Asset-based credit: As easy as ABC?

The flavour of the moment in private credit starts with an ‘A’ for asset. But how the phrase ends often depends on the type of product and the manager that’s selling it.

Asset-based finance, long the province of banks, is fast becoming the latest tasty treat in private credit. Its broad range and underlying collateral is making it easy to digest.

“We are generally financing everything in the real economy,” says Dan Pietrzak, global head of private credit at KKR.

“Almost anything that you touch every day creates an eventual stream of contractual cashflows that goes into the asset world,” says Joel Holsinger, partner and co-head of alternative credit at Ares Management, citing auto and student loans, as well as royalties from streaming on Netflix or listening to music, to name a few.

Asset-based credit touches many parts of the economic landscape, encompassing asset-based lending, which before 2008 was also done by commercial finance companies such as GE Capital. It also takes in speciality finance, which is lending that occurs outside the traditional corporate banking and commercial real estate system, secured by financial or hard assets.

4 key questions for investors

The assets run the gamut from consumer to commercial loans, against both longer-term assets like mortgages and equipment, or financial assets such as shorter-term receivables. They include ships and infrastructure, as well as less tangible assets such as intellectual property, and more esoteric financial assets like litigation finance and insurance settlements. Also on the menu: cashflows from credit cards and financing speciality lenders.

Estimates of market size vary depending on how it is defined, but KKR puts the private ABF market at a current $5.2 trillion, and expects it to rapidly grow to $7.7 trillion over the next five years. For private credit, “it’s fair to say that the asset-based market opportunity is at least as big as the $1.5 trillion direct lending world”, says Ivan Zinn, founding partner and chief investment officer of Atalaya Capital Management.

The market for asset-based lending alone is “massive”, according to Darius Mozaffarian, president of White Oak Global Advisors, whose ABL business is largely concentrated in North America, the UK and Australia.

He estimates that the ABL market, which generally involves revolving loans backed by receivables and inventory and equipment, currently totals more than $5 trillion, with the banks providing roughly 90 percent of those loans.

Call it what you will, the vast opportunity for ABF, or ABC, is leading private managers, many of whom are coming under fundraising pressure for traditional cashflow-based direct loans, to bolster these businesses, both through purchases of loan portfolios and in-house origination.

In October, a consortium led by Sixth Street Partners, including KKR, agreed to buy the GreenSky home-improvement loan platform from Goldman Sachs, at a discount to the $1.7 billion Goldman paid for it last year.

What are the drivers?

Part of what is driving those asset sales by the banks – the granddaddies of
asset-based lending – is increased regulation and the fallout from the regional banking crisis. They have been busy streamlining their businesses and unloading their ABL portfolios to private credit managers.

For example, Ares funds in June struck a deal with PacWest Bancorp to acquire a portfolio of speciality finance loans totalling $3.5 billion of commitments. In the same month, KKR, whose ABF business represents more than half of its $78 billion private credit platform, agreed to buy as much as €40 billion of eligible and future PayPal Pay Later loans originated in Europe. The trend is expected to continue.

“With rates going up, the economy is in a state of play,” says Lowell Citron, head of the debt finance group at law firm Lowenstein Sandler. “With banks tightening credit in the ABL area, it’s harder to syndicate larger deals, and banks aren’t writing as big cheques as they were.”

Some managers, like Ares and White Oak, which has a large non-
sponsored business, have been building their ABF businesses for many years. Some, like Castlelake, focus exclusively on asset-based investing, including its long-standing, home-grown, asset-based private credit business.

Filling the vacuum

“Banks pressed the brake pedal, and where there’s a vacuum, there’s a need,” says Isaiah Toback, partner and deputy co-chief investment officer at Castlelake. Higher interest rates are another factor.

“The sharp back up in rates has negatively impacted the securitisation markets and mark-to-market losses have resulted in a significant retrenchment of loan purchases by regional banks,” says Bill Awad, head of residential and consumer asset finance at Barings. “The fallout from that is that you have a greater number of origination platforms looking to sources of private capital.”

Because banks have pulled back and financing is harder to come by, “the underlying return on assets without financing has to go higher”, adds Ed Cong, a partner and senior portfolio manager for structured credit and asset-based lending at Marathon Asset Management. He says the firm has been doing a lot of investing in the strategy in the 10-15 percent return range without leverage.

Uncertainty about the economy and about corporate borrowers’ ability to service their debt is enhancing the attractiveness of the asset class for both managers and investors in ABL products. “In a distress scenario you have the ability to take back the asset, which gives you higher recovery levels,” says Cong.

Higher inflation can actually be a plus, “because it increases the price of most hard assets,” says Awad. “There’s a general tailwind on the underlying price of the collateral.”

