Specialty Finance in Depth - Post 2
A closer look
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According to Preqin, total assets in private credit are expected to increase to $2.3 trillion by 2027, up from $1.6 trillion in 2020. Plenty of articles and reports reference and examine these figures (I will share a few on this blog) and you can also find them easily via a Google search. This article from Queen’s Business Review states that “private credit” and “golden age” generates 17,000 results! What I want to focus on is a smaller, but rapidly growing piece of this market called specialty finance. This space is harder to get figures on and more challenging to understand - especially if you are trying to raise your first few million of debt financing. Lending companies, debt capital markets, credit facilities, collateral, covenants, loan tapes, buy boxes, advance rates, eligibility criteria - all of it is a recipe for passerbys to alts and private credit to venture elsewhere. This is fine, and to be expected candidly, because of the niche, complex, idiosyncratic, and ‘specialized’ nature of the lending.
Much of the growth in private credit is expected to come from direct lending, sponsor finance, mezzanine, and the four food groups of real estate debt, but asset-backed lending strategies (a/k/a Specialty Finance or SpecFin) I predict will also grow meaningfully in the years ahead. This blog is dedicated to supporting those who want to better understand, access, and network with peers in SpecFin and because of where I spend time, fintech lending, at its early, innovative, (and messier) stages.
In this second post I want to go in-depth to begin a breakdown of this often overlooked area of private credit. What are these SpecFin strategies? What are the underlying assets? Why is this area of private credit growing so quickly? How are these loans originated? How are they underwritten? Who are the new originators in this space? How do fintech lenders fit into this area? What are the lenders to these lenders looking at when they make a credit decision? Where do banks fit into this discussion?
Taking this in reverse:
Q: Where do banks fit into this SpecFin discussion?
My take: SpecFin grew after the 2007-2008 global financial crisis when regulations, accounting rule changes, and tighter, more burdensome capital requirements led many banks simply to retreat. Combined with 2023 bank failures, commercial and consumer deposit flight (which caused stress at even more banks), additional regs, and additional Basel III rules, all proved to be wind in the sail for a different type of financial institution to fill the void. The new SpecFin lender wasn’t the bank down the street but was instead the private credit fund, hedge fund, alternative asset manager, or fintech lender. Banks haven’t gone away by any means and some remain quite active in providing warehouse facilities, particularly to Series A (and later) fintech startups.
Q: How big is the SpecFin market?
My take: Depends. I really hate that answer. Below are three estimates from informed sources on the matter. I will let you be the ultimate judge. Safe to say, its pretty damn big when it involves trillions of dollars.
Private Debt Investor, Pimco, Ares (the Ares piece is dated and says as of 2017 there were 400+ firms). If anyone has an updated list as of 2024 I would love to see it. The chart on page three of the Ares report shows the drop in securitization volume in 2008 with the rapid increase in the number of specialty finance companies.
Q: What are the drivers of growth?
My take: Pretty widely reported here - not a great deal to add. Regulation, Basel III, bank failures, investors hunting/demanding yield, technology, fintech innovation, etc.
Q: What are the strategies specifically?
My take: Asset-based finance is increasingly taking place outside of banks and traditional lending institutions. Examples include auto loans, student loans, loans to SMBs (small and medium-sized businesses), consumer loans, elective medical procedures, home improvement, equipment leasing, and more. Future posts will explore some of the drivers behind the growth in these areas but the biggest reasons according to a nice report by PIMCO (and many others I could have cited here) include among other things regulation, shrinking balance sheets at banks who were once active in these asset classes, and new accounting rules (also see Basel III link above). Additional factors include the growth in fintech (including the number of specialized tech forward lenders and banks like SVB who are focused on this booming area), advances in how data is captured and utilized in underwriting and risk management decisions, a boom in VC (and M&A) investment - even with the pull back in the VC asset class the past couple years, and changing consumer preference.
Q: What are the lenders to the SpecFin lenders looking for as they expand or double down in some of the emerging, niche strategies within SpecFin?
My take: One potential set up for SpecFin lenders is financing assets and originators with some combination of the following in no particular order: niche, specialization, lesser correlated assets, not an overwhelming amount of capital pursuing the space but enough capacity to justify getting involved, a team that possesses some distinctive edge in how they get deal flow (known as originations or sourcing) PLUS a minimum amount of tape to prove this (e.g. loans they have actually made), green light on all existing regs (and little, no headline risks), reasonably complex so as to not attract a flood of competitors and differentiated enough to offer returns that investors characterize as durable (at least for a period of time) and idiosyncratic. One more thing lenders to fintech lenders and specialty finance companies look for is capacity. With all the money that has flooded into private credit in the past decade, having relationships with originators who can scale from $100 million in annual volume to $250 million and eventually over $1 billion is preferred. Examples of these niche, specialized strategies include variations of mezzanine and preferred equity real estate lending, gap financing in the media and entertainment industry, aircraft and marine finance, life insurance premium finance, royalties, litigation finance, intellectual property, NAV financing, SaaS financing, various forms of fintech lender financing, embedded financing solutions, and many more.
Q: How are these loans originated?
My take: Over the past 15 years the number of specialty finance lenders and originators of these asset-backed loans has increased significantly. Check out the old Ares report above for this data. Origination strategies vary from fintech lenders using digital marketing strategies to drive borrower traffic to creating a direct sales force. Because of the specialized and sometimes ‘off-the-run’ nature of the assets, as well as the underwriting, collateral, data, potential for recovery in the event of default, regulatory considerations, servicing, administration, and capital markets dynamics - originations take on a different complexion than larger, more established sub-categories of private credit. Access to high volumes of qualified borrowers, sufficient amounts (and flexibility of) debt financing, cash on hand to fund CAC (overhead spending), the use (or not) of technology in sourcing, underwriting, and managing, and the expertise of the team in managing smaller balance (but higher volumes of loans), are just a few of the key factors for specialty finance companies.
