Introduction to Asset-Based Finance
Asset-based finance refers to a broad category of investments and lending that aims at providing funding not only to companies, in particular Small-Medium Enterprise, but in general every creditworthy borrower which is able to provide a collateral to back his/hers loan. This willingly generic definition highlights the sheer size of this particular asset class, estimated by KKR & Co. to be around $4.5 trillion, and its crucial ability to provide portfolio diversification, not only through a worldwide exposure, but through the possibility to invest in a plethora of diversified hard and financial assets.
Private Credit has been traditionally linked to corporate direct lending, however, over the past decades the ABF credit solutions are gaining increasing interest. The Asset Based finance investment is privately originated by an Investment manager and its return is dependent on the cash flow performance of pools of the underlying, comprising financial assets, such as non-performing loans, or hard asset such as real estate.
Private Asset-Based Finance enables Investment Managers to access to a diverse opportunity set characterized by a low correlation with traditional asset classes. Thus, ABF represents a valuable alternative form of diversified investment which is expected to grow. According to KKR & Co. Inc, an American global investment company which is well known for its exposure to multiple alternative asset classes, the Consumer and SME segments alone are expected to reach $6.9 trillion. If we also consider NPLs it is expected to reach $9.5 trillion over the next five years. Moreover, after the COVID-19 pandemic, due to the increased demand for credit, Asset-Based finance is likely to see further growth. For example, due to the financial hardship caused by the pandemic, Small-Medium Enterprises are gradually converting their revolving credit facilities to asset-based lines of credit, leading to a growth in the small-medium enterprise segment of the broader set of ABS.
The ABF market opportunity set stretches between Small-Medium Enterprise, to Consumer Finance, including Non-Performing loans, Student Loans, Equipment leasing, credit cards and an extreme large set of opportunity. The analysis is focused on some of the most important segments of this broad asset class, identified as Small-medium enterprise (SME), Consumer/mortgage finance, and hard assets.
Private Credit has been traditionally linked to corporate direct lending, however, over the past decades the ABF credit solutions are gaining increasing interest. The Asset Based finance investment is privately originated by an Investment manager and its return is dependent on the cash flow performance of pools of the underlying, comprising financial assets, such as non-performing loans, or hard asset such as real estate.
Private Asset-Based Finance enables Investment Managers to access to a diverse opportunity set characterized by a low correlation with traditional asset classes. Thus, ABF represents a valuable alternative form of diversified investment which is expected to grow. According to KKR & Co. Inc, an American global investment company which is well known for its exposure to multiple alternative asset classes, the Consumer and SME segments alone are expected to reach $6.9 trillion. If we also consider NPLs it is expected to reach $9.5 trillion over the next five years. Moreover, after the COVID-19 pandemic, due to the increased demand for credit, Asset-Based finance is likely to see further growth. For example, due to the financial hardship caused by the pandemic, Small-Medium Enterprises are gradually converting their revolving credit facilities to asset-based lines of credit, leading to a growth in the small-medium enterprise segment of the broader set of ABS.
The ABF market opportunity set stretches between Small-Medium Enterprise, to Consumer Finance, including Non-Performing loans, Student Loans, Equipment leasing, credit cards and an extreme large set of opportunity. The analysis is focused on some of the most important segments of this broad asset class, identified as Small-medium enterprise (SME), Consumer/mortgage finance, and hard assets.
Small-Medium Enterprise (SME)
The number of different financing options available to SMEs with the high potential of growth has significantly increased over the last years. The banks have lost their attraction for lending after the 2008 crash and in the UK, Brexit has compounded to this situation by increased tensions in the country. The Cambridge Centre for Alternative Finance has demonstrated that the alternative debt funding sector grew by over 30 percent in 2017 in UK, reaching £6.2 billion.
One of the popular solutions for small businesses who cannot use the banks for borrowing is asset-based finance. This type of lending differs from traditional lending and uses movable assets such as receivables or equipment as a collateral and the primary source of repayment for loans, thus being very convenient for SMEs. ABF gives the business an exceptional opportunity to increase the income by allowing them to earn revenue from the asset while paying for it overtime. For SMEs Asset-based finance is flexible and may take many forms depending on the collateral: accounts receivable financing, warehouse receipts, purchase order finance, factoring and leasing.
