The expertise and financial solidity of the servicer is something people often overlook in specialty finance. Christian Brehm of FC Capital explains why this would be a mistake.
How would you describe FC Capital's approach to specialty finance? What does specialty finance mean to you?
The definition of speciality finance is not universal in terms of what is covered and not covered by different fund managers. A simple definition of speciality finance is everything that is not corporate or commercial real estate, which opens up a very large field including asset-backed lending; securitisation; borrowing base funding arrangements; and funding of various classes of receivables or non-traditional assets, such as art, digital assets, aviation assets, superyachts, film production, sport teams, etc. At FC Capital, we pride ourselves on providing and designing unique financing arrangements in speciality finance. We distinguish between two transaction types: one is transactions linked to receivable or asset with related cashflows, and the other is structured funding arrangements for illiquid and value-driven assets. Our current focus is on asset-backed transactions (in particular large-scale equipment), bespoke receivable structures for non-bank and fintech lenders, and non-traditional lending against government R&D grants or litigation portfolios. The returns for these transactions are very attractive to our investors and provide excellent structural protection and recoverability. We exclude consumer-linked buynow- pay-later and investment-grade receivable portfolios, because those returns are not necessarily attractive to our investor base. Our focus when structuring funding arrangements is cashflows and asset-backing with good recoverability.
What should LPs consider when looking to explore a specialty finance strategy?
Depending on exactly how you define peciality finance, there is tremendous interest from LPs for this type of lending that often provides similar, if not better, risk-adjusted returns. That is because of the financing arrangement that comprises asset, security and associated cashflows, meaning investors have recoverability as well as yield. In certain parts of the private credit portfolio, for various LPs, these types of products have a special spot because there is an income associated with them. Speciality finance is also relatively uncorrelated from M&A or private equity activities, which have recently reduced in volume. It can also provide a stable and robust deployment profile with a much shorter J-curve than seen in the PE-sponsored space. When investing in speciality finance, it is important that LPs pick the right manager to underwrite these transactions, which often require a specialist skill set compared with corporate lending.
“When investing in
speciality finance, it is important
that LPs pick the right manager to
underwrite these transactions”
What should managers focus on when providing funding into the specialty finance space?
The focus varies depending on the part of the market. In many areas, I would recommend understanding the servicer, which is often overlooked. For example, in non-bank financing, the work starts with who the servicer is, what their credit underwriting procedure is, and then working our way into their actual loan book that we lend against. You normally have a security focused on a non-recourse or bankruptcy-remote structure where there is a secured asset trust that you lend against. Next, the question is what it looks like at the asset trust level, and what you provide funding against, which could be consumer receivables, commercial receivables, etc. We evaluate their pricing, default rates and loan book history. A good loan book demonstrates a stable underwriting with strong recoverability and a diverse seasoning among its receivables. Then we would focus on structural protection and specific mechanics in the funding arrangements, which may be a first-loss piece or even a subordination arrangement among other mechanics. These often vary depending on the type of receivables, the underwriting policy and their cash conversion profile. We also interlink the security structure with deep analytics of the historical, existing, and projected receivables portfolio. For example, in litigation finance, we assess receivables, also nown as work-in-progress, duration of the portfolio, win rate and cash conversion. The pricing, advance rates and required structural protection will be reflective of those parameters and analytics. We are also interested in specialist equipment financing. Covid-19 disrupted the supply chain, so certain large-scale and specialist equipment was in short supply, which significantly drove up its alue. We spent a lot of time conducting due diligence in this highly specialised space. We asked for more aggressive amortisation profiles on some deals we wrote in 2021, where we felt asset rices were overstated. As a lender focusing on capital protection, we exercise caution because there are inherent risks in these transactions where you need experience to ask the right questions nd source the right deals. Equally as important as underwriting is portfolio management and monitoring, especially when it comes to a growing receivables loan book. We have in-house actuarial esources to monitor loan book movements, risk distribution and receivables behaviour.
What are the drivers of opportunity in this space today?