Q: How are these loans underwritten?
My take: First lets look at this from the standpoint of the originator (e.g. the company making the loan to the SMB, consumer, etc.) and then look at it from the standpoint of the private credit lender or asset manager (e.g. one of the primary financing sources for earlier stage, smaller, and particularly newer specialty finance companies).
Side note: Respected trade press like abfjournal and Asset-Backed Alert cover the middle and upper ends of the specialty finance market where the largest deals and largest lenders are playing. If this is your jam you know this already. That segment of the market won’t be the primary focus of this blog. Different factors, considerations, and issues are at play when you talk securitization and bigger loan volumes. This space can’t be totally ignored either - because many firms starting out in this ecosystem aspire to grow and get to these capital markets one day.
The SpecFin lender or originator - companies making loans across the SpecFin market employ various underwriting approaches depending primarily on the underlying collateral. What are they financing? Underwriting specialized real estate possesses different characteristics than aircraft, SaaS subscriptions or litigation. Fintech lenders who are launching a new lending solution from scratch have many more options (and decisions) to make - and get right - as they attempt to grow their loan books. Matt Burton, formerly of QED, wrote a nice paper on building a loan business back in December 2019 that is worth checking out.
The lender to SpecFin’s or fintech originators - Lenders who finance specialty finance companies and fintechs making loans as part of their business look at a variety of factors that are worthy of a future post (or several). This isn’t an exhaustive list by any means and definitely not advice - just a starting point. For the younger company these debt capital providers will look not only at the experience of the team and their ability to grow originations to a meaningful size (scale starts in the tens, eventually hundreds of millions and should reach $1 billion+ annually) but first at the loans already originated (e.g. the ‘Loan Tape’ or ‘Tape’), the performance and profitability of this loan tape, underwriting criteria (e.g. ‘Credit Box’ or ‘Buy Box’), the quality of data that goes into making a lending decision, the accuracy, completeness, and output from the firm’ accounting and finance function, the depth of all record keeping and evidence of security/collateral, the existence of a regulatory memo/opinion (and which law firm prepared it), origination capabilities to adjacent markets or foreign markets, servicing model, examples and outcome of foreclosure, lending policies and procedures and other internal controls, cash runway, software vendors/technology stack, and detailed pro-forma financials and models. Getting a lender, particularly at the early stages, to provide financing to a SpecFin or tech-enabled lender in smaller sizes (asset-based credit facilities of $15-$20M and far below to as little as $1-$5M) can be particularly challenging. Getting your first few million to make loans is worth several future posts and where we will go in the future. These are the future SpecFins and fintech lenders and they need the resources (knowledge, connections, partnerships, etc.) I hope this blog and related content can help provide.
Q: Who are the new originators in the space"?
My take: Fintech lenders and specialty finance companies have proliferated in the past 15 years. A Google search will populate various lists and these market maps are neat visuals (Pitchbook did a version covering fintechs who raised VC, which offers a few) outlining providers - but these are by no means exhaustive or current. As a former syndicated loan and debt capital markets banker, one of the unique aspects of the specialty finance space I find compelling is that it combines a needed, entrenched financial services solution (making asset-based loans has been around for a long time and isn’t going anywhere), is big (and growing), and undergoing change (due to technology and new originators). It is particularly fun working in the fintech and tech-enabled lending side where these groups aim to employ technology to get (and stay) ahead.
Despite my optimism, risks loom. It has been said many times, and is worth repeating: making loans is easy, getting repaid is the harder part. One feature of this blog will be sharing public resources and information about SpecFin that attempts to further highlight the firms, executives, and market participants finding success and innovating. Who are the newer firms making money AND in the business of making loans? Can these firms be profitable sooner with more industry access, technology, or partnerships. Is the staffing and opex required to build a fintech lender between tech, originations, customer support/success, compliance, (and everything else) necessitate large amounts of VC? Great questions we will explore in the posts ahead.
Q: How are banks participating in the specialty finance market?
My take: Page 8 of the attached LSTA presentation outlines some activities where banks are active in private credit, which includes specialty finance. Banks remain active in this arena and activity includes regulatory relief trades, portfolio sales, the establishment of new partnerships with alternative asset managers and private credit firms, and venture debt financing. I wont sleep on banks and hope to highlight where banks are supporting this area. Stay tuned.
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About Me:
My name is Andres Sandate and I am based in Atlanta, GA where my family and I have lived since 2006. My wife and I have three young children who keep us very busy, but also making lots of memories. I grew up in Newton, Kansas, attended The University of Kansas and then did an international MBA while living and working in Italy for several years in the early 2000s. For fun I love to coach my kids sports teams, cheer for the KU Jayhawks in basketball and Kansas City Chiefs in football, exercise, and read. I have spent my professional career in capital markets, alternative investments, the securities business, and most recently a couple of fintech startups and a private credit fund. I am passionate about innovation, exploring new topics in our industry, and meeting (as well as learning from) new people. Three years ago I created a podcast called ATLalts to share what I discovered across private markets, alternative assets, startups, and the world of non-traditional asset investing. Interviewing CEOs, startup founders, investment managers, and investors in order to inform, educate, and inspire listeners is a goal of each episode. If you want to reach me email andres@atlalts.com.
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