While private credit funds have had a major impact in corporate direct lending, they are also branching out into increasingly diverse forms of lending. Often bracketed together as speciality finance, managers are lending to buy portfolios of loans, backing specialist non-bank lenders, financing operating equipment or vehicle leasing, or exploiting niches that banks and other managers cannot.

Where banks begin to retrench from markets we are again seeing private fund managers stepping in to fill the capital void with institutional money. While direct lenders across numerous countries now have the dominant market share in leveraged lending, there are similar patterns emerging across various other parts of the credit market.

One team that has seen the shift in market players across the receivables financing space is law firm Macfarlanes’ speciality finance practice in London.

“Our client base has certainly flexed,” says Andrew Perkins, who leads the practice at Macfarlanes. “Our clients were all banks in the past but we see a lot of new entrants into the market and they’re willing to take bigger risks and seek out more niche opportunities.”

But it’s not just credit fund managers who are taking advantage of banks leaving the receivables finance space. Insurance companies and even some pension funds have also become more prevalent providers of capital in speciality finance areas, putting institutional capital directly into the hands of borrowers.

However, banks can still be highly active in speciality finance. “It really depends on the deal,” says Perkins. “There are pockets of specific expertise in banks that will look at providing finance themselves and of course the cost of capital is cheaper than alternative providers.”

The result is a highly divided market where banks and alternative lenders each fill their own niche. Banks are free to chase the low-risk, low-cost financing in the larger-cap market while fund managers and institutional investors are looking at different deals with more complex financing needs, with greater risks but also better returns. Although alternative lenders have taken market share from the banks, it’s one that banks don’t really want to be exposed to. This is helping to increase the options available to borrowers, but does not result in intense competition for deals.

While alternatives managers are able to thrive in this new environment with less bank capital, difficult market conditions with high inflation, rapidly rising interest rates and the looming threat of recession are things no one can ignore. But speciality finance may be well set up to weather a more challenging economic environment.

“We invest in mortgages and unsecured debt and are currently focusing on subsets that are more credit sensitive and less rate sensitive,” says Peter Troisi, partner at Balbec Capital.

Focus on the credit

Troisi explains that, investing in the non-performing part of the market, portfolios are tightly analysed on the quality of the credit on offer and correctly pricing the risk, rather than being focused on how short-term changes in interest rates will impact the performance of the portfolio.

“In today’s market we’re investing through a lens that markets could get a lot worse,” says Troisi. “There are factors today we have not seen for more than a decade in the US. Interest rates are going up and we’re in a situation now where we might see rates continue rising while we’re also in a recession, even though conventionally we would expect to see rates fall in that environment.”

The unusual situation of rising interest rates and recession is one that Balbec has modelled as part of its investment process, and being able to understand how assets will perform in unexpected scenarios offers investors some comfort that speciality finance managers will be able to respond to the kind of volatile market we see today.

As institutional investors become even more sophisticated in their approach to fixed income, speciality finance is increasingly attractive, particularly in light of today’s economic woes.

Troisi says: “Investors look to us for less correlation, low volatility and yield. The capital itself is coming from a variety of allocation buckets. We’re seeing some investors allocate from distressed allocations, but an increasing amount of capital seems to be coming from traditional fixed income buckets.”

Carlos Mendez, managing partner and co-founder of Crayhill Capital Management, says his firm’s approach offers something for LPs “seeking a defensive position in fixed income that are income oriented and looking for high-single-digit quarterly dividends”.

In many ways the story in speciality finance is much the same for the rest of private credit. Investors have suffered years of low yields from traditional fixed income products that has left many struggling to meet long-term liabilities. As they seek replacement investments within alternatives they are also looking to accurately target their risk-return aims. Speciality finance is another piece of the puzzle, offering portfolios that can be potentially made of thousands of individual, underlying loans as opposed to the three dozen or so seen in direct lending. For this they can expect rates of return that remain elusive in public markets despite increasing rates.

Speciality finance is one of the fastest growing and most innovative parts of private credit markets. As banks continue to be hampered when stepping into the space, institutional money will continue to play a vital role in providing finance for businesses and consumers.

Crayhill eyes supply/demand imbalance

“There aren’t usually highly competitive processes, and most of our deals are bilaterally negotiated in private,” says Carlos Mendez, managing partner and co-founder of Crayhill Capital Management, an asset-based alternative lender active in the speciality finance market.

Crayhill backs non-bank originators, servicers, developers and owners focused on a range of areas of speciality finance, including equipment leasing, transportation factoring, trade finance, renewable energy and media receivables.

Mendez says these areas all have deep capital needs, which means competition with other managers or banks is rare because this is a market where there isn’t nearly enough capital to go around. For fund managers this enables a highly selective underwriting process, with all the loans secured against assets, providing additional safety for investors.

“There’s a big supply and demand imbalance in speciality finance,” Mendez says. “It’s a good environment for us when capital is being withdrawn and, today, we are seeing returns that are 200-300 basis points higher than they were pre-covid and the credit quality is better too.”

One factor contributing to the lack of finance being provided to non-bank lenders is the Dodd Frank Act. While the act aimed to prevent an expansion of so-called “shadow banking” by preventing banks from investing in non-bank lenders, it enabled institutional money to fill the void and provide loans to speciality finance firms.

“It really allowed our capital to come to the marketplace without the need to compete with FDIC bank finance,” Mendez adds.