framework around enforcement in the event of default, such as whether to appoint a receiver or initiate administration proceedings, and how quickly the asset can be liquidated under current market conditions,” says Poulin. “As a result, asset-backed lending calls for a blend of skills: asset valuation, legal and structuring expertise (especially around security agreements), and strong credit underwriting capabilities.
“When lending against infrastructure assets, an additional layer of insight is needed – specifically, a thorough understanding of regulatory frameworks and the underlying technology – to properly assess the long-term value and resilience of the collateral.”
Where next for ABF (and its liquidity)
Given the drivers supporting ABF’s growth in popularity have not changed, and it is still providing yield, diversification and structural protections to investors, the asset class is expected to make up a growing share of portfolios. HighVista’s Chan calls its continued expansion a “logical step” while Mount Street’s Plagemann expects investors to get more “comfortable” with ABF as its benefits become more widely known.
Despite this optimism in the industry, ABF does raise some asset class-specific considerations that a growing cohort of newcomers will need to familiarise themselves with. Liquidity – or more specifically, a lack of it – is typically an issue that is not at the forefront of investors’ minds until something goes wrong. ABF is still an emerging asset class for many investors which means liquidity has not become a primary concern yet, but this may be worth preparing for given the underlying assets supporting such debt could be hard to trade quickly.
“Investors should also be aware that secondary liquidity might not be available to the same degree as in other asset classes,” warns Plagemann. “However, the security packages available and over-collateralisation (if provided) allow investors to fully benefit from an illiquidity premium over other asset classes with comparable risk profiles.”
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ABF’s increasing popularity looks set to continue, with this asset class attracting larger allocations and becoming a core holding for some. The merits of ABF are becoming more widely known, but the same cannot be said for the complexities of this area of private debt. Its structural nuances, as well as the fact it can open up investors to an extremely wide pool of underlying assets, means ABF is still currently better suited to those with the specialist expertise and resources to match. For instance, some ABF debt holders may find themselves in difficult situations if they needed to offload such positions, only to find the underlying assets are illiquid and hard to sell quickly.
If ABF’s adoption continues at its current pace, firms without the required knowledge and expertise in this area may be in for a steep learning curve.