This is how specialty finance prepares to take off

From European infrastructure to residential mortgages in the U.S., interest in private forms of credit outside the corporate or commercial real estate markets is rising. And, according to Kraus (Pimco), uncertainty about the macro scenario will provide an additional boost. How to ride the trend

by Giulio Zangrandi

Factoring and leasing. But also loans to households in order to upgrade homes or perform other work. A season of growth is on the horizon for specialty finance, the set of private credit forms that move outside the corporate or commercial real estate markets and are backed by a real asset to support the investment stream. This is the convinction of Kristofer Kraus, portfolio manager at Pimco, who thinks that uncertainty about the macro scenario will play its part in boosting the trend and excellent opportunities for investors will arise either in or in the US. A phenomenon that promises to benefit asset managers on several fronts.

What is the snapshot of specialty finance today and how did it get to this point?

Against the backdrop of tighter lending conditions, ongoing regulatory and accounting changes, as well as an unwinding of bank balance sheets, the market for private debt in the broader sense has grown considerably since the financial crisis. In addition to direct lending to companies, the focus has shifted above all to the segment of special financing: The volume of "specialty finance" in the USA exceeds the market for private direct lending by more than four times, and the asset class is also on the rise in Europe.

Currently, the specialty finance segment in the private credit market is expected to face the next phase of growth as investors need to diversify their private credit allocations beyond middle market direct lending and the segment also promises higher risk-adjusted returns.

Specialty financing encompasses all types of private credit that do not fall within the realm of corporate and commercial real estate markets. They are often secured by an asset, typically through hard collateral that supports the cash flow of the investment itself. This can be a house, a car, an aircraft, an asset, or even business receivables and intellectual property, to name just a few examples.

How might this trend generate investment opportunities?

Specialty finance is an all-important lubricant for the entire global economy, from consumer-related debt such as residential mortgages, credit cards, student, home improvement and solar loans, to loans for durable goods such as equipment-based lending or aircraft leasing. In addition, technological advances have created niche specialty finance asset classes, including sectors linked to royalty streams on intellectual property.

Banks are still active players in these markets. However, there is an ongoing shift in financing activity towards a newer ecosystem dominated by specialty financing providers. This is expected to be a persistent secular change that will drive industry growth for decades to come. The specialty finance market is deepest in the US, but the asset class in the U.K. and Europe – where lending is more bank-dominated – has recently grown rapidly.

This also opens up new investment opportunities for investors. While private markets have been a stable source of capital for specialty lending markets, the asset class is still emerging as a dedicated private credit allocation for investors. Key reasons include complex structures and, in some cases, high entry barriers.

Which could be the role of asset managers in all of this?

Alternative lenders like Pimco can facilitate this access and, at the same time, play a unique role as capital partners to many non-bank originators. In all these sectors, non-bank lenders are reevaluating their financing models in the face of ongoing market volatility. Capital is the lifeblood of specialty financiers, many of whom rely on regional banks for their financing. Other "Originate to Distribute" specialty financiers depend on active securitization markets. The subdued activities in securitization and traditional capital markets, as well as the retreat of banks, underscore the importance of stable capital partners.

It’s clear that asset managers who undertake such engagements and provide investors with access to this asset class cannot merely target sub-sectors in an isolated manner. What is crucial for successful investments is a fundamental credit approach and the assessment of the stability of underlying assets and cash flows, even across sectors.

Which could be main opportunities in the US market?

Looking at the US market, we see pockets of value, especially in residential mortgages, solar and home improvement loans, and equipment financing. Prices have become more attractive as available bank capital diminishes and the demand for specialty finance increases. This is a trend from which we expect to see a longer-term structural shift in prices and higher yields for unleveraged securities in many of these sectors.

And what about the European market?

The European market also appears attractive overall. However, unlike the United States, European banks still dominate the financial system due to fewer alternatives for moving money from point A to point B. Therefore, it's important to strategically seize opportunities. Hence, it is essential to purposefully seize opportunities. For example, within the consumer-related sectors, residential bridge lending in the U.K. presents compelling opportunities. The property market there has been underbuilt and needs upgrades. Those loans generally have low loan-to-values and high margin, so they often screen as compelling relative value within residential credit. Also, we like data infrastructure financing in Europe, where markets are fragmented with various jurisdictions governed by different data protection laws. Across both, there is an acute need for financing to construct these assets in markets that are severely undersupplied.

Why should investors consider an allocation to specialty finance today in a high volatility environment?

Overall, it should be noted that private specialty investments can potentially provide higher returns than private corporate lending – with less volatility, and possibly higher risk-adjusted returns than other private asset classes and equities. In our view, given the current uncertain inflation and interest rate trends, specialty financing presents compelling investment characteristics. The assets’ principal pays down over time rather than in a bullet payment at maturity, de-risking the investment, shortening the duration, and allowing for efficient redeployment of capital based on opportunities. Additionally, it provides a welcome diversification of the risk profile, with low investment return correlations to markets, the economy, and one another. These factors make a strong case for investments in specialty financing when the markets and economy slow.