Global ABS 2024: KBRA's Day 3 Recap

KBRA reviews day three of Global ABS, with private credit the main focus

The third and final day of the Global ABS 2024 conference featured a focus on private credit, a topic of interest in the credit markets. This provided a popular and refreshing finish to the conference, with interesting topics ranging from the middle market to fund finance. Below we provide a recap of some of the final day’s panel topics.

The Rise of Private Credit: Growth Expectations & Future Evolutions

As highlighted by the strong attendance for a morning start, the panel was very positive on the growth prospects for the private credit market. The consensus view was that allocation to private credit will continue as the sector still offers good yields to investors. High interest rates are providing challenges to borrowers as they struggle with the cost of financing, but for investors, the higher yields in the market support its growth and the availability of lending.

Transparency in the market would be helpful to support continued growth, it was noted, and there is some positive progress with technology supporting the development of data and information. Regulators have highlighted transparency as a concern and may drive future development in this regard, according to the panel. Technology developments have also been helpful on the investment side, allowing some investors to get data on performance at close to real time.

The securitisation investors that are active in the private markets, namely significant risk transfer (SRT) transactions, have learned from the financial crisis. They are aware of the credit and reporting structures as well as the performance of underlying collateral. One panellist said some transactions are making use of ratings, largely to offer either a third-party verification to their risk departments and benchmark against other trades or based on the demands of the investor.

Panel members cited a degree of competitive tension between direct lending and the leveraged loan market. But this was viewed as a positive thing as it leads to growth and innovation. In general, the market has segmented into a relatively standard product in the leveraged loan space, with private credit offering businesses a more flexible option in collaboration with the leveraged loan market, or as an alternative that may better suit the business.

Private Credit Keynote

The speaker expected a “ripping” ABS market on the expectation of rate cuts. (Shortly after this panel, the European Central Bank cut the policy rate by 25 basis points.) There is a transition of capital to private markets rather than public markets and this is included in insurance solutions. The unrated ABS market has seen significant activity in the last two years. Moreover, there is limited supply and huge demand as illiquid assets have been hot.

The emergence of a European securitisation market has given way to five pillars — banks, insurance, sovereign wealth, pensions, and private credit — which both work and compete with each other at the same time. With the exception of banks, the other players have matched funding. In contrast, banks borrow short and lend long, and also essentially have government guarantees. As systemic risk is associated with the banking sector, bailouts by government regulators have really only been provided to this sector.

Banks in aggregate hold $23tr of balance sheet with one half of that representing the type of collateral used in securitisations. According to the panel speaker, if $1tr migrates to the private credit market, it will be as large as the direct lending market. As a result, in five to six years from today, the Global ABS conference could comprise half a private credit focus and half a public securitisation focus. Given the