Beyond Corporate Credit: Exploring Asset-Based Finance for 2024

Asset-Based Finance (ABF) has been grabbing the attention of many investors who are looking to take advantage of private credit investing, while also diversifying their portfolios. The asset class is vast, covering everything from consumer loans to mortgages to music royalty contracts.

We sat down recently with Daniel Pietrzak, Global Head of Private Credit, and Varun Khanna, Co-Head of Asset-Based Finance, to discuss where the opportunities are, where the risks are, and what they see ahead for the next 12 months.

Let’s start at the beginning. What exactly is Asset-Based Finance?

Daniel Pietrzak: To think about it broadly, think about loan or credit products that finance the real-world economy. It is not traditional corporate credit, not regular loans to companies. We estimate that ABF is a $5 trillion market and growing (Exhibit 1). And with all that, there has not been a lot of scaled capital raised in the space.

EXHIBIT 1: Private ABF Growth Forecast

We think about it in four buckets:

Consumer and mortgage finance is the largest part of the market. Generally, we're investing in secured loan portfolios. They may be secured by real estate in the case of mortgages or cars in the case of auto loan portfolios, to name two examples. We have also focused on home improvement loans and other secured portfolios of loans to prime borrowers, such as recreational vehicle (RV) loans.

Commercial finance includes a lot of lending that banks used to do but have pulled back on of late. Typically, that involves loans to commercial borrowers secured by their essential assets. Activate Capital, where we help provide financing to Irish homebuilders, is an example of that. As another example, we’ve made investments backed by trade receivables for a large hardware manufacturer.

When we invest in hard assets, we actually own and control the underlying assets, which we think can offer a degree of downside protection. Those assets typically generate lease income, generally over a relatively long period of time. Aviation leasing or single-family rental homes are examples of this.

Contractual cash flows are a little more off the run. As an example, the music royalty space is an area where we’ve been active. We like this segment for its attractive income profile and the lack of correlation with the wider economy.  

How was 2023 for ABF investing?

Varun Khanna: Investment professionals and market participants have been concerned about whether there will be a hard landing, how the consumer will fare, and how asset prices will move, all of which have a direct bearing on investment performance of ABF. We have been more selective and more conservative in assessing risks. Despite that, I’ve been surprised to find we have been busier in 2023 than ever before. The reason for that is the significant dislocation in both the banking sector and the public capital markets.

DP: The rate environment has had a more muted impact on returns in ABF than in other private credit products like direct lending. We're probably only a couple hundred basis points wider versus deals we would have done a few years ago. That said, the quality today is higher. We could have subordination or additional first loss below us on more deals or just higher quality loan portfolios. So, I think from a risk-adjusted perspective, the environment for investing in 2024 and what we are expecting for the next few years is quite strong.   

Where have you been seeing the most interesting opportunities? 

DP: As Varun mentioned, disruption in the banking sector is creating some opportunities. This disruption or volatility has been happening for years, and Asset-Based Finance has grown in part due to the pullback in bank lending since the Global Financial Crisis (Exhibit 2).

The failures of Silicon Valley Bank, Signature Bank, and First Republic in the earlier part of 2023 led to many U.S. regional banks becoming more strategic with their balance sheets. They’re more thoughtful about the products they’re in, both in terms of their own liquidity positions and whether those assets are core or non-core. They’re also thinking about potential additional regulation. All of this creates challenges for capital availability and liquidity, which has encouraged many banks to shed assets. This is not 2008 or 2009, though. Banks are not selling assets in a fire sale. It’s a slower process, and I think the more elevated level of activity we’re seeing will persist for the next handful of years.

In addition to selling assets, we’ve also seen regional banks take a step back both from providing capital and buying assets from specialty finance platforms throughout the United States. That has allowed us to step in and fill the void as either the capital provider or the buyer for those assets.

EXHIBIT 2:  Total Number of US Commercial Banks

What kinds of assets are U.S. regional banks selling?

DP: They are looking to sell assets, core or non-core, that are generally performing, with the sale price closer to par so it's not capital-destructive. The bank may decide it no longer wants to be in a non-core business, or it may need to reduce existing exposure to a core business line in order to keep lending in that area. We have not seen U.S. banks selling portfolios of distressed or challenged assets, though that could happen down the road.

And why are these portfolios desirable?

DP: Banks have been selling portfolios with very attractive risk profiles, including portfolios of loans to consumers with very high credit scores—almost super-prime. We normally would not be able to access that kind of risk. Because these consumers have been more insulated from the effects of inflation than lower-income consumers, we see it as a really interesting opportunity.

Varun, are you seeing similar trends among European banks?

VK: The banking landscape in Europe is different, with fewer smaller or regional players. Bank balance sheets are healthy; they are under less pressure to sell assets, but they are capital-constrained. They want to continue lending in their core sectors and are looking for innovative ways to free up capital. Offloading capital that is tied up in existing loans allows them to originate new loans.

We did three deals in Europe in 2023 in which we essentially provided a capital relief solution to banks. As an example, in one of these deals, we worked with a bank to free up some capital that they had tied up in a portfolio of existing, seasoned prime auto loans. The bank issued some mezzanine debt secured by the loan portfolio, which we bought, and the bank retained the equity and senior piece of the debt. So, the bank freed up some capital, which they needed, and retained some “skin in the game,” creating an alignment which we like. From our perspective, we knew exactly what was in the portfolio and how it had performed in the past, and by purchasing the mezzanine debt, we were able to create an investment with an element of downside protection and alignment with the bank.