All these forms of Asset Based Finance are reliable and yet understated peers to the other forms of alternative borrowing, offering the businesses reliable access to working capital with low risk. Yet according to the recent figures more than three quarters of UK SMEs are still not aware of their ability to secure financing based on their turnover rather than their credit score.
However, this form of funding is still expanding at a very high pace in both developed and developing markets across the world, with 2018 seeing a global ABF volume of lending against assets and invoices at approximately $3 trillion. The drivers behind this growth are mostly tighter banking covenants restricting SME lending in most countries worldwide. The pace of growth of ABF varies between the regions, with more established markets (having a higher baseline) such as US and Western Europe. However, there is also a highly growing demand in emerging economies in Central and Eastern Europe (CEE), Africa, and Asia-Pacific.
The United States is considered the home of invoice factoring, according to the Commercial Finance Association, the volume for factoring in 2018 was $101 billion and the estimates for asset-based lending are of $465 billion. In Europe, UK, France, Germany, Italy and Spain hold two thirds of factoring volumes across the continent. There has been a remarkable growth of ABF in recent years, ABF is expected to retain its prominent position and will continue to ensure that SMEs and growth businesses can access the funding they need.
One of the popular solutions for small businesses who cannot use the banks for borrowing is asset-based finance. This type of lending differs from traditional lending and uses movable assets such as receivables or equipment as a collateral and the primary source of repayment for loans, thus being very convenient for SMEs. ABF gives the business an exceptional opportunity to increase the income by allowing them to earn revenue from the asset while paying for it overtime. For SMEs Asset-based finance is flexible and may take many forms depending on the collateral: accounts receivable financing, warehouse receipts, purchase order finance, factoring and leasing.
All these forms of Asset Based Finance are reliable and yet understated peers to the other forms of alternative borrowing, offering the businesses reliable access to working capital with low risk. Yet according to the recent figures more than three quarters of UK SMEs are still not aware of their ability to secure financing based on their turnover rather than their credit score.
However, this form of funding is still expanding at a very high pace in both developed and developing markets across the world, with 2018 seeing a global ABF volume of lending against assets and invoices at approximately $3 trillion. The drivers behind this growth are mostly tighter banking covenants restricting SME lending in most countries worldwide. The pace of growth of ABF varies between the regions, with more established markets (having a higher baseline) such as US and Western Europe. However, there is also a highly growing demand in emerging economies in Central and Eastern Europe (CEE), Africa, and Asia-Pacific.
The United States is considered the home of invoice factoring, according to the Commercial Finance Association, the volume for factoring in 2018 was $101 billion and the estimates for asset-based lending are of $465 billion. In Europe, UK, France, Germany, Italy and Spain hold two thirds of factoring volumes across the continent. There has been a remarkable growth of ABF in recent years, ABF is expected to retain its prominent position and will continue to ensure that SMEs and growth businesses can access the funding they need.
Consumer / Mortgage Finance
Consumer / Mortgage finance deals mainly with the broad field of consumer lending characterized by non-standard collateral or borrowers who often have more difficulty accessing bank funding (e.g. students). For example, in this category we can find lending provided to individuals to buy a car or renew his/her house.
These types of “unconventional” lending allow not only to assume a long position in market segments otherwise difficult to touch, but also enjoy higher rates than the one obtainable, for example, in the fixed income market. At the same time, since these lending are often characterized by a collateral, the overall risk for the lender is mitigated.
More importantly, due to the unconventional nature of the collateral considered and the absence of strict regulatory requirements, like with the mortgages, this kind of funding allows financial institutions to be more flexible and better profit from booming markets. For example, taking into account the vehicle-lending market, KKR & Co. Inc captured the growth opportunity in U.K.’s used vehicle-lending £700 million in assets across 83,000 loans which yield an average annual interest rate in the high teens.
