ASSET-BASED LENDING IN PRIVATE MARKETS

Asset-based lending (ABL) has emerged as a critical element within the private debt landscape, offering unique opportunities for both borrowers and investors. This approach involves senior loans secured by tangible assets, such as equipment, inventory, and accounts receivable, providing a robust mechanism for financing across various economic segments. For Limited Partner (LP) investors, understanding the intricacies of ABL is essential for leveraging its benefits and mitigating associated risks.

Why Invest in Asset-Based Lending?

Asset-based lending presents a compelling investment proposition due to several key attributes:

• Large, Diverse Opportunity Set: ABL encompasses a broad range of industries and asset types, providing extensive opportunities for investment across different economic sectors.
• Downside Protection: The collateral securing ABL loans helps protect principal risk and can potentially appreciate with inflation, offering a cushion against market volatility.
• Attractive Income Solution: The underlying assets in ABL typically produce recurring, often contractual, cash flows, ensuring a stable income stream for investors.
• High Barriers to Entry: The complexity and resource intensity of managing multi-sector ABL portfolios result in less competition and the potential for higher returns.
• Portfolio Diversification: Exposure to diversified sectors, idiosyncratic borrower events, and low correlation to general corporate credit enhances overall portfolio stability.
• Flexibility in Deal Structures: ABL transactions can be tailored to meet the specific needs of both borrowers and investors, allowing for customised capital solutions that command a premium.

KKR exemplifies the strategic approach to ABL, leveraging its relationships with sponsors and advisors to capitalise on underserved and mispriced lending opportunities. KKR’s ability to provide flexible and reliable financing solutions underscores ABL's appeal in offering downside protection and attractive income streams.

“So the banks were always that source of capital. As they moved away, they left a tremendous number of prime borrowers. In the last five years, the cumulative loss is two basis points over that time. So it's just a very low-risk, or almost no risk, investment-grade asset that has been left underserved.” - Invictus Capital Partners

Practical Examples and Case Studies

KKR has been a leader in the asset-based lending market, strategically positioning itself to capitalise on opportunities in the private asset-based finance (ABF) sector. After the 2008 Global Financial Crisis, KKR expanded its ABF initiatives, targeting a global market expected to grow significantly. KKR categorises the ABF opportunity set into four main sectors: Consumer/Mortgage Finance, Commercial Finance, Hard Assets, and Contractual Cash Flows. This diversified approach enables KKR to mitigate risks and enhance returns through strategic investments.

Invictus Capital Partners focuses on originating and managing high-quality loans backed by commercial real estate, residential mortgages, and other tangible assets. Invictus emphasises rigorous due diligence and active management to ensure that the assets provide strong collateral and stable cash flows.

Key Considerations and Risks

While ABL offers significant opportunities, it is not without risks that LP investors must consider:

• Credit Risk: The primary risk in ABL is the potential for borrower default. Rigorous credit analysis and due diligence are essential to assess the financial health and asset quality of potential borrowers. Invictus Capital Partners highlights the importance of this approach in maintaining asset quality and performance.
• Origination Volume: The ability to originate high-quality loans is crucial.
• Market Cyclicality: Economic downturns can lead to increased default rates, impacting the performance of ABL portfolios. Strategic positioning and diversification, as practised by KKR, can help navigate these cyclical fluctuations.
• Regulatory Environment: Changes in regulatory policies can affect the ABL landscape, influencing loan terms and borrower behaviour. Staying abreast of regulatory developments is crucial for managing potential impacts on investments.

"KKR's approach to collateral differs by investment type, but all methods involve granular analysis. For portfolio acquisitions, we review individual loan attributes and analyse factors such as historical delinquency roll rates, loss to liquidation, and borrower characteristics." - KKR

Data-Driven Insights

Recent data underscores the growth of the global ABL market, with assets under management reaching substantial levels. This growth is driven by increasing demand from middle-market companies seeking flexible financing solutions and investors searching for higher yields in a low-interest-rate environment.

Strategic Implications for LP Investors

For LP investors, ABL offers a strategic avenue to enhance portfolio returns and achieve diversification. A successful ABL strategy involves:

• Robust Due Diligence: Conduct comprehensive due diligence to evaluate borrower creditworthiness, asset quality, and the overall risk profile of potential investments. KKR’s meticulous approach to evaluating collateral and market conditions exemplifies this diligence.
• Portfolio Diversification: Diversify investments across various sectors and geographies to mitigate risk and enhance return potential. Invictus Capital Partners’ focus on a broad range of asset types supports this strategy.
• Active Monitoring: Engage in active monitoring of loan performance, maintaining close communication with borrowers to anticipate and address potential issues proactively. This proactive approach is essential for managing the risks associated with ABL investments.

 Conclusion

Asset-based lending represents a dynamic and growing segment of the private debt market, offering LP investors attractive yields, diversification benefits, and opportunities for capital preservation. By understanding ABL's strategic advantages and inherent risks, investors can make informed decisions that align with their investment objectives and risk tolerance.

Stay tuned as our series continues to explore other critical themes within Private Debt, providing deeper insights into the diverse opportunities available in this investment category.

Further Reading

You can read more about this and other private market themes on the Global Fund Search Website by clicking this link.