Northleaf: The growing market for specialty finance lending

Investor appetite and borrower demand for specialty finance is growing. But this is a niche market that requires a specialist approach, says Northleaf managing director Michael Morris.

This article is sponsored by Northleaf Capital Partners

What exactly is specialty finance?

When we talk about specialty finance, we are really talking about companies where the primary business line and means of profit generation is the origination and servicing of some form of financial asset. This will typically involve loans or financial receivables but can also refer to other financial assets, such as royalty streams.

Michael Morris

The traditional banking system and capital markets are less receptive to lending to niche segments of specialty finance, which creates a compelling opportunity for capital providers like Northleaf to step in. Our platform lends across a range of traditional industries, but we have a dedicated team that has developed expertise in specialty finance lending over the past five years.

Investors are increasingly drawn to this market due to strong risk-adjusted returns, high cash yields and the less correlated nature of the underlying investments as compared to the broader economic environment. These assets also offer attractive diversification characteristics as part of a broader investment portfolio.

Where within that definition do you focus your attention and why?

You can break the specialty finance market down into three buckets. There is consumer lending, which focuses mainly on non-prime and sub-prime loans to consumers. There is the commercial side, which primarily includes small business loans, factoring arrangements and equipment financing.

Then, there is esoteric or niche financial assets. These are areas that don’t directly relate to consumer or commercial credit and may include litigation finance, healthcare receivables and other royalty streams, possibly related to intellectual property. At Northleaf, our primary focus is on esoteric and niche financial assets. These are more complex, harder to access and less understood areas for traditional capital providers. We believe that greater inefficiencies in these categories provide better risk-adjusted returns for our investors.

How has this part of the market fared during the pandemic?

Importantly, in the current environment, esoteric financial assets offer very low correlation to economic cycles. Performance tends to be driven more by idiosyncratic events – for example, the outcome of a specific legal proceeding in the case of litigation finance – rather than the broader macro environment or default rates in the corporate credit world. In addition, loans are typically secured by underlying pools of hundreds or even thousands of individual financial assets. This further diversifies risk and ensures that overall performance is not tied to a single event or credit outcome.

Due to the low-correlation nature of our specialty finance portfolio, our borrowers have continued to demonstrate strong and consistent performance across origination and collection metrics, while maintaining low loss rates. Our specialty finance platform has a strong track record and has performed exceptionally well, even during the covid-induced economic shutdown.

What are your predictions for what the future holds for specialty finance?

We will continue to see more capital coming into this space, as investors see the potential for achieving attractive risk-adjusted returns with the added benefit of diversification from the rest of their private credit allocation.

In particular, I think we will see more interest in the esoteric areas of the asset class, given not only the strong returns but the uncorrelated nature of these investments.

What factors are driving more institutional capital into this market?

Institutional investors like ourselves have developed niche expertise and are providing flexible and dynamic capital that is successfully facilitating the growth of specialty finance businesses. Our capital solutions can include debt capital and equity capital and may be structured as loans, JVs or direct acquisitions. More recently, and as a result of covid, meanwhile, we have seen traditional banking systems retrench from this market. Banks are returning to their core areas of traditional lending activity and creating opportunities for lenders with niche experience to step in. In the past year, Northleaf completed several investments that would previously have gone to a bank, including a prominent legal finance platform and a healthcare finance business. Furthermore, we have been able to execute these transactions on attractive terms and with attractive economics.

How do skill sets needed for specialty finance differ from traditional private credit?

This really is a specialty area where credit investors need a specialist skill set and a specialist approach to successfully originate and execute.

From an origination perspective, there is a different ecosystem of borrowers, intermediaries and funding providers. Dealflow is often generated through direct contact with the underlying specialty finance platforms. Having an established network and deep relationships with key players in the space is therefore critical.

From an execution standpoint, there is an essential knowledge and experience component required to adequately and successfully underwrite the risk of these businesses and to execute attractive structuring to generate strong risk-adjusted returns. We create highly bespoke documentation and legal structures customised to the assets and platform. There is no one-size-fits-all approach.

For example, we recently facilitated a transaction in the medical liens space that involved the acquisition of a pool of assets, financed with both senior debt and preferred equity. Our firm led the financing, drawing on the experience and knowledge of our specialist professionals who have been investing in that niche space for almost a decade. We also leveraged the experience of management teams of our portfolio companies currently operating in the space. The resources and experience we brought to the table were a differentiating factor that allowed Northleaf to diligence, structure and close the transaction on an expedited timeline.

Michael Morris leads the origination, evaluation and monitoring of private credit investments in North America, with a focus on non-sponsored and specialty finance transactions