Differentiating ABF strategies in a rapidly growing asset class

As it base finance and as it backed finance, what's the difference? Is there a difference? Whatever your preferred flavour, ABF is a hot topic right now. It's often described as the new frontier in private credit, but it seldom defined clearly. Of course, it's not easy to do so. ABF stretches from aviation financing to investing in pools of mortgages. Think of things you can put your hands on. They can be financed. For some time, it's been considered a subsector of private credit. That's because many of those entering the ABF space are private investment firms, some of which are offshoots of big direct lending firms. But as the market grows, it's coming into its own, and it's important to understand the differences between cash flow lending and asset lending. In this special episode, sponsored by Castle Lake, journalist David Brook is joined by Isaiah Tobak, deputy chief investment officer at the firm, which is a global, pure play, asset-focused investment manager and ABF specialist. We'll impact them in you shy of the market, and be delving into what LPs need to consider when investing in it. We'll also look at how an ABF firm contends with a never-changing economic cycle, and the ways lenders protect themselves when completing transactions. Finally, we'll be answering that big question, what is the difference between asset-based finance and asset-backed finance? I'm Hannah Roberts, and this is the private debt investor podcast. Okay, so we've asset-based finance versus asset-backed finance. How is the market defining these terms? Poorly. So it's the right question to start with. Asset-based finance is generally any financial investment where you are using the value of an underlying asset to drive your credit thesis. That can be a hard asset that has intrinsic value, it might be a plain building or a financial asset, I think a stream of cash flows, whether it be a loan that you are financing or something along those lines. Asset-backed finance is a sub-segment within asset-based finance. That is typically ABS, right? So we are talking about bankruptcy remote vehicles that are financing a discrete pool of assets that typically aren't changing over time. I think importantly what's shared between both of them is this is not corporate finance. This is not cash flow modeling and profit forecasting. The underlying asset needs to be able to be divorced from the corpus of any type of company. So we often have investors come to us with strategies where they're looking at secured corporate and saying, "This is asset-based finance." It's very important nuance for the market to ensure this space is really not meant to be corporate finance in any way. And then, so thinking about ABS, both ABS, I guess, overcoming increasingly popular among institutional LVs, I'm wondering what LP should be mindful of. I mean, I'm thinking about the types of processes ABS investors watch LPs look for when they're prioritizing managers. To me, there's really two questions. So first, it's at the LP level and trying to make sure that the LP clearly defines their goals with the investment. One thing that I often say is that ABF is about, as instructive as a term, is talking about alternatives. Within the ABF markets, there is asset-based private credit. There is asset-based equity. Some of our counterparties are buying pools or going into the expansive parts of the market, all of which should come with very different risk tolerance and risk return parameters to them. And so it's one of the questions I ask with LPs all the time is if you're looking for an alternative to corporate direct lending, you probably want asset-based private credit manager. If you're looking for an alternative to distressed credit and alternative to capital solution strategies, that might be where you want to go to a more traditional ABF taking the equity portion of these portfolios. So that's the question for the LP. As it relates to the managers, then what should managers or LPs look for within managers, first has to do with, are they an experienced manager? Have they managed it downside before? Do they have the internal capabilities to create product that can go through credit cycles? Are they able to point to that? Have they navigated through sticky situations together? That's a first. The second is the depth of the underwriting skill. Do they have in-house internal structuring? Do they have internal relationships? Do they have internal data? Data is essential to mapping this market correctly. So for us, if you are a newfound asset-based manager, you're an offshoot of one of the existing large corporate direct lending managers. We've seen many of our competitors set up asset-based finance businesses. If you believe in our thesis that you need to understand the quality of credit that's being underwritten at any point in time, down at the loan level data, I don't think that's possible to just snap your fingers and start one day. And so do they have all of those offerings in-house? And then finally, it's what are the components that are creating the return? Most importantly, I think LPs underestimate the role of leverage within this market. And how are you as the GP getting to your return components? Is it from owning warrants in these companies? Is it from structural enhancement? Are you taking leverage at the fund? The number of times I've had conversations with LPs where they're comparing fund types, which would be the equivalent of comparing leverage private equity strategy to senior corporate direct lending. I mean, that's how disparate the risk profiles that they're comparing for a single mandate. I think that there's an under appreciation. Yeah. And so this is the strategy where you have to keep your eyes on the front page of the Wall Street Journal, on the Bloomberg Seminole every day. And a map clicking on the news can go up or down depending on the day of the week. So how can maybe you have specialists invest through such a cycle when it can be very uncertain? Yeah. Yeah. I mean, the macro certainly moves. We're talking about providing capital to the real economy. The real economy is what we're reading about, right? How is the consumer changing? How are home prices changing? How are small businesses being affected by changes to oil prices? All of these different mechanics create the soup of what underlies these markets. However, for us, oftentimes it comes