The case for speciality finance

As more direct lenders pop up, the allure of speciality finance strategies may be getting stronger.

Private credit has firmly established itself as an asset class that can and should play an integral role in a limited partner’s portfolio, no matter the profile of the investor – or so the narrative goes.

That has resulted in an educated LP clientele – a theme that came up in this year’s annual Private Debt Investor US roundtable and an observation many managers and advisors have echoed to PDI in recent months.

“Their knowledge base has developed very rapidly,” said Pat McAuliffe, the head of direct origination at NewStar Financial. “We used to say, ‘OK, let’s walk back on that and go over what first lien senior secured actually means.’ We don’t find that anymore. [Now], they ask us good, detailed and well-researched questions.”

As the level of investor awareness and sophistication rises, LPs also begin committing more capital to the asset class, resulting in a flood of capital to mid-market lending vehicles. That space is “demonstrating material deterioration in credit underwriting and future return potential”, according to a new study by Willis Towers Watson.

The nuances of investing in more esoteric financial assets – rather than a first lien senior secured term loan to a business services company – can be much more intricate, something LPs now could be better positioned to understand. This may not have been the case until recently.

“However, with the [private debt] market increasingly diverse and growing rapidly, it is not easy to understand its complexities,” the study said, adding that this may have contributed to the focus on direct lending. “We feel this approach is much too constraining.”

Now could be the time to take the proverbial shackles off.

The buildup of mid-market lending capital did not occur overnight – it was several years in the making, and the accumulation of money for other private credit strategies will also take time. Speciality finance funds can also provide higher returns, which would benefit LPs as overall direct-lending returns have come down in recent quarters, as the Cliffwater Direct Lending Index showed.

“I believe LPs are looking for more and more ways to get exposure to private credit without overlapping on the same deals,” NXT Capital head of corporate financing and senior managing director John Finnerty said. “So, going into some of these niches really helps expand their exposure.”

Speciality finance vehicles have drawn substantial interest, with Atalaya Capital Management’s Atalaya Asset Income Fund IV hitting its hard-cap of $900 million in May – a sizeable jump from the $525 million hard-cap it hit from Fund III. Neuberger Berman announced the same month that it would be launching a speciality finance unit.

Speciality lenders may have dwelt in the wings of the stage until now, but their time to take the spotlight could be here.