US Investors Look to Specialty Finance as Interest Drops in Private Credit

Investors who have binged on the US private credit market in the last few years are now turning to the growing specialty finance space where competition is less intense and spreads are more attractive.

Because of the complexity of the lending structures, the specialty finance market is only a fraction of the size of cash flow lending, but investors are attracted to the potential for double-digit returns and the enhanced protection from asset collateralization.

Specialty finance firms are non-bank lenders that make loans to consumers and small to midsize businesses, which may have difficulties obtaining financing otherwise. The space covers a wide gamut of strategies, including, but not limited to, asset finance, aviation leasing, life sciences, shipping and equipment financing.

“Investors are particularly attracted to the fact that there’s underlying collateral supporting the loans. Over the last 20 years, asset-based loans experienced less than one-third of the annualized default rate of cash flow loans,” said Bruce Spohler, co-chief executive officer of Solar Capital.

With spreads tight across the direct lending space given the heightened competition among players, investors with private credit allocations have been bound to look elsewhere for returns.

Just US$22bn was raised globally for private credit in the third quarter with Europe leading the charge with US$13.9bn raised and the US lagging with just US$6.5bn raised, according to data firm Preqin.

“We believe specialty finance offers the most compelling risk adjusted returns in the market today,” said Dan Pietrzak, co-head of private credit at KKR, whose specialty finance loans are 9% of its business development company’s net asset value, but the firm is aiming for a range of 10%-15%.

PROS AND CONS

The lender-friendly characteristics of specialty finance, including wider spreads, low leverage and tighter covenant packages, are increasingly bringing capital to the space.

“Specialty finance deals, because they are often more bespoke in nature, allow lenders to avoid some of the competitive dynamic that can cause lenders to compete on documentation to win business – such as forgoing the inclusion of many financial covenants,” said Justin Burns, a principal at Atalaya, a investment firm involved in specialty finance, which is part of its overall private credit strategy.

Some characteristics of the market, however, could deter credit firms from getting involved in the sector. For instance, the process to source, underwrite and manage specialty finance deals can be meaningfully different when compared to traditional direct lending.

Portfolio churn is a key concern. With 12 to 18 months of average life, asset-based and life sciences loans have shorter durations than cash flow loans, which can remain two to three years in a lender’s portfolio.

Refinancing risk is a constant for asset lenders, which are forced to seek other investment opportunities to compensate. Due to the shorter durations in the specialty lending space, risk assessments are done within shorter windows than those of typical middle market loans.

“With cash flow lending, you’re trying to predict Ebitda five to seven years in the future, whereas asset-based loans are underwriting near term collateral values,” Spohler said.

Worry prevails that despite the entry barriers, specialty finance is not a market immune to excesses and that the risks associated with looser documentation prevalent in the cash flow lending market may soon extend to the sector.

“Before it was trendy, we invested in aircraft leasing, but significantly limited our activity in the sector beginning three years ago when the risk had become more elevated as a result of too much capital entering the market,” Spohler said. (Reporting by David Brooke. Editing by Michelle Sierra and Jon Methven)