Private debt is already a broad asset class, covering an incredible array of strategies, companies and sectors at various stages of growth. But the growing presence of speciality finance is taking the industry into new and interesting fields, many of which fall outside of the conventional areas that have come to be associated with private debt.
So, what is speciality finance? The answer is complex, because it incorporates such a wide range of businesses and lending strategies that don’t easily fall within existing definitions such as senior debt, subordinated debt or special situations. Perhaps the simplest definition is that it provides debt finance to businesses that could never normally raise debt anywhere else, either because of their financial circumstances or because of the type of collateral they wish to use to securitise the debt.
Common types of debt finance incorporated in this umbrella term include non-performing loans, aviation finance, asset-based lending and music or healthcare royalties lending. Some of the companies that speciality debt providers target are seeking new sources of capital as banks re-price risk and move out of the market, while others target areas where banks have never been before, usually because they require significant specialist knowledge and complex, bespoke lending arrangements.
Tod Trabocco, managing director and co-head of Cambridge Associates’ Credit Investment Group, believes a mix of regulatory and technology change are leading to speciality finance strategies gaining more traction among debt investors today than they have in the past.
“Banks are being forced out of non-core strategies by the regulatory environment and so these assets are finding their way into private credit vehicles. In the US, we see RMBS and some NPL being affected by regulation, while in Europe the focus has been on leasing and NPL,” he says.
“At the same time, new technology is aiding what I call the democratisation of disintermediation, with platforms that enable borrowing money through the Internet.”
“The companies we work with are revenue generating but not yet profitable and they’re not yet on the radar of private equity either”
Raeto Guler, IPF
Just as banks are moving out of these areas due to excess risks, the continuing low interest rate environment – which is only just starting to slowly turn around after a decade – means increasing numbers of investors are hunting yield in more exotic locations. Returns can vary wildly depending on the chosen strategy, but a recent Cambridge Associates report, Private Credit Strategies, an Introduction, authored by Trabocco, suggests investors can expect anything from 7-11 percent for aviation finance, right up to as much as 20 percent for music or healthcare royalties.
Ari Jauho, partner and chairman of fund of funds manager Certior Capital, has made select investments in speciality finance, principally aviation finance, and says there are many good opportunities for investors.
“Strategies such as asset-based lending, some real estate debt opportunities or corporate risk strategies have a lot of opportunities in Europe right now and many sub-sectors show a lot of promise, but in general the smaller niches are better,” he says.
One example of this kind of highly specialist lender is IPF Partners, which lends to healthcare SMEs that have yet to reach profitability and cannot raise debt finance from conventional sources. The firm was established in 2011 and closed a €105 million vehicle in 2015 and began marketing its second fund this year targeting between €150 million-€200 million.
Raeto Guler, founding partner of IPF, says his firm can typically help bridge the gap for companies that have already received venture capital funding but are not yet ready to move onto the next stage of investment and growth.
“We look to come in after venture capital. The companies we work with are revenue generating but not yet profitable and they’re not yet on the radar of private equity either,” he explains.
By being a highly specialised lender, Guler claims IPF can work more closely with individual firms to understand their specific needs and understand both the product the firm is marketing (and typically such firms only have a single product) and the costly process of receiving approval from healthcare regulators.
“General lenders find it hard to understand many of the medical and science aspects that matter here and they also don’t understand the regulatory approval process or the risks it involves,” says Guler. “You can’t take a standardised approach, the debt needs to be structured into tranches and the covenants have to be bespoke as well. There’s also an intensive monitoring side and in that respect, we act more like an equity investor as we take positions on the board.”
Forensic due diligence
Much like mezzanine finance, the line between debt and equity in speciality finance is blurred, and royalty financing is one area in which this is taken to the extreme.
In these types of arrangement, a lump sum will be given to the owner of some intellectual property, often music rights or pharmaceutical rights, so they can invest to launch new products or market their existing product. The owner of these rights then gives the lender a share of the royalties received for a specified period of time or until a pre-set ceiling is reached, and the loan is collateralised through the intellectual property itself.
The main advantage of this type of financing is that companies can raise investment capital without having to give up an equity stake, and more convenient payback terms with less severe penalties for default.
However, such financing can have due diligence implications for LPs, according to Trabocco.
“Many of these strategies are due diligence intensive and are far removed from private equity and venture capital investments. The underwriting is very different, as are the servicing needs. You have to approach speciality lenders as you would a business as they can be very labour intensive due to the need for active servicing. They also have very rapid cash flow that needs to be redeployed regularly,” he says.
Certior Capital’s Jauho says getting to grips with the individual strategies within the speciality finance umbrella is crucial, as each operates very differently.
“Just within aircraft leasing, you need to look at whether the payments will cover the loan – which is generally less risky – or if the asset needs to be sold at the end then you’ve got to be able to make a judgment on its likely value and how difficult it might be to sell,” he explains.
For LPs hunting yield, which are willing to deal with the heightened due diligence that speciality finance requires, this diverse array of strategies could offer superior returns while debt investors wait for interest rates to slowly creep upwards.
Similarly, for fund managers – if they want to diversify their offering and have a solid servicing operation, or are capable of acquiring one from a bank leaving the market – speciality finance could offer just the opportunity they are looking for, though it pays to hire specialists that bring the kind of expertise required to beat return expectations.
The democratised disintermediation of the credit industry is set to continue for the foreseeable future and one can expect to see many more niche approaches on the horizon.