How do you define speciality finance?
Speciality finance tends to be asset-oriented. The inverse of that is corporate-oriented finance. When there’s a loan involved, the collateral tends to be a specified, ring-fenced group of assets, and that group of assets can be either static or dynamic.
When there is no loan, speciality finance refers to the purchase of pools of assets and the recoupment of the investment through a steady stream of payments. It’s different from private equity where you buy not a pool of assets but one asset, and you recoup your investment in one fell swoop with a sale, or in a couple of fell swoops with a dividend recap and a final sale.
At Cambridge Associates, speciality finance includes everything from rediscount lending to music royalties, movie royalties, healthcare royalties, trade finance, life settlements and non-performing real estate loans. So, it’s extremely broad.
How does that differ from direct lending, where you’re getting your capital back through interest payments and the credit is generally secured by all the assets rather than a single one?
In direct lending, your risk is enterprise value. That’s important because you could be a direct lender lending to a borrower that has a lot of equipment. You have a claim on that equipment. You’re much closer to speciality finance doing that if you’re a direct lender lending to a business services company that has no assets.
How are LPs thinking about the strategy?
They love it at the moment. When they’re allocating to private credit, they see the dwindling market for mezzanine. They see the competition in direct lending, and they’re looking for something interesting to do where they can lock up capital for a decent return. And they recognise that speciality offers a lot. For returns, you can get LIBOR plus 2 percent to a gross 15 percent. You can get trade finance at the lower end, which gives you highly diversified global exposure, and you can get non-performing loans at the higher end. Aircraft leasing alone has strategies that range from 5 percent all the way up to 15 percent.
LPs see a long list of positive attributes in speciality finance: the current levels of interest payable, the high yields, and the fact that it’s self-liquidating and uncorrelated. And they think to themselves, “this is a place where I want to be”.
Investors are generally knowledgeable about corporate private credit. But given the intricate nature of speciality finance, has it taken them a little longer to warm up to the strategies?
One hundred percent. First, the sheer variety means it’s difficult to apply the same exact underwriting approach for the different managers. At the end of the day, there is a core credit principle that underpins all these strategies, and so that provides an analytical foundation.
But when you think about, for instance, life settlements, you think about actuarial tables, you think about healthcare spending – you’re processing a set of data points that are vastly different from what you might see in railcar leasing. For movie royalties, you’ve got to learn about slate financings, how movies perform in a downturn and how digitisation is changing that.
So, there’s a lot of different things you have to look at when it comes down to underwriting these speciality finance firms.
Where is it going within LPs’ portfolio allocations?
It’s generally going into private credit allocations or it’s going into uncorrelated baskets. Generally, what we’re seeing is that LPs that have allocated to direct lending and mezzanine are hitting their target allocations and are looking for other things to do. Or LPs are getting a little bit nervous about what they’re seeing in the credit markets on the direct lending and mezzanine side. They’re looking for alternatives that offer security and ‘first-dollar-out’ risk. That includes distinct strategies within speciality finance, such as rediscount lending and some asset-based strategies.
If you’re allocating out of uncorrelated baskets, you’re probably not going to be looking at something that’s correlated. We probably won’t be looking at aircraft leasing because that can be more correlated than, say, a life settlements strategy, which has no correlation to the market.
Has speciality finance been an area that large asset managers are moving into, or do they see it as more trouble than it’s worth?
In my conversations with GPs, I’m detecting a couple of trends.
First, those that have speciality finance already get it, and they’re looking to expand. Second, when I speak to a GP that lacks speciality finance and they ask me what they should do, I say, “Well, you need a non-corporate strategy.” They all nod their heads and say, “We were just talking about this.”
So, there’s a lot of recognition that if you want to be an asset manager in the credit space, just having corporate exposure is probably inadequate.
How are they going about building these platforms?
Some are going to try to do it on their own. They’ll do that by hiring a couple of pros to join the team, give them an allocation within a larger fund, a series of funds or an SMA. Some are actually trying to buy whole teams. I’m hearing about large asset managers that are looking to buy really speciality, niche strategies. It comes down to the question of buy versus build.
What are some of the chief misunderstandings you think are out there?
I think frequently investors fail to recognise the structuring, intricacies and attention to detail that go into the execution of these strategies. For example, one investor has said, “No, I don’t want to do asset-based lending with large retail exposure,” not recognising that the level of analysis that goes into that retail ABL strategy dwarfs anything that is available to an equity analyst on Wall Street.
Third parties will actually go in and check the pricing on retail items to make sure that they’re accurately reflected – not just in the general ledger but also to ensure they are not being sold at a discount at the cash registers. They go in and check a sweater hanging on the rack for the price. They go to the cash register and make sure that $40 is actually being charged at the point of sale for a sweater that is being sold for $40 on the tag.
I think the next phase of the learning curve is understanding the detailed structuring and attention to detail that’s paid by a lot of these managers.