As the covid-19 epidemic unfolds, the short-, medium- and long-term economic impacts of the global shutdowns are still unknown. Although institutional investors are proceeding carefully with loans to non-bank lenders and speciality finance companies, one thing hasn’t changed: the search for yield.
The essential characteristics of some private credit investments, and particularly direct lending, could in certain situations meet institutional needs for short-duration investments that deliver yield with low correlation to public markets.
In our view, there are five niche areas of direct lending that could be worth considering in the current covid-driven economy.
1 Residential non-performing mortgages
One of the economic impacts of covid-19 will be a surge in non-performing residential mortgage loans. For credit investors, this means transitioning from funding new loans to purchasing non-performing loans at distressed prices.
Starting in late February, the marketplace underwent a noticeable shift as the number of banks and other mortgage owners looking to sell NPLs increased dramatically. NPL prices have dropped significantly on both an absolute basis and as a percentage of the underlying homes’ value. This provides institutional investors and family offices with a compelling entry point into this asset class, even in this uncertain economy.
2 Collateralised art lending
In times of crisis, owners of fine and decorative art, antiques and collectibles can raise cash based on the value of their art assets.
The global art market is driven by scarcity and value and moves in ways that are often independent of – and even counter to – macroeconomic cycles. Providing loans to finance lenders specialising in art lending can potentially yield non-correlated returns for institutions looking for short-term investments. This kind of first-lien, senior secured lending involves substantial collateral and loan-to-value ratios of 40-50 percent, with a typical maturity of 12 months or less.
In previous periods of economic crisis and market volatility, the Artnet index of the top 100 artists not only showed more resilience than other asset classes, but also retained greater value, according to the Deloitte and ArtTactic Art & Finance Report 2019. Between 2000 and 2018, the index produced an 8 percent compound annual growth rate, compared with 3 percent for the S&P 500. The index has outpaced S&P growth consistently, even considering the 35 percent decline the art index experienced from 2008 to mid-2009. The report said that although it took the S&P five years to regain strength, by 2013, the art index bounced back and even outperformed its 2008 peak, within just two years of the drop.
3 Buy now, pay later
During economic shocks, consumers still need to make purchases, but many do not want to use credit cards due to high interest rates. To bridge this gap, many retailers offer ‘buy now, pay later’ services, which allow consumers to make interest-free purchases on installment plans when shopping online. The retailers pay the interest – a fair price for attracting consumers who may otherwise purchase nothing.
There are several reasons why providing debt capital to specialised lenders in this space makes sense right now. With an average loan maturity of less than 60 days, the asset class is ultra-short duration.
Since the covid-19 shutdowns, the risk profile for buy now, pay later specialised lenders has improved. They have significantly elevated their underwriting standards by increasing FICO requirements and conducting more extensive income and employment verification. At this point, many specialised lenders now have portfolios that are 100 percent ‘post-covid’, thus providing investors with a clear vision of the underwriting profile in the current market environment.
4 Co-living companies
Since 2004, home ownership in the US has slipped to 65 percent from 69 percent, according to the US Census Bureau. This trend could continue in light of the economic shock caused by the virus, coupled with tighter mortgage standards.
At the same time, the overall US rental rate has been rising steadily every year. The millennial generation – the largest in US history, and currently representing 26.4 percent of the country’s population – is looking for affordable alternatives to paying high rents, and a weakening job market may accelerate this trend. Reports have shown that co-living companies saw an uptick in occupancy as tenants looked for homes in which they could abide by ‘shelter in place’ orders.
Co-living spaces provide access to a private bedroom and shared living space and kitchen. The accommodation is often tailored to the needs of young professionals who want to live in style in the heart of major cities, but who do not have the funds to get their own place.
For institutions seeking non-traditional real estate investments, providing direct loans to co-living companies offers compelling exposure to short duration (typically nine to 12 months), high-quality tenant credit risk. They also offer a differentiated risk profile relative to other investment opportunities in alternative lending.
5 Canadian asset-backed lending
Investors seeking secured lending opportunities outside the US don’t have to look too far. Despite covid-19, Canada has several opportunities through asset-based lenders with loan-to-value ratios at 50-60 percent. The country’s banking sector is highly consolidated, and strict regulatory requirements create opportunities for non-bank lenders.
Competition for asset-based lending as a source of funding for medium-sized Canadian businesses is limited, but awareness is growing. Investors can come in as first-lien lenders using inventory, accounts receivable, real estate and equipment as collateral.
One of the country’s standout asset-backed loan sectors is the security and defence industry. Between 600 and 800 companies engage in the sector, which tends to be countercyclical. Canada is committed to spend in excess of $40 billion over the next 15 years on its military, but these defence and security companies have limited financing options.
Loan terms for asset-backed lending are 12-24 months, which is attractive to institutions that are looking for short-duration credit investments. One of the reasons Canadian collateralised loan opportunities are relatively untapped is because deal-seekers lack the contacts to gain introductions, particularly in the close-knit defence industry.
In the last few months, the global economy has shifted as a result of the pandemic. Although we may eventually return to a world that looks similar to the one we left behind in February, the entire planet will be forever changed by these unprecedented events. For institutional investors, finding yield in new, previously untapped sectors is going to be essential to generating uncorrelated returns in this uncertain time. If there’s one thing we know for sure, it’s that we can no longer count on ‘business as usual’ to carry us through.
Jon Barlow is founder and CEO of Finitive, an institutional private credit platform based in New York