Castlelake on the experience factor in asset-based lending

As traditional banks retreat from asset-based lending, private credit is poised to fill the gap, according to the co-founders of Castlelake.

This article is sponsored by Castlelake

With banks retreating from asset-based lending, there’s a growing opportunity for private credit managers to step into the void like they have done in so many ways throughout the history of the asset class. And the climate looks friendly for asset-based lending opportunities, in particular. However, those most likely to succeed in this corner of the private credit market will have hard-earned experience that’s not so common, say the co-founders of Castlelake, Rory O’Neill, executive chair and co-CEO (above left), and Evan Carruthers, the co-CEO and chief investment officer.

This is no ordinary economic climate, without the distinct signs of a recession, but one that no one mistakes as a bull market. How do you describe the current conditions, and what is driving interest in asset-based lending?
Rory O’Neill

Rory O’Neill: I think you can trace this back to the global financial crisis. Since the GFC, there has been a retrenchment of banks from different aspects of the lending arena, both in North America and Europe, and now there are simply fewer banks to approach for credit. Fifteen years ago, there might have been 30 banks in each European country willing to finance assets – now at times we may see only three. It has been similar in the US, where regulatory requirements seem to have motivated banks to retreat from assets. As a result, we believe that private credit has gradually become more important to asset owners.

In terms of asset-based lending, I think we are seeing a mirror image of what took place in the corporate cashflow direct lending space over the last seven years. First, syndicated loan markets largely replaced the banks in that arena, and then private credit direct lending largely replaced the syndicated loan markets.

It’s our view that we are now at an inflection point where the capital markets that used to provide this kind of lending appear to have closed, alongside an apparent waning appetite from the banking system. That leaves a real need for private credit, because, as we all know, an economy without credit isn’t much of an economy.

Evan Carruthers

Evan Carruthers: We have found that limited partners are more interested in asset-based private credit exposure than before, continuing a trend that, in our view, also began around the GFC. Investors sought private market opportunities as a search for yield in a low inflation, free money environment when sovereign debt, high-yield or investment-grade fixed income opportunities don’t offer much reward.

We are aware that environment has changed. However, inflation like the kind we are seeing today can act as a net-positive for asset-based lending, particularly when compared with corporate direct lending. Consider wage inflation, raw material or input cost inflation. Those factors are generally a net-negative for a corporate income statement but certain asset values, on the other hand, rise with inflation.

While we are seeing increasing interest in asset-based lending from investors, it’s still far from being a crowded space, so we do not believe that investors are competing for deals the same way they are in other private markets. And with less competition, we believe that more structural protections can be achieved.

Can you give any examples of how inflation is impacting the assets that are suitable for private credit solutions?

EC: Let’s take a real-world asset that we finance: an airplane. An airplane costs much more to get off an assembly line today than it did two or three years ago because of input costs. Consequently, the value of that hard asset is going up and we believe asset-based lenders can potentially benefit from that inflationary tailwind. We believe this also makes asset-based lending a natural hedge in an institutional investment portfolio.

RO: In our view, there is also less economic risk in that asset because it isn’t tied to corporate cashflow.

Asset-based lending may make a great deal of sense for a private credit manager given the current market, but Castlelake was founded back in 2005. How did the firm’s strategy evolve to be equipped for the space?

RO: In the simplest terms, asset-based lending is primarily about sourcing and risk mitigation. Once the debt instrument is structured, there’s typically limited upside beyond the par and the coupon, so the downside is what we believe really needs to get managed. And in my view, the only way to excel in sourcing or risk mitigation is experience with the assets in question. That is why we have sought to be disciplined about maintaining a consistent focus on the arenas where we have been “battle-tested” through multiple economic cycles.

I have spent the majority of my 32 years of experience investing in the same categories that Castlelake is focused on right now. I believe that disciplined approach gives us the relationships and credibility as a counterparty to source effectively. And having made equity investments as well as credit investments, we have gained experience managing assets in these categories during downturns.

In what parts of the market is Castlelake seeing the greatest opportunity for asset-based lending from private credit firms?

EC: With experience dictating where Castlelake’s asset-based lending practice goes, we are focused on three primary categories today that we believe have or are experiencing a retrenchment from traditional sources of capital. First, is the speciality finance space, specifically financing consumer credit and small business credit. Here, we have seen capital markets nearly evaporate as a source of capital and banks have certainly retrenched. We know that approximately 50 percent of US consumers face difficulties gaining access to traditional bank credit at the moment, so there is a large opportunity set that alternative credit can step into to help address the need.

The second bucket is real assets, and here we think there is significant opportunity in commercial real estate. Although we admit that people have been talking about commercial real estate’s “maturity wall” since the GFC, unlike the last time there was talk of such a wall in 2012-13, we are in a very different interest rate environment. We are seeing a deep need for alternative capital in both North America and Europe.

The third bucket is aviation, and that’s a slightly different case study, because we believe the fundamentals are compelling in the current environment. Airplanes are full and airlines are generating revenue. However, it’s also a sector that’s emerging from a full-blown depression during covid, only to be hit with the war in Ukraine and the seizure of aircraft by Russia.

And that means banks potentially saw massive losses on their aviation activities over the last few years. But with a recovery well underway, both airlines and leasing companies have significant financing needs, and traditional sources have seemingly dried up for now, so we are bullish about filling that void. We are also quite comfortable doing so, since we started Castlelake with an aviation investment strategy and Rory has invested in aviation since 1993.

How should LPs vet the experience of private credit managers in asset-based lending? How do they evaluate the promises of a pitch deck to find the manager with sufficient experience to excel in that sourcing and risk mitigation?

RO: If I’m sitting in the LP seat, the number one thing I’d ask is if this group has ever managed through credit cycles. Because prior to covid-19, we were in the midst of a 12-year bull run in credit, and there are many credit providers who have never been through a credit cycle. To get through an entire cycle, that provider would have had to manage through a downturn, where an expertise with the underlying asset really matters.

EC: That gets to a critical point in this space. We believe credit providers need to be active managers of the asset. In the sectors we invest in, it’s very difficult to be a passive investor. When a manager has core asset expertise, they have a strong understanding of how an asset will likely perform in a downturn and can seek to structure the loan accordingly. Then if something goes wrong, they can roll up their sleeves, engage in the workout and protect that downside.

Simply put, we think active asset management capabilities are critical. As an example, we have over 60 team members who are involved in managing our aviation assets, because we know the space is cyclical and expect that something, if not a pandemic or a geopolitical crisis, is going to rattle the sector eventually.

There’s also a data element to that core asset expertise. Take the speciality finance sector: through our relationship with one of the largest credit card issuers in the non-prime space, we have real-time data on consumer behaviour. We have an ability to see how consumers behaved during the GFC, for example, and underwrite to the context of the current market and what an extreme downside scenario might look like. Either a manager has that data, or they don’t. It goes back to having experience through a full cycle, and the asset management expertise to ensure that an opportunity is vetted for the best, and potentially worst, of times.