The opportunity in consumer loan portfolios

Investors are poised to take a bigger slice of a market traditionally associated with banks. Jerome Henrion, co-head of specialty finance at M&G Investments, explains why

Exposure to consumer loans (residential mortgages, personal loans, auto loans, student loans, credit card advances and small business loans) has, until recently, been the almost exclusive domain of retail banks in Europe. But large-scale structural changes in the banking landscape in Europe have opened this hitherto inaccessible sector to investors, who can now seize opportunities in this emerging area of the private debt market.

Huge potential

The private debt market is continually evolving, with the best opportunities often found in emerging, complex and under-served areas. The early years of private lending to corporates by non-bank lenders in the wake of the financial crisis is an example. Specialty finance in Europe looks set to be another.

The emergence of a specialty finance sector in Europe therefore represents an opportunity for institutional investors, such as pension funds and insurers, to gain exposure to one of the largest and best-performing portions of European bank balance sheets. Already a well-established asset class in the US, where the banking system to GDP ratio is much smaller and capital markets more established, specialty finance investments can offer a way for investors to diversify their existing private debt portfolios by investing in inherently diversified loan assets, with historically lower loss rates than corporate bonds with comparable yields and less volatile returns.

Consumer loan margins have remained attractive and stable even against a backdrop of improving household finances in Europe. In contrast to certain corporate sectors where low interest rates have caused leverage ratios to increase substantially, household balance sheets have continued to improve. Regulations have also required lenders to adopt tighter lending criteria for consumer loans, which has led to better loan origination standards and made it harder for borrowers to borrow to unsustainable levels in the event of a downturn.

Increased capital and leverage requirements are driving banks to reduce capital and balance sheet intensity of not only non-core but also core loan assets. The traditional route of selling the first-loss, ‘junior’ risk positions in large pools of banks’ corporate loan books to investors, has been an efficient way for banks to reduce capital usage on this portion of their loan books. But it does little to help them comply with balance sheet size-driven requirements as the loan assets remain on the balance sheet. Selling whole pools of loans, which can improve banks’ capital position and leverage ratios, while maintaining their ability to grant new loans and maintain customer relationships, is of particular relevance to high quality, performing consumer loans on banks’ balance sheets.

This has created a large-scale and growing opportunity for institutional pools of capital, such as those managed by M&G, to selectively acquire or originate high quality pools of consumer loans to offer investors compelling risk-adjusted returns compared to more established areas of private debt.

Innovation in traditional bank finance

The development of the non-bank loan servicing industry together with technological solutions for the ongoing management of the underlying loan pools has also allowed for the origination of loan pools from non-bank origination platforms directly.

Non-bank lenders, often financed by institutional capital from asset managers, originate high quality, diversified pools of performing specialty finance assets.

Specialty finance in action

Specialty finance investing requires a high degree of expertise and experience to identify compelling value opportunities. At M&G, we have the market presence and experience to source and analyse the best investment opportunities available in the market. The following investment examples illustrate how specialty finance can work in practice.

Alongside other investors, we acquired a pool of highly seasoned and performing Irish residential mortgages from a bank, with our share financed by working with relationship banks to obtain non-recourse term debt against the assets. We undertook detailed analysis, including extensive due diligence of the origination and performance of the underlying mortgages, overlaid with Ireland’s macroeconomic, demographic, housing and mortgage market trends.

In another example, having a solid understanding of the business model and depth of due diligence meant that we were able to partner with a ‘point of sale’ finance provider for the second time, having previously purchased the senior debt from their inaugural securitisation of consumer loans in 2017. This time, we purchased the junior-most tranche of the securitisation, with the provider able to gain capital and balance sheet relief on this portion of the loan book.

Recently, we provided a mezzanine debt facility secured on a portfolio of student loans from a specialist lender that serves an under-served but attractive segment – international students attending top global schools for specific advanced degrees. As part of our analysis for this investment, which took several months, we undertook a detailed analysis of the lender’s current loan book, their origination and servicing policies and their growth plans. The facility is also structured to permit only performing loans to be eligible in the borrowing base.

Dependent on the nature and timing of our exits, we target high single digits to low teens IRR returns from these investments.

Limited competition,
sizeable opportunity

Specialty finance is a less-competed area of the market, with less capital currently chasing deals, unlike in more mature areas of private debt such as corporate direct lending. Deal flow should continue to increase as banks’ ongoing deleveraging activity continues apace – in 2017, the proportion of performing loan portfolios sold by European banks (by deal value) more than doubled1 – and non-bank lenders further develop their origination capabilities to fill the gap left by the banks’ retreat.

There are a few asset managers offering specialty finance strategies to institutions in Europe, but having the experience, scale, capacity and flexibility can help to source the best opportunities and ensure selectivity over what assets make it into an investment portfolio.

1 Deloitte, “Lift Off – Loan portfolio markets continue to soar: Focus on Europe. Global Deleveraging Report 2017-2018”

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested.Past performance is not a guide to future performance

To M&G, specialty finance is a specific investment strategy and is distinct from the speciality finance sector