In the traditional banking market in Australia and globally, there is limited appetite to provide these types of speciality finance facilities. Such structures are quite complicated and intensive in terms of the analytical skill set needed, with sometimes hundreds of thousands of receivables that must be modelled out. We observe a shift towards specialised credit providers like ourselves. We see growing demand from borrowers in speciality finance in Australia, New Zealand and the UK, with not many active lenders in the space, especially for facilities of less than A$100 million ($64 million; €60 million). Many banks have shut down their securitisation teams or have a convoluted underwrite and credit approval process, partially driven by stricter regulations and constrained balance sheets. We are also happy to provide additional funding to existing borrowers with a strong track record. In doing this, we may consider facilitating a new lender into the asset trust and subordinate ourselves, thereby achieving better risk-adjusted returns and enabling our borrower to obtain cheaper and bigger overall funding. That is a winwin solution for everybody, the borrower, the incoming lender and us, as we achieve better returns and still receive strong protection. These facilities require a lot of work and specialist capability around facility restructuring, and facilitating discussions among various parties. Thanks to our experience and ability to provide more capital through creative structures, borrowers often see us as an enabler to help them grow, mature and ultimately attract new types of capital. Another key opportunity for speciality finance is the need for portfolio diversification within private credit portfolios of institutional investors, which is usually skewed towards PE-sponsored lending. The majority of our investors like speciality finance because lending is backed by a diversified portfolio of hundreds of thousands of receivables with varying characteristics. Having said this, the LP investment team’s capability is also important to successfully engage with speciality finance managers. Regardless, speciality finance is an asset class that should be considered in every private credit portfolio thanks to its high risk-adjusted returns.
How are business models adapting to the current macro environment?
The overall macro environment is challenging, with interest rates going up and consumers, SMEs and large corporates facing higher funding costs. We have seen some borrowers becoming more stringent in their underwriting and adjusting the credit rules as to how they construct their portfolios going forward. We have also seen a shift in how firms operate. For example, in the consumer finance space where people expect a bit of pain, so they focus more on risk management rather than sales and customer retention. The right borrowers are more conservative than bullish, which we like, because we want to make sure we have a book that is performing in a rising as well as a falling market. In the non-conforming lending space, we see rising appetite and activities. Again, the focus is on good assets, appropriate funding arrangements, robust underwriting and the right pricing. An opportunity with these characteristics gives us a lot of comfort. Some of our borrowers are heavily engaged in back-testing and stress-testing their books, to see how their portfolios behave in different market conditions, and to manage them accordingly. Less ophisticated underwriters and servicers don’t do that, but we require that sort of sophistication from our borrowers.
What are the headwinds facing specialty finance going into 2024?
As we go through 2023, we see stabilisation of the global economy. Even though there are still significant risks globally, there are positive signs supporting a lower chance of the US going into recession as implied in the capital markets. However, we expect more headwinds in the consumer lending space, which will test BNPL and fintech operators. It’s becoming harder to find the right portfolios and servicers. Recently, we have seen some failures in BNPL, not necessarily because their portfolios underperformed, but they were not generating the right net margin to keep the light on for their servicers. We expect to see more of these, which will test the recoverability thesis and skill set of some managers in how they deploy resources to manage such situations that may involve engaging with third-party recovering firms.
How would you describe the outlook for the asset class as a growth area within private credit?
We believe speciality finance has a fantastic outlook due to its growing demand by existing borrowers as well as new entrants, as we observe in Australia and New Zealand. Another important driver is the diversification of investors and their private credit books, where we see very sophisticated LPs allocating to speciality finance, and other funds recognising the attractiveness of it and so they want to catch up. In the short and medium term, we see good investment opportunities with moderate advance rates and great risk-adjusted returns. Advance rates have significantly dropped over the last 18 months. Prior to that, we saw advance rates of 90 to even 100 percent for some warehouses. Going forward, we will see positive adjustments and further growth in the speciality finance space. However, we are careful about how bullish we get. There is a fine line between taking more risk and not getting the right pricing, or taking on too much risk which, with economic changes, can quickly deteriorate a transaction. We are always conscious about macroeconomic developments and continuously monitor these arrangements to see what pricing and advance rates are digestible, regardless of what the market is doing today. Overall, speciality finance is a fantastic space for private credit providers and LPs. Investors can enjoy regular income
streams and benefit from structural protection and recoverability, all of which are enabled through the specialist capability of the right managers.