In the Consumer/ Mortgage finance asset class, the most developed segment is the one which invests in non-performing loans (NPL). Non-performing loans are deteriorated bank loans characterized by a low probability of payment due to the worsening of the financial conditions of the borrower.
Due to the COVID-19 pandemic and tougher regulation, such as Basel IV, non-performing loans have started to weigh heavily on banks' balance sheets and in particular they require financial institutions to raise capital in order to cover their potential losses. However, from an outsider point of view non-performing loans can represent an interesting investment choice that, although undoubtedly risky, can provide high yields in the long run.
Indeed, banks are sometimes required to offload from their balance sheet non-performing loans for multiple reasons, ranging from regulatory obligations to simply the presence of a market stigma, this opens the possibility of purchasing this type of loan at a particular advantageous discount. Needless to say, in this phase, due diligence and getting an accurate valuation of the collateral (mainly real estate) of the loan are of utmost importance. Moreover, also the understanding of the economic background and of the reason why a particular cluster of loans has been downgraded to non-performing might play a role in measuring the possible exposure.
Consider for example a loan made to a restaurant that has seen its activity drastically decrease due to the lockdown procedures ordered. With high probability it will face difficulties in making the payments on time and thus its loan might get downgraded to non-performing. However, it is possible that this stressed condition is just temporary, linked mainly to the pandemic. In other words, this type of non-performing loan can generate long term returns once the Coronavirus outbreak will end. However, banks, particularly in a financially challenging environment like the one we are living in, might not have the luxury of time and thus they might be forced to sell those loans.
Hard Asset
Following the 2008 great recession and a higher regulatory pressure on capital, banks have been forced to decrease their investments within the hard asset class. Private creditors have taken advantage of the void left by banks through increasing investments in this segment. Indeed, new capital requirements have driven the banks’ focus from owning these assets to extend senior financing against them. Hard assets include real estate, aircraft leasing, containers, green energy, railcars.
Within hard asset we have chosen to focus on investments in both the real estate and in the aviation business.
Private equity firms, hedge funds and institutional investors have all been investing in the American Housing Market since 2012 when the real estate prices dropped to historical lows. KKR and BlackRock both have a minority stake in Home Partners of America (HPA) a company focused on the Single-Family Rental (SFR) Business. HPA was founded in 2012 by the former bond trader Lewis Ranieri, accredited as a pioneer of Mortgage Backed Securities. HPA owns single-family real estate properties across the U.S. and rents them for a five-year period at the end of which it grants the possibility to tenants to purchase the house. The option to buy the house at the termination of the renting period is what distinguishes HPA from its competitors which instead prefer to hold on to properties long term. By potentially selling the property once the rental period has expired, HPA is able to save on the upkeep expenses and on the renovations that would have to be performed if the houses were instead to be rented to a new tenant. HPA’s business has been growing significantly, the funds provided by private investors were needed to keep up with the growing demand. In 2018 there were rumors of a potential Initial Public Offering, however to date the company has remained private and has kept funding itself through debt and internal financing.
The SFR market segment in which HPA is primarily concentrated used to be predominantly dominated by smaller investors, however this changed after the 2008 financial crisis. As the housing bubble bursted many properties were vacated and institutional investors acquired many of them, stabilizing the market. Investors identified in this market segment a growing and attractive opportunity. As of 2018 detached one unit rentals were 12 millions, and this figure is projected by analyst to grow over the next decade.
Private credit investors have also been turning their attention towards the aviation business. While the commercial airline industry is a sector with a relatively low profitability the demand for aircraft is increasing as airline traffic volumes have been steadily growing over the last twenty-five years, as industry reports show, from 2005 to 2019 the number of passengers has more than doubled. Many analysts project this trend to continue as there is a huge untapped market, according to Boeing CEO, in 2017, 80% of the world’s population had never taken a flight. As the world becomes increasingly connected this percentage is bound to decrease, eventually leading to a growing demand for commercial aircrafts. Airline traffic has also been on the rise following the increasing need for commercial cargo space. As of 2020, Amazon utilizes cargo planes to be able to timely serve its clients, requiring more space on planes as the number of orders increases. The whole airline industry, including aircraft leasers, has been severely hit by the Covid-19 pandemic, which could have a worse and more long-lasting impact than 9/11 or the financial crisis had. It will certainly take years for the market to recover and for investors to see a return in this hard asset class.
