Exploring Asset-Based Finance: Funding the Real Economy

A growing market segment offers diverse opportunities for private lenders and investors.

Asset-based finance provides much of the financing for the real economy and a compelling proposition for investors. But what exactly is it, and what makes it a different breed from other private credit investments?

It starts with the sprawling, vibrant consumer sector, which is more than two-thirds of economic activity in many of the world’s major economies—including the US and Europe. Consumers borrow money for a lot of reasons—to acquire property, buy cars and purchase household goods. Companies use asset-based finance, too.

A New Chapter in the Private Credit Story

Who provides the vital capital that supports the needs of the real economy? Historically, banks did, but the picture has changed over the past few decades. Pressure from crises, tighter regulation, financial innovation and consolidation have crimped banks’ balance sheets. They’ve struggled to keep up with growing loan demand from consumers and businesses.

After the global financial crisis, private lenders stepped in to fill this capital gap, providing capital to companies in the US middle market owned by private equity firms. Today, this form of private lending is a well-established market with many lenders jockeying for business.

Today, we’re seeing a new chapter in private lending unfold.

Banks remain under pressure, unable to meet the borrowing needs of the real economy, and private credit investors are again stepping in to fill the void. New entrants to lending markets, specialty finance companies, are one of the driving forces. Harnessing new technology and taking advantage of changes in financial markets, these non-bank lenders have provided capital to underserved consumers and small businesses.

Unlike banks, specialty finance companies don’t have big balance sheets to hold loans, so they partner with outside sources of capital such as private credit investors (Display). Specialty finance platforms source, originate and service the loans; private credit investors set the parameters for borrowers and collateral types, provide the capital and own the loans.

Asset-Based Finance vs. Corporate Lending: The Tale of the Tape

To better understand how asset-based finance fits into the overall private credit mix, it helps to think of it as a complementary category to corporate lending.

When corporations secure a private loan, their cash flow provides the backing for interest payments and loan repayment (Display). If the corporation defaults, the amount the lender recovers can be uncertain and takes time to resolve. 

Asset-based loans work differently. They’re backed by income-generating hard assets, such as energy infrastructure or leased airplanes, or by pools of financial assets such as auto loans and residential mortgages. These assets secure the loan and generate their own cash flows. In a default, that asset backing generally provides strong and more predictable recoveries.

These loans are highly diversified because the economic drivers of the underlying assets are diverse. Pools of consumer loans originated by specialty finance companies often include thousands if not tens of thousands in each deal.

The self-amortizing nature of asset-backed loans means that they repay their principal gradually over time, becoming less risky as they do. That’s distinct from the way corporate loans work: they pay income over time but don’t repay any principal until the end of the loan term. And asset-backed loans are credit remote: they’re not tied to a company’s balance sheet and therefore the risk of corporate defaults.

A Burgeoning Market Yet to Be Fully Tapped

Asset-based finance offers investors access to a growing opportunity set. There’s more than $6.3 trillion in debt in the specialty finance ecosystem and more than twice that in the under-pressure banking system. That potential addressable market dwarfs the combined $3 trillion dollars in the direct lending market and liquid high-yield markets.

From what we see, this opportunity hasn’t yet been fully reflected in investors’ allocations. That’s probably because it’s a wide-ranging asset class and not all private lenders have the know-how to navigate it effectively.

Sizing Up the Potential Benefits of Asset-Based Finance

Investors who access the asset-based finance market could find attractive potential returns and diversification. These investments offer a yield premium because they’re less liquid than similar public securities—and because lending arrangements can be complex. Along with healthy income, they also offer potential capital gains, because they’re often made at a discount.

Asset-based finance may also complement investments in direct corporate lending and public-market risk assets such as corporate bonds and equities. We believe they bring a level of economic diversification that may help cushion portfolios in declining and turbulent markets.

Of course, capitalizing on potential requires the expertise to get up close and personal—assessing individual loans and gauging the balance between opportunity and risk. If private lenders get the formula right, we believe they have a good chance to reap the benefits.