What is Specialty Finance?
Specialty finance can be defined as financing activity that occurs outside of the traditional banking system. The focus is on providing capital to commercial and consumer borrowers inadequately served by mainstream banking channels. Beyond asset-backed, consumer and SME lending, specialty finance also covers esoteric financial assets such as litigation financing, buy-now-pay-later, accounts receivable, merchant cash advances, and equipment leases.
Following the financial crisis of 2008, increased regulation across the ecosystem coupled with unsteady market conditions forced traditional financial institutions to alter their lending policies. The increased capital requirements and risk governance on banks opened the door for alternative finance providers to capitalise on disintermediation opportunities. The emergence of ‘fintech’ companies contributed to fill the gap.
Mainstream banks have become burdened by a lack of flexibility. Individuals and companies sourcing credit from specialist lenders, however, are often those with non-mainstream credit profiles. This does not mean they are unattractive opportunities, as many still display traits that make them good candidates to lend to, but rather some characteristics such as leverage ratio or time in business do not necessarily fit within the credit parameters of traditional financial institutions.
The art of lending in specialty finance
Specialty finance investments are more complex and harder to access for institutional money compared to private corporate debt. Credit investors need a unique skill set and approach to successfully navigate in this arena, both in terms of origination and execution. Investment opportunities are typically generated through strong industry relationships.
Specialist lenders have been able to outperform traditional corporate debt in returns, with alpha generation associated with the ability to originate niche opportunities. The tighter supply of traditional financing, combined with a set of borrowers with more price inelasticity, has resulted in higher returns in specialist lending markets. The challenge for firms is to ensure that there is no significant reduction in underwritten credit quality whilst earning a premium.
The option for specialty finance loans to generate a predictable cash flow stream enables them to pay consistent principal and interest on investments. Loan portfolios in specialty finance are also well-protected as they are often secured by large underlying pools of individual financial assets, which diversifies potential risk across investments.
Specialty finance investments are distinct in their uncorrelated nature compared to the macro economy and market volatility, even in comparison to other equity and debt investments available to most investors. Therefore, these assets provide an attractive diversification for an investment portfolio.
The future of specialty finance
The global private debt market is predicted to more than double from $1.21 trillion to $2.69 trillion in 2026. Direct lending and distressed debt account for 65% of global private debt (Preqin 2022). Specialty finance lending accounts for less than 10% of the total asset class AUM. This is where specialist lenders identify and fund interesting market niches, creating opportunities for accredited investors.
The UK has the most sophisticated and diversified private debt market in Europe and, globally, it sits only behind the US. The UK fintech sector has also cemented its position as the fintech leader of Europe, with London topping the Savills European Fintech Occupier Index 2021. Therefore, the UK is a strong hub for producing appealing specialty finance opportunities.
In addition, COVID-19 highlighted the importance of specialty finance firms playing an active role in addressing the financing needs of consumers and businesses who are ineligible for more traditional funding as credit underwriting parameters tightened at several large financial institutions.
One of the most favourable aspects of specialty finance has arguably been its lack of competition. Since most of the institutional sponsorship has gone towards direct lending, firms in the specialist lending arena have not had to compete as aggressively on price or terms. However, given the private debt market’s year-on-year growth rate and strong risk-adjusted return potential, there is merit for more institutional private credit strategies to incorporate UK specialist lending investments in the future.