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Investing in innovative and uncorrelated private strategies

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Specialty finance was a hot topic at SuperReturn US East. One presenter from Cambridge Associates noted that specialty finance is the fastest growing category they are managing for investors right now.

The trend toward specialty finance is no surprise to speakers on a recent panel entitled "Investing in innovative and uncorrelated private strategies".  They say LPs are growing wary of being over exposed to correlated strategies while valuations are high. Finding an experienced specialty finance team can be one way to get access to deals that aren't likely to crop up in a traditional private equity fund.

"What we have seen over the past few years is that more LPs have moved to create a private credit allocation or at least have a home for private credit and that creates an opportunity for us," explained Michael Weinmann, managing director at healthcare financing firm, CRG. "In some cases, we've seen that allocation come out of the hedge fund bucket because private credit has been able to generate more alpha recently."

Niche opportunities

$3 billion CRG provides debt and equity solutions to both public and private healthcare companies. According to Weinmann, investors are interested in blended debt and equity deals because the return stream is assured but can't be market timed. "We're looking at deals that would never pass traditional underwriting because the companies are cash flow even or slightly negative because they are reinvesting every dollar back into the business," Weinmann says. "We want to be in growing companies but that often means being willing to take risks."

"We're looking at deals that would never pass traditional underwriting because the companies are cash flow even or slightly negative because they are reinvesting every dollar back into the business"

He adds that investors looking at specialty finance transactions will want to take the time to find a deeply experienced team, especially if they are focusing on a specific part of the market the way CRG does with healthcare.  "If done correctly, a senior secured debt transaction could be considered like equity. The behaviour is going to be the same, but you need an experienced team," Weinmann said.

Another growing area within specialty finance is litigation finance.  Investment firms that run litigation finance as a strategy typically offer companies financing for an impending legal case and expect to be repaid plus a portion of the pay-out.

"A few years ago, no one had heard of litigation finance," said Agustin "Gus" Araya, a partner at Cordillera Investment Partners. "Now investors are aware of it and more firms are involved." Araya notes that as the area has grown, it is clear some strategies are more successful than others. "If your focus is on settlements, for example, it's much harder to make money there because you have to really hit scale."

Cordillera invests across a range of specialty finance asset classes including litigation, live events, marinas, even live events.

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Traditional with a twist

For investors that want something slightly more traditional than boat marinas or live events, vanilla specialty finance is also a growing part of private equity. David Wachter, managing director at W Capital Partners has seen significant interest from LPs in growth equity secondaries as well as buyout minority secondaries. Investors that have experience with private equity are often already familiar with some part of the secondaries market and he says that makes the conversation a bit easier.

"Recently we worked with MindBody, which provides reservation software for yoga studios. That transaction was a combination of growth equity and a liquid tender offer to eventually get them to the IPO stage," Wachter explains. "Investors that had been with the company for ten years were cashed out and new investors were already pretty clear about what was going on. That's really helpful in any transaction."

The panelists agreed that education and clarity about assets are the two key components to understanding any specialty finance deal. For investors that are willing to put in the time, access to niche parts of the market or secondaries transactions can bring diversity to a portfolio. "We think there are a lot of unique opportunities out there," said Cordillera's Araya. "It's just a matter of having a good team in place and partnering with strong management teams at the portfolio company level."

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