Over the past 15 years, many institutional investors have steadily built their allocations to private debt, seeking yield in the attractive lending opportunities left as banks shored up their capital ratios in the wake of the Global Financial Crisis. Today, many of those portfolios are large enough that investors are looking to diversify them.
In this paper, we propose “specialty finance”, also known as private asset-backed or asset-based lending, as a potential solution. It offers exposure away from the private equity-sponsored corporate credit risk that accounts for the bulk of private debt portfolios. We believe it can also offer abundant higher-yielding opportunities with a shorter duration—under two years, in contrast to the four to seven years common for private credit maturities and private debt funds. We also believe that bespoke structuring of these privately placed investments can add attractive downside protection and further diversification benefits.
Executive Summary
What Is “Specialty Finance”?
- Finance markets have disaggregated and disintermediated, often enabled by new technology.
- New, tailored finance products and new loan originators have proliferated, requiring new backing from the capital markets.
- The risk profiles of these new products differ meaningfully from those of traditional private corporate debt.
Structuring and Credit Enhancement
- Market participants can negotiate structures with loan originators who take equity-like first-loss exposure beneath them and bespoke covenants that are more favorable to investors.
- This provides downside protection, sometimes in exchange for capped upside participation, and further diversification from macroeconomic risks.
A Market That Has Seen Limited Institutional Competition
- Sourcing and structuring transactions is operationally demanding and, in our view, depends on an appropriately resourced and dedicated team with extensive industry networks and experience; as with Neuberger Berman’s Specialty Finance team, this would ideally include senior operatives with hands-on experience with specialty finance companies and alternative lenders that have originated many of the opportunities in the asset class.
- This limits competition for transactions, adding a final point of differentiation and complementarity next to traditional private debt strategies.
How Structuring Can Provide Downside Protection
Yield for a hypothetical portfolio with a 4% modeled loss estimate, 3% of principal held in escrow, and a 14% target yield, under various loss scenarios
Source: Neuberger Berman. This model is presented for illustrative purposes only as an overview of the theme described herein and is not representative of any actual opportunity or investment. Yield data is presented for illustrative purposes only and not as a suggestion, projection, or guarantee that any such returns will be realized or achieved or that an investment strategy will be successful. Yield represents the applicable contractual yield under the given loss scenarios. It is presented as a characteristic, and actual yield achieved may vary significantly. Yield does not take into account any applicable fees or expenses that investors would experience, which would reduce returns. The illustration shows an unlevered hypothetical portfolio.
