The Tailwinds Behind Asset-Based Finance
What does the asset finance market look like today?
When we think about asset-based finance, we are talking about a large market. Estimates vary significantly but we view it as a $15 trillion -plus market, so that is material in size. In comparison with direct lending, it is meaningfully larger and the diversification opportunities it offers are compelling.
One of the things that is helping asset-based finance in general is that private market activity is growing. Within that, private credit as a totality is seeing significant secular and structural tailwinds. From the adoption perspective, direct lending and senior secured, hybrid and mezzanine strategies have seen sizeable growth, so asset-based lending is really the next extension of the growth in private credit.
When we consider asset-based finance versus direct lending, at the heart of direct lending is non-investment grade lending that is highly indexed to financial sponsors and private equity activity. With the growth of drawdown funds in senior direct lending, there is a large volume of non-investment grade credit in portfolios.
Asset finance, on the other hand, is really about financing assets that are not tied to the ongoing corporate entity, so it is pools of typically diversified collateral which lends itself well to investment grade equivalent risk exposure for the most part. We look at asset finance as having really four main pillars: pools of real estate assets, residential or commercial, pools of consumer exposure, pools of hard assets and pools of financial assets. For us, that last bucket covers a broad range of financial assets including fund finance, namely subscription lines, credit asset-backed loans and private equity-backed NAV lending amongst others
Why is there such a compelling narrative for asset-based lending right now?
One of the benefits of asset finance is that it offers a materially larger diversification play relative to other fixed income exposures because of that non-corporate exposure and lower correlation. It does not need to see performance of the corporate or a refinancing event; instead, it is largely self-amortising. It also provides positive relative value versus public fixed income while offering material structural protections.
There is a structural change in the market going on, too, which is creating secular tailwinds for the development of this product in the private markets.
First, there is a push effect, which is around bank regulation, bank costs of capital, the need for greater depth and the need for customisation for borrowers. All of those things align towards the institutionalisation of this market, which has historically been bank heavy. Banks have finite balance sheets and there has been some dislocation along with greater regulation, making it a natural place for an extension of private capital formation to bring in more institutional involvement.
The pull effect is driven by asset allocators, as different investors look at the market with different lenses. As allocators think about the segmentation of portfolios, there will be an overall alternatives allocation, and within that there will be high yielding and low yielding opportunities. In addition, investors will also evaluate how to deploy capital to optimize their broad fixed income exposure – whether that is in the public or private arenas
We see insurance capital, for example, beginning to reassess its own strategic asset allocations and thinking about corporates versus non-corporates and spread premiums. Insurers are focused on liquidity, yield and duration when making allocations, and they are currently re-evaluating how they can best achieve their goals. That means looking again at alternatives buckets and what flavour of private market exposure makes most sense, particularly as it relates to non-investment grade corporate credit and direct lending.
Then, at the same time, there is a growing consideration of this fixed income replacement option. LPs ask themselves: how do I want to get that income, what liquidity do I need, what liquidity can I trade-off for what premium, and how do I optimise a fixed income pool that may or may not be part of alternatives.
When you consider the push and the pull, the balance of those tailwinds is that both borrowers and investors are finding material benefits in asset-based finance.
What are some of the more interesting areas of asset-based finance?
We actually think a lot of the space is interesting, and all those main pillars of activity are generating compelling opportunities. We like the areas where we see more structural demand – there is a natural housing shortage, for instance, so we like exposure to that as we believe that is likely to sustain and offer some interesting value.
The consumer has also held up pretty well and, given the granularity of these pools, one can get some interesting exposure there. Digital infrastructure is another area, in areas such as data centres where the need for capital can be customised to fit the requirement for capital from those companies.
Finally, fund finance is an example of an opportunity where secular growth in private markets requiring leverage, coupled with some of the pullback in bank lending, has led to some repricing of risk exposure in a pretty interesting way. The subscription lines market used to have many more participants, but the pullback has shrunk capacity and led to some increased pricing that is creating opportunities.
How does asset-based finance fit into an investor’s portfolio, and what does that mean for the outlook in the asset class?
It offers the advantages of diversification, structural protections and relative value. That makes it complementary to both fixed income and alternatives in investor portfolios.
So, who will find this most interesting? Insurance capital continues to see growth and asset finance is an attractive general account asset, so insurance capital is quite a big player in this space.
Other asset allocators are looking at their fixed income portfolios, whether they are state pension funds, corporate pensions or endowments, because they all access their liquidity needs over longer periods of time.
In the investment grade world, it is about yield but also about incremental spreads, and that combination means this strategy will remain attractive in other rate environments as well. The utility and attractiveness of this space will continue to hold as rates come down.
The real question is about relative value: relative to public corporates, you can pick up 100 to 200 basis points here, and relative to investment grade corporates, this looks attractive within a portfolio construction on a risk-return basis.
I equate asset-based finance today to where direct lending was five to eight years ago: it’s big, it’s noteworthy, it has value as a core allocation in investor portfolios, and there is the potential to attract significantly more capital and expand the addressable market. That creates a huge opportunity for it to be accepted deeper into portfolio allocations.
When you think about the runway, the important thing is that the heart of asset finance was traditionally done on bank balance sheets. When you think about the scale of the market today and the amount of capital being formed, the fact is that the supply is still meaningfully larger yet. As capital forms, the capacity to do different types of financing, investing and customisation means the addressable market will continue to grow, and that makes the opportunity set here compelling.
How do you see the evolution of the direct lending market and how does asset finance play into this narrative?
The senior part of the capital structure in asset-based financing is typically investment grade equivalent risk, which has the benefit of providing attractive return on regulated capital, which is beneficial for capital allocators like insurance companies. When they look at strategic asset allocations, their appetite for that risk is greater than it would be for traditional direct lending.
Asset allocators generally want to access the risk spectrum, considering their term structure of long-dated versus medium or short-dated exposures and seeing what premiums they can get for each part of that term structure.
The good news is that direct lending has been around a long time and the experience among asset allocators has been pretty positive, with good returns and a premium to public markets that has proven out. Now the question becomes how those asset allocators are thinking about fixed income and private allocations more broadly, with investment grade debt being the natural extension as it is typically the largest part of their portfolios.
The non-correlation features of asset-based finance are playing out in an interesting dialogue today. If you want to play in the alternatives space right now, you are taking a lot of corporate exposure, and the same is true in the investment grade bond market. Whether you are bullish on economic growth or more conservative, at some point your re-evaluation of how you want your portfolio to set up and what kind of correlation you want brings you to asset-based finance.
Furthermore, traditionally if you wanted high quality investment grade equivalent risk, that was generally indexed towards public bond markets or some securitisation. People played in that space because they valued liquidity. There is no doubt that the private markets are, by definition, less liquid, but there is a real cost to liquidity. That cost is generally evidenced in tighter spreads in public debt and the truth is liquidity tends to be the most scarce at the greatest time of need. There is a cost of monetising for liquidity and some friction caused on exit.
That is why the term structure on asset finance is interesting, because an investor can have some long-dated exposures of seven to 10 years, some three- to five-year exposures and some shorter duration, if they want. As that becomes more robust, allocators are re-examining that cost of liquidity and this reallocation between fixed income public and fixed income private.
