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Specialty Finance

Heading beyond direct lending into specialty finance

Posted by on 14 November 2018
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Patrick Stutz - featureWhere else can you go in private credit other than direct lending? Patrick Stutz, CIO at Bayshore Capital, analyses the specialty finance strategies and gives us some guidance on the different risks and opportunities they offer.

What exactly is specialty finance?

To the best of my knowledge there is no commonly agreed definition for specialty finance and therefore it has become a tag for a wide range of lending arrangements from consumer and small business/commercial lending to capital relief transactions, asset-backed lending, non-performing loan transactions to emerging market lending and all sorts of opportunistic credit.

At Bayshore, we narrowly define specialty finance as “lending to a lender”, i.e. a specialty finance lender - such as a private fund - providing senior balance sheet financing to a specialised loan originator, such as an equipment leasing firm, who then uses the balance sheet to grow the loan book. The lender’s return typically consists of fixed interest, arrangement fees and often some equity upside. Originators tend to focus on a narrowly defined target audience where they have identified a growth opportunity due to a credit gap in the end-market (for example, credit cards to immigrants), or they might have to refinance existing liabilities. In the past, these originators would receive bank financing, but regulatory changes have made these kinds of arrangements unattractive for banks. As a result, originators rely increasingly on private non-bank financing.

Why should investors consider specialty finance strategies in addition to direct lending?

In our view, specialty finance provides two main benefits: attractive risk-adjusted returns and diversification. Returns are more attractive because there is less capital chasing the vast range of these opportunities. Most capital invested in direct lending targets plain vanilla corporate lending to mid-market borrowers. Alternative asset managers love this business as it is very easy to scale AUMs into the billions and the synergies with their existing activities in traded corporate credit and/or private equity.

Specialty finance, by contrast, is hard to scale as the ticket sizes are smaller, investing is very process heavy (monitoring, servicing, structuring) and the portfolio turns faster than a corporate credit book, requiring a constant flow of new ideas. That said, the underlying markets in specialty finance (consumer credit, commercial loans, real asset loans) are substantial, so there are plenty of opportunities out there. This leads to more demand for capital in specialty finance than is available, allowing specialty lenders to dictate terms and build more protection into their deals; quite the opposite from the covenant-lite world of the corporate lending market. Regarding the diversification benefits, we believe it makes sense to diversify private credit exposure with some investments in specialty finance. Specialty finance provides exposure to a different set of underlying risk factors than corporate cash flows, and loans are often heavily secured or asset-backed, thus providing investors with lower correlation and strong downside protection.

What are the main risks associated with specialty finance and how do they differ to other more mainstream private credit strategies?

Fraud, operational and underwriting risks are higher in some areas of specialty finance, both on the level of the lender and the originator. Both tend to be smaller firms with potential operational deficiencies. Due diligence should really focus on that aspect. Transactions are complex in structure which opens the door for fraudulent behaviour, be it through an outright fraudulent borrower or a rogue employee within the borrower’s operation. An example of what can go wrong is Argon Credit, a direct lending platform whose bankruptcy forced the closure of at least one specialty finance fund. The structural complexity is what keeps many lenders away and allows the specialists to charge a “complexity premium”, which increases returns for investors.

As you might expect, specialty lenders have become pretty good at monitoring and protecting themselves against these additional risks and more importantly, charge a hefty risk premium to the borrower, but accidents still happen. In addition to learning from past mistakes, technological advances have reduced risk in specialty finance substantially. Other risks to watch are the potential for cash drag in investment portfolios and a team’s experience in dealing with problems, as they do occur.

Which specialty credit strategies offer the best risk adjusted returns?

The secret of specialty finance is to find a situation that looks “risky”, and then find a creative way to substantially de-risk via structuring and collateral. We are seeing some very interesting deals in capital equipment sale-and-leaseback that yield IRRs of high teens with strong protection. Another area is point-of-sale merchant installment loans where a buyer gets immediately approved for credit. Technology has improved the quality of underwriting dramatically which should improve the loss rates on these loan books. And then there are some niche receivables finance opportunities that we have come across that we think are very attractive. For instance, Greek export receivables which are insured, and receivables related to the rebuilding of post-hurricane Puerto Rico which are guaranteed by the Federal Emergency Management Agency (FEMA), a U.S. government agency. These are niche opportunities, but with a bit of effort investors can build a highly attractive book of diversified specialty finance exposure.

How do you see specialty finance strategies developing in the coming years?

The future of specialty finance will be defined by its performance during the next downturn. I have no doubt that the demand for such credit will continue to increase. Banks are withdrawing from anything with a high capital charge, and that’s exactly where specialty finance steps in. Basel III will be fully implemented in 2022, and the regulatory tide moves very slowly, so there is plenty of space to grow businesses in the space. Technology, especially AI and blockchain, will also continue to make credit origination easier for smaller firms, and I think they will require a vast amount of funding. But it’s crucial that the current vintage of lenders performs well when the credit cycle turns, or it will take a long time for investors to come back.

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Under the spotlight: Patrick Stutz
 
Patrick Stutz, CFA, is the Chief Investment Officer of Bayshore Capital Ltd., based in London. Patrick advises Bayshore’s investment committee and is responsible for investment research and sourcing. Patrick has over 20 years of global investment experience across asset classes. Prior to joining Bayshore in 2013, he was a portfolio manager for Ivory Capital, an alternative investment firm. He served as a manager of alternative strategies for RMF/Man Investments in New York from 2003 to 2010. 
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