Within hard asset we have chosen to focus on investments in both the real estate and in the aviation business.
Private equity firms, hedge funds and institutional investors have all been investing in the American Housing Market since 2012 when the real estate prices dropped to historical lows. KKR and BlackRock both have a minority stake in Home Partners of America (HPA) a company focused on the Single-Family Rental (SFR) Business. HPA was founded in 2012 by the former bond trader Lewis Ranieri, accredited as a pioneer of Mortgage Backed Securities. HPA owns single-family real estate properties across the U.S. and rents them for a five-year period at the end of which it grants the possibility to tenants to purchase the house. The option to buy the house at the termination of the renting period is what distinguishes HPA from its competitors which instead prefer to hold on to properties long term. By potentially selling the property once the rental period has expired, HPA is able to save on the upkeep expenses and on the renovations that would have to be performed if the houses were instead to be rented to a new tenant. HPA’s business has been growing significantly, the funds provided by private investors were needed to keep up with the growing demand. In 2018 there were rumors of a potential Initial Public Offering, however to date the company has remained private and has kept funding itself through debt and internal financing.
The SFR market segment in which HPA is primarily concentrated used to be predominantly dominated by smaller investors, however this changed after the 2008 financial crisis. As the housing bubble bursted many properties were vacated and institutional investors acquired many of them, stabilizing the market. Investors identified in this market segment a growing and attractive opportunity. As of 2018 detached one unit rentals were 12 millions, and this figure is projected by analyst to grow over the next decade.
Private credit investors have also been turning their attention towards the aviation business. While the commercial airline industry is a sector with a relatively low profitability the demand for aircraft is increasing as airline traffic volumes have been steadily growing over the last twenty-five years, as industry reports show, from 2005 to 2019 the number of passengers has more than doubled. Many analysts project this trend to continue as there is a huge untapped market, according to Boeing CEO, in 2017, 80% of the world’s population had never taken a flight. As the world becomes increasingly connected this percentage is bound to decrease, eventually leading to a growing demand for commercial aircrafts. Airline traffic has also been on the rise following the increasing need for commercial cargo space. As of 2020, Amazon utilizes cargo planes to be able to timely serve its clients, requiring more space on planes as the number of orders increases. The whole airline industry, including aircraft leasers, has been severely hit by the Covid-19 pandemic, which could have a worse and more long-lasting impact than 9/11 or the financial crisis had. It will certainly take years for the market to recover and for investors to see a return in this hard asset class.
Conclusion
To sum up, we believe that asset-based finance represents an important and interesting alternative market segment to keep an eye on, moreover when it is likely that we will experience a rebound in the private demand after the Covid-19 pandemic.
The wide plethora of assets covered, from used cars to aviation, highlights the crucial ability of ABF to provide portfolio diversification, both geographical and industry-wise, which allow to mitigate the overall risk. At the same time, the unconventional assets used as collateral, together with the willingness to cover uncharted markets like the one of NPLs, allow investors to be rewarded with higher returns compared to the conventional forms of investment. Therefore, Asset-backed finance can represent a viable alternative for those who are looking for higher returns in this otherwise low interest rates environment, but who still want to maintain a sustainable level of risk exposure.
ANALYSTS:
Simone Boldrini
Federico Adorini
Vlademir Chogoshvili
The wide plethora of assets covered, from used cars to aviation, highlights the crucial ability of ABF to provide portfolio diversification, both geographical and industry-wise, which allow to mitigate the overall risk. At the same time, the unconventional assets used as collateral, together with the willingness to cover uncharted markets like the one of NPLs, allow investors to be rewarded with higher returns compared to the conventional forms of investment. Therefore, Asset-backed finance can represent a viable alternative for those who are looking for higher returns in this otherwise low interest rates environment, but who still want to maintain a sustainable level of risk exposure.
ANALYSTS:
Simone Boldrini
Federico Adorini
Vlademir Chogoshvili