From an LP perspective, “there had not been many good ways to access asset-based lending, at least not in the form or range of what’s available”, says Brad Bauer, a partner and co-chief investment officer at Värde Partners. Although there has been a slow build in the space since the global financial crisis, “interest has taken a big turn post-pandemic, amid the regional bank fallout”, he adds.

At the same time, “investors have seen the success of corporate direct lending, but they acknowledge that by adding another manager in that space, they’re not adding more diversification,” says Zinn. “There’s a fear that if you were later in the game and hadn’t made corporate direct lending allocations, you want to do something that’s slightly different from traditional direct lending.”

Moreover, even though direct lending has performed well, and has met return expectations on average, “there’s a question about whether companies can support their debt service in this interest rate environment”.

There are significant differences between direct and asset-based loans. “With corporate loans, you get your principal returned only when the company is sold or refinanced, which is three to seven years away,” says Zinn, while with ABL, “capital starts coming back immediately, and you’re not waiting to see how things did over five years”.

“One advantage of ABS over direct loans is that broadly speaking, securities can be marketed or sold,” says Michael Gontar, chief executive officer of InterVest Capital Partners. “You might still lose money on the investment, but there’s usually a market to sell into.”

Another comparative plus: “While the value of hard assets is fairly predictable in shorter periods of time, it’s significantly more difficult to predict asset values five years down the line,” he says.

“Pairing the right skills with data and tools allows us to run scenarios in a way that’s very difficult to replicate in the corporate lending context,” says Bauer. “You have direct access to the underlying asset, which makes these lending strategies unique.” Not only does this provide downside protection, but “most of those assets are self-liquidating and naturally cashflow their way down to zero; they’re not dependent on an exit”.

Risk killer

Amortisation helps lower the risk profile of ABLs. “The Latin root of amortisation is to kill, and because ABLs amortise, they are the killer of risk,” says Zinn.

There’s an important distinction between asset-based and asset-backed lending, which people often conflate, says Dan Zwirn, chief executive officer and chief investment officer of institutional asset manager Arena Investors.

Asset-based lending functions as a subset of asset-backed lending, and is typically secured by accounts receivable, inventory and machinery and equipment, each of which are current assets on a company’s balance sheet.

Like factoring, in which the lender agrees to pay a company the value of an invoice less a discount for commission and fees, asset-based loans can help companies improve their short-term cash needs.

Asset-based lending, however, is not as simple as it sounds. “It is not typically well understood by investors,” says Zwirn. He says Arena has done rudimentary exhibits to help educate investors. “We were afraid we would appear patronising or pedantic, but we got a thank you for sending them.”

White Oak’s Mozaffarian adds: “To do asset-based lending is not easy; it takes time and requires investment in technology, infrastructure and people. We’re managing current assets on the borrower’s balance sheet, whose values change every day, and which converts into cashflow.”

Because ABLs are secured primarily by receivables, which are due and payable by the buyer of the product, lenders must look at the creditworthiness of the buyer, or counterparty, as well as the borrower. The good news is that it’s a fast-moving business, with receivables generally collected within 60 to 90 days, and inventory, which can be liquidated in 120 to 180 days.

Lending against longer-term assets may be more tricky. “People take comfort making a loan against a hard asset they think is monetisable,” says Zwirn.

“But people have got burned when they’ve discovered that some assets without reasonable prospects for ultimately producing cashflow are not assets that are monetisable.” Think textile plants, where the value can turn out to be much lower than was initially thought.

Another issue? “When something blows up, there’s a tremendous delay between when it happens and when it becomes visible,” says Zwirn. “Because a number of asset types are imploding at the same time and investors frequently have financial incentives to delay disclosure, the truth leaks out very slowly.”

Still, most agree that ABF will continue to grow and emerge in importance. “What’s exciting is that the demand is coming from borrowers who need a solution,” says Toback.

Awad adds: “The amount of capital entering the asset-backed finance sector is definitely picking up. We’re just at the tip of the iceberg.”

Offering clarity in ESG

With an increasing number of institutional investors seeking out investments that allow them to meet their ESG obligations, ABL could offer a clear path to achieving these goals, writes John Bakie

By having loans backed by a hard asset over which the fund manager has a high degree of control, it can be much easier to push companies to make positive environmental changes and simpler to demonstrate that environmental and social obligations have been met.

William Barrett, managing partner and co-founder of placement agent Reach Capital, says asset-based lending can offer a more seamless way to meet these goals.

“It can be easier to demonstrate ESG with real assets. If you’re investing directly into clean energy or energy-efficient buildings, then there is a much clearer alignment with environmental objectives than you might get with cashflow lending to a corporate.”

ESG lending has been fraught with difficulties over measuring and demonstrating adherence to environmental goals and this could make ABL an attractive option for LPs.