Already popular before the pandemic, niche and specialty finance have seemingly managed to attract more interest from a wider range of investors since the pandemic. But do investors really know what the risk and return profiles are like, and how to select managers operating in this field? You-Ha Hyun, Investment Director at Perpetual Investors, shares his insights in our exclusive interview.
Q: Has niche and specialty finance truly kicked off since the pandemic? How big is the opportunity?
Since everyone has a different meaning how to describe specialty finance, I want to emphasize how we categorize this strategy vertical. To us, specialty finance covers segments which are typically not correlated to the corporate credit market. The form of underlying securities can vary and also include equity-like instruments that are somewhat senior in the capital stack or have cash flow patterns that resemble a credit investment.
In our view, this market has been increasingly attracting the interest from the broader set of investors thanks to the attractive return profiles. But if anything, the pandemic rather acted as pause button with priorities – especially during the first lock-down – on the management of the existing portfolio.
Generally, it is difficult to give an exact number of the addressable market since this segment is so fragmented. One of our GPs estimates the music royalties opportunity at $30 to $40 billion over the next five years. In the legal assets space, the addressable market is even estimated in the low three digit $ billion range. Adding this up, we deem this sufficient to attract significant institutional capital, and secular trends will further increase the attractiveness. In this context, we are positioned to benefit from being an earlier mover by building industry relationships and multiple arbitrage.
Q: What kind of returns are targeted and being realised across niche and specialty strategies?
For us to invest, speciality finance investments should produce a risk premium to the corporate credit investments and generate a return in in the high single to mid double digits (net). We further consider whether a strategy generates a cash yield, like royalties, or is exit dependent, like pay-in-kind situations. The data is not as extensive as in private equity or corporate credit markets, but we have observed activities confirming our assessments.
Q: What are the risks associated and does the risk premium make sense to investors?
It is a relatively young asset class, for which one will not find sufficient data. Exit viability is definitely something we assess very carefully, especially since one will need to make a judgement call in the absence of broad evidence for exited investments.
We assess whether there will be any contraction in the exit valuations of the underlying assets, in particular for investments that have a back-ended return profile or are of self-liquidating nature. Additionally, we evaluate whether the potential buyers universe is large enough, providing viable options for the GPs.
Each strategy has to be considered individually and assessed at the deal level. Foremost, the key questions are: What are we buying into? What is the capital used for? Are we buying certain assets or lending against a collateral? How is the asset ring-fenced if it comes to an insolvency? What is the upside? Are there any?
Furthermore, the tax drag for non-US investors may reduce the net return. The question is whether the GPs are able to set up a tax efficient structure due to the size of investments available. Many targeted GPs have fund sizes below $500 million.
Overall, we believe that the available risk premia are attractive given the less mature market.
Q: What does your manager selection process look like?
Given the fragmentation of the speciality finance market, identifying the right GPs is probably more time consuming, but we think if done systematically, the right strategies can be identified. For that, we extensively leverage our network in the befriended family office community or referrals through relationship GPs and boutique or specialized placement agents. Most niche strategies would not make it into the books of the big firms given the limited scalability and the lack of critical size. Therefore, it is a very proactive approach to sourcing.
The due diligence process in turn is not too different from what we would go through for PE or established PD sub-segments. However, for the niche strategies we will place stronger emphasis on the top-down view of the relevant markets: do we understand the premium? Is the market size sufficient? What are the other players active in the field?
Alignment of interest and the terms are important, too. Many GPs in the niche segments do not have the same level of institutionalization and therefore we need to see a path towards a fully institutional quality GPs, if that is not the case yet. Referencing has become more profound these days since travelling is non-existent making it impossible to meet with the GPs in person.
Q: How do you see emerging managers? Are they too risky or worth the leap of faith?
It is worth the leap of faith, but it will not form the majority of our target portfolio. For emerging managers, there is a great opportunity to be a value adding investor for the operational set up. We can bring advice based on our experience of investing in the more institutionalized world.
For us, the expected risk-return profile improves through preferred terms when being one of the first LPs. In some situations, we try to negotiate terms that could reflect founders’ discount, or to be a shareholder at the Management Company level for a limited period. We also consider partnerships through JVs or investing share classes for specific strategies within an open-end structure. This provides the emerging managers with some cushion to fund their operations until they have been able to create a sufficient pool of capital for the strategy.
Under the spotlight: You-Ha Hyun
You-Ha Hyun leads the private debt program at Perpetual Investors GmbH, a German based single family office. In this role, he is mainly responsible for managing the private debt portfolio and focuses on manager selection across the broad spectrum of the private debt universe. You-Ha has more than 12 year experience in the alternative investment segment having done primary, secondary and co-investments at large institutional organizations such as an insurance company, a public organization and a fund-of-funds. You-Ha began his career in the M&A advisory business at KPMG and is an economist by training.