From Nerd to Star: The Rise of Asset-Based Finance

Even if you are an occasional consumer of financial news, you would have most certainly heard about “private credit”. It’s the number one game in town right now. It’s having its moment in the sun. People want to talk about it, people want to be in it, and they want to be around others who are too. There are several reasons why it is currently the most-talked-about-investment strategy which won’t be explained here because that can be found anywhere and everywhere (just search “private credit” on YouTube and you’ll see interviews with the heads of credit from every $50bn+ fund discussing private credit; it’s a helpful exercise if you need a reminder of who is running credit at which fund).  

About a year ago, at the very end of these news stories, “asset-based financing” (ABF) would be mentioned as a new area of focus. As the year progressed, asset-based financing moved up in the story and now it merits its own articles, white papers and research reports which are celebrating it as the “next big thing” in private credit.

This meteoric rise in interest in ABF is very exciting. However, what many don’t realize is that this sector – also called structured credit, securitized credit, structured finance, securitization (so great that it has multiple names) – has been around for decades but has largely been ignored. Except for two major events (the Enron debacle and the GFC – to be discussed in another article), it has existed in the shadows of other credit products without anyone giving it much attention.  It was the “nerdy” table working in the corners of finance and happy to give the spotlight to its more popular peers – leveraged finance and high yield bonds. Prior to the GFC, if someone said they worked in structured finance, they were usually met with blank stares because most people had never heard of it (however during the GFC, the world finally learned about securitization but not in a good way).  

Nowadays, industry and mainstream publications, such as The Wall Street Journal and The Financial Times, are writing about ABF (the term that the market is settling on). Rather than trash the product as they did during the GFC, they are heralding its merits. The nerdy corner table occupants who were previously ignored are now in the spotlight. And this recognition is long overdue. As those who have been in the industry since the early days, this product always deserved more attention with its solid risk-adjusted returns, structures with natural downside protection and low correlations. However, two new factors finally pushed it into the spotlight - the current banking environment and the expansion of financial technology.        

Strong Risk-Adjusted Returns & Downside Protection

Asset-based finance has always been a credit product where investors could earn a premium without bearing additional risk. Structured deals usually pay a “complexity” premium compared to corporate debt but are senior to other leverage, de-risk over time with amortization and can have excess asset coverage (eg, credit enhancement or over-collateralization) to absorb losses. Additionally, the sector has low correlation to other financial products, including corporate debt, and is thus a good diversifier in any investment portfolio. Finally, it has a [partial] natural hedge to high interest rates. Unlike corporate borrowers who are struggling with interest coverage in the current rate environment, ABF’s coverage is relatively stable since asset yields usually move in tandem with liability costs.  

Current Banking Environment

The current banking environment is probably discussed as often (if not more) than ABF. Basel III endgame, CECL, regional banking crisis and other events are forcing banks to retreat from markets that they once dominated and creating an opportunity for non-bank capital providers to intervene. One category of non-bank lenders that does not receive much attention is the specialty finance lender. In the past, banks were the largest providers of consumer and commercial credit and financed these loan originations in multiple ways. They dominated credit card and auto ABS back in the day but also accessed other debt products and their deposit base for liquidity. But since the GFC, banks are not originating loans to consumers and businesses to the same extent and specialty finance lenders have filled the gap (financial technology advancement also helped, which is discussed next). These finance companies do not have the same access to multiple leverage markets as banks do (due to size, credit rating, among other things) and are thus heavily reliant on the ABF market to provide economical capital. The ABF market has experienced growth in recent years, fueled by this entry of more originators and sectors. However, this expansion would not have been feasible without a broadened investor base. Fortunately, credit funds and insurance companies who may have previously invested in other credit and equity markets are now increasing their allocations to structured credit due to its attractive returns and increased opportunities.  

Financial Technology

Financial technology innovation has broadened the range of assets eligible for financing through the ABF market. For example, ten years ago, we still carried cash in our wallets. Today, virtually every payment we make is via credit card or a cashless transaction. One credit card swipe creates four opportunities to monetize via ABF: the purchase amount itself (“credit card receivable”), the credit card fees paid to the banks, the leasing of the card terminal and the small business loan provided by a fintech lender. Credit card receivables were one of the first asset classes to be securitized, but the other cashflows – fees, lease payments and small business loans that used to be a bank product but are now provided by tech-enabled lenders – are relatively new and have contributed to the ABF market’s expansion. Products offered by these fintechs straddle many markets including consumer finance, auto, commercial, transportation, just to name a few. Technology has also facilitated the underwriting, transfer and financing of these assets, which may have previously been an obstacle for some to invest in this market. Not only has the availability of data to incorporate into underwriting proliferated, but also the ability to efficiently process large amounts of data has improved with advanced software and third-party systems. These have greatly reduced friction points to investing in the ABF market.  

How long will ABF be part of the popular crowd? The factors discussed here aren’t disappearing anytime soon – if at all. However watch out. Popularity comes with wannabes, and if everyone tries to get a piece, a frothy market will arise which will drive senseless risk-taking to gain market share. Finally, the elephant in the room – a potential recession (and without a major government stimulus) could test underwriting models and compress expected returns which may scare some away and push securitization back to the corner table.