We are not doing this with every bank or in every asset class, but rather trying to pick the banks where we see the potential to form strategic and scalable relationships, meaning we can do repeatable transactions in asset classes where we have strong secular convictions, and in which we and our banking partner have expertise. The bank in the auto loan deal has a 15+ year history in auto lending, for example.

Where are the interesting opportunities outside the banking industry?

DP: We’ve seen larger companies, including well-known brands, being a little more thoughtful about their capital allocations. Where they may have once used their own balance sheet or sought capital from a bank, they have increasingly wanted to partner with private lenders like us.

VK: PayPal is a good example. In 2023, we became the company’s exclusive partner for its consumer finance offering in Europe, agreeing to purchase €2 billion in existing loans up front and up to €40 billion of consumer receivables over the next two years.

PayPal is a household name with millions of customers using their core payments offering. However, they also provide consumer finance to a select subset of customers, an offering that is critical to their business proposition but quite capital-intensive. Through the KKR partnership, PayPal can continue offering consumer finance in a more capital-efficient manner, while we get to fund a diverse portfolio of receivables in a sector where we have long standing history and expertise; a win-win outcome in our view.

We’ve been working on another deal with one of the largest auto manufacturers in Europe. Just like PayPal, this is a large corporation with operations across a number of countries. A key pillar of growth for the company, in addition to its core business of selling cars, is a subscription and leasing alternative for consumers. Our funding partnership provides the company with a scalable, less capital-intensive solution to quickly ramp up their subscription business across Europe, while providing more consumers with access to flexible car subscription solutions.

Are there any other sectors or asset classes you’re keen on in 2024?

DP: Generally, we are pretty constructive on risk, even though we believe we’re going to have higher rates for longer and a mild recession in the United States at some point. With where interest rates are, there may be some opportunities in residential mortgages that are attractive relative to the risk, given that loan-to-value ratios are quite low at this point. On the other hand, we are carefully considering the affordability of housing and what that might mean for the investment thesis. We still think both aviation leasing and lending are fairly attractive these days, particularly if you have the ability to play in multiple parts of the market.

How has your approach to investing in the ABF market evolved over the past few years and what are the risks that you are most concerned about in 2024?

DP: The breadth of our platform, as defined by our multi-sector and global approach to ABF, allows us to constantly look at relative value across a number of sectors and geographies. From time to time, we pivot in how we approach a particular sector or asset class informed by what we are seeing across several markets.

Looking to 2024, we're going to continue to stay away from many of the same things we stayed away in 2023.  These would include niche asset classes that may be either hard to scale or that carry the potential for binary returns. We’re not in the energy credit business, for example, nor are we looking far outside developed markets like the United States and Western Europe.

VK: In the United States, leasing and single-family rental have been very successful themes for us over the past several years. We were early movers in these sectors, where we saw an attractive and scalable opportunity to deploy capital. In single-family rental in particular, we were able to successfully monetize our early investments during 2021 and 2022. Recently, we have been somewhat more cautious in making new investments in this segment. The wider market dislocation has offered us compelling investment opportunities in other sectors, and we have pivoted to those areas. U.S. regional bank portfolios are a good example of that. Longer term, we remain constructive on the leasing and housing sectors and will look to lean back in as market conditions evolve.

In the broader consumer space, we're skewing to prime borrowers, who are more insulated from the effects of inflation, and taking more collateralized or secured consumer risk to get the extra layer of security from the underlying asset. That is why we are focused on mortgages and auto loans, rather than credit card receivables and unsecured loans.

Digging deeper into consumer risk, we are more selective and cautious on U.K. consumer risk than any of the other markets in which we invest.  You have the higher rates and higher inflation that are impacting every consumer in every part of the globe, plus the added impact of Brexit. In the U.K. mortgage market, rates are only fixed for the first 2-5 years, and then they flip to floating rate. In the last 12-18 months, people who have moved from fixed to floating rates have seen debt service costs increase substantially. That trend is going to continue (Exhibit 3).

EXHIBIT 3:  Number of Owner-Occupied Mortgages that Will See Monthly Mortgage Cost Increases at the end of 2024 and end of 2026 Relative to Q2 2023

What do people get wrong about ABF?

DP: As recently as five or six years ago, many investors were still getting their arms around what ABF was. Is it subprime mortgages? CLO equity? The same stuff that caused the Global Financial Crisis? But that’s changing as it’s become a hot topic over the last 12-18 months. People are looking to increase their private credit allocations, and they’re starting to see ABF is a way to do that in a more diversified manner (Exhibit 4).

EXHIBIT 4: Asset-Based Finance Has Performed Differently than Other Asset Classes

As far as persistent misconceptions, we are not just buying CUSIP securities on the open market. Private ABF transactions are all bilateral, privately negotiated deals. We have a 50-person team that is dedicated to our ABF investment strategy, with a broad sourcing footprint covering banks, finance companies, and advisors. Our team leverages the expertise we have acquired in certain sectors and what I view as either proprietary or incumbent deal flow, meaning renewals of deals we have already done.

What are the top reasons investors need to pay attention to ABF in 2024?

VK: With movement in rates and in the current macro environment, investors have been increasing their allocation to private credit. We are increasingly seeing a desire to do this in a way that gives investors more diversification, given that typical portfolios have exposure to corporate risk, whether through private equity holdings or direct lending. ABF gives investors diversification away from large corporates, while a multi-sector ABF strategy provides internal diversification by investing in different types of non-corporate assets. This moment reminds me of where direct lending was in 2012 or 2013: a fast-growing market to which most investors are underallocated. We’re in the early innings, and that’s often the time to pay attention.

Interviews were edited and condensed for length and clarity.