down to your ability to navigate these markets. So first, we believe very strongly that an ABF offering should be multi-strat. I think that many of our sub segments, there are points in time where they're interesting. There are points in time where they're less interesting. You need to have a manager who can move in and out of those markets. So that's one of the ways you stay invested in these spaces. The second is where you are in the capital structure. If you are an asset equity lender or investor, that is very different than being a second lost lender. So from a risk tolerance perspective, I think it changes in terms of macro risk and exposure. I think having a common risk lens in the way you approach these markets is really important. It has to do with what is the quality of credit that's being written at any point in time? So oftentimes, a great macro environment leads to rapid expansion of credit, which also means credit quality deteriorate. And for us, that's usually a yellow, if not red light signal for us. We do not want to finance a vehicle where the assets that are being created have weak underlying standards. A brief example of that. If you look at 2022, right, we're coming out of COVID. We had seven trillion dollars of stimulus brought down to the US consumer right into their wallets. The consumer delivered their balance sheets. It was one of the fastest deal everings we have seen. And what we saw were bank lenders and non-bank lenders rapidly deteriorate their credit underwriting standards. We had about 15 months of continuous credit underwriting weakening. That signal told us we should not be in the market today. 2022 consumer installment loans. Performed worse than 2007 vintage loans. So when you ask about the macro market, I think that's a great example to tell you that the macro is important, but the competitive environment and quality of credit is probably more important. And for us, those are the signals that we really look to. As a credit investor, I'm paid to be class 70. The best environment for me is one where the macro recession has already happened. There's far less competition. It can't get worse from here in some respects. That's a great opportunity for us to invest. The worst market environment is rip-roaring economy and highly competitive market. Because the economy can only downturn from there. We will see credit deterioration at downturn. I don't want to say otherwise, of course, we will. But if the loans that were written that we are financing are of a high enough quality, they're designed to already withstand that type of environment. So for us, the macro matters, competition and credit quality matters more. Interesting. A lot of biggest pitfalls of the deal that ABF specialists can look out for. So downside protection is one of the most important parts of asset-based finance in general. The beauty of whether it's ABF for asset-based private credit or just asset-backed securities is this is a covenant-heavy market in the liquid format. So what trades inclusive is covenant-heavy. So I think one of the most distinct differences from the corporate markets, where the term OMB market and the high yield on secured market, those are covenant-light businesses. So when you go to the private markets, you're fighting against not only competition, but you're fighting against that alternative to make a different decision for that at Borrower. This market, the liquid market security, is already heavily covenanted. And for us, when we think about really the magic of bringing direct relationships data and in-house structuring together, this is really where that magic happens. So we are often including novel covenants that will look to the quality of the underlying assets. They look to deliver us, obviously as a lender, we are looking at our advance rates at all time. We are looking at borrowing bases at all time. And so for us, when we think about performance right all going back to that risk lens that mindset of the world's always going to get worse you know in our base case scenarios we're assuming a serious recession we need to make our returns through that environment and so for us the the covenant packages that we design seek to take cash away from the vehicle and deliver us as the lenders we are going to define what the loans look like but importantly if we see deviation importance we're picking up the phone we're having a conversation and you as a CFO of this Rezzie mortgage originator you want my capital you signed up for that commitment it's important remember you're not a bank you don't have access to on-demand deposits you need my capital I'm an important part of how you've thought about your financial planning for the year so when I call and say we have a problem we're going to work together to put new assets into that portfolio that work one of the things that I think LPs are probably underestimate is how important that is like many of the abf practitioners go out there they buy loan portfolios they finance a static pool they take a a big trade has been financing portfolios off bank balance sheets when you do those things you have a portfolio that is defined day one and yes you can create covenants that protect you we believe in that I don't think that these are bad investments but fundamentally if the world starts corining there's no new assets coming into that vehicle you own what you own you're financing what you finance and you hope that the covenants are sufficient in our position we not only have all those covenants but we are working to bring new assets into the portfolio it's why I always say we are abf as their asset base as opposed to asset back because it is one of the key distinctions of we don't have this discrete pool we're working with that originator to constantly tailor a portfolio and then retailer that portfolio right to meet the needs interesting as to kind of this market kind of ensures when we talk about you frontiers and then we talk about its next stage of evolution I'm just just like what is next step for abf how does it kind of mature for ever I mean how managers continue to differentiate as capital flows increase as we talk a little bit about second ago well returns compressive guess we see that in a private credit lending market or direct lending is a lot more of a kind of commoditized product compared with maybe what some of the kind of abf investment so just kind of curious how you kind of see the next step in the evolution of this market sure sure absolutely so first we're in the very early innings this is the equivalent of corporate direct lending in 2013 just to put it in the right where are we in the game and point to saturation you know you're talking about a market the addressable market is significantly larger than corporate direct lending in terms of what's coming what's next how's the market going to differentiate a couple of things so first one of the things we're very wary of of a castelake at castelake is the securitization of everything it does seem like this market is bringing out some of the most novel financial innovation that we've seen in close to two decades now we're seeing the repeat of a lot of security types we haven't seen since the financial crisis and castelake believes again if if you buy into our thesis of data will tell you when to enter a submarket a lot of these asset classes don't have the data to tell you now's the right time and certainly there are many unknown unknowns in many of these markets and so for us I think as the market matures some of those asset classes will accumulate enough data and enough performance history for us to feel confident to move into them I don't think we're anywhere near that today it in terms of how the market differentiates itself we all live and die by our track record and I think at the end of the day discipline time and market history of workouts the ability to navigate risk you asked before and I didn't quite answer the question about you know bad times we're heavily invested in transportation aviation assets you know in circles of finance we always talk about the downside scenario being the scorched earth scenario and I'm recovering aviation banker myself that's what I did prior to my time at castelake and one of the things we always talked about in aviation banking was well there's never been a time that the global fleet gets grounded that's why these are great assets you can move these aircraft around and so for us when we think about risk when we think about track record you need to make sure the counterpart of your working with has been together and through a credit cycle together that is how you will ultimately see your way through a true credit event there's a much of a role for AI in the ABF today or in the future that's an interesting question yes and no absolutely in the form of the high data proficiency markets right if we think about consumer finance we think about residential finance small business finance where you have hundreds of thousands millions of line items I believe in the use of AI for credit underwriting I think alternative data is a really fascinating way of thinking about consumer credit behavior you'd be terrified at some of the things that these companies can see about you as as an individual consumer they can see how long you take to type things how where you scroll through do you have multiple credit pages up at one time and they use these in their prediction models and they have gotten better and better and better so you know you asked before also about compression of returns it's interesting we have seen over time the cost of the consumer come down in various periods of time but the credit quality is improving partly because of tools like AI do I think AI ever becomes a decision engine for what we do I think we're pretty far away from that do I think that we can be better at the way we underrate within each of our markets and better at ultimately predicting market movements over time yeah I think that there's a role there a final question is just that we have a kind of retail investment is there a future for the retail investor in ABF it seems like a very kind of different type of it's a very different type of market already what you make of the future of retail investment in ABF complicated it's definitely a touchy subject within the markets today for a number of reasons so first this is a bespoke underwrite it is a bespoke type of risk and what we don't want to see is a market that grows so rapidly and I think the problem with retail capital is retail capital comes in very quickly very aggressively it's also very fickle it can leave very quickly this asset class has not developed any type of secondary traded market I think we're in the early endings of that within corporate direct lending it does not exist within the ABF markets and so investors should not be signing up for vehicles where they think that they can get their money in and out very quickly likewise when retail capital comes in in their typical forms are you think about interval funds and these other types of products where there's some level of liquidity but it's not predicated on trading the assets that's the typical answer someone gives as well we're not doing that we hold some cash and that's how we deal with it go back to the way we think it makes sense to capitalize this market we exist to finance the non-bank lenders we get paid to give them a capital C committed facility and we're able to charge better structures and higher rates of return for that commitment but definitely I need to know that my capital is there right I'm giving a forward commitment for the finance of new assets I need to know that my capital is not hot money it's not liquid money that can be withdrawn so if you believe in the value of forward funding you can't have retail there are many ABF practitioners who are doing these trades right where they are counter-party and transaction that's all they are they're not a strategic piece of capital for one of these originators but they are coming in and saying I will buy this loan pool I will I will help this liquidating bank whatever the situation might be that's a perfectly fine version for retail to participate in because it's a point in time transaction and then if they need to redeem hopefully you can sell your asset but for us forward lending I don't think it's the right product so it seems we're not likely to see ABF on Robinhood anytime soon as we heard ABF is a fast growing market and as with any asset class that grows rapidly it's important that investors understand why it can be part of their portfolio but also that there are challenges ahead that's all for today thanks again to Isaiah Tobak from Castelig for joining us if you want to hear more episodes you can search wherever you listen to podcasts or at pei-private credit.com I'm Hannah Roberts with PEI group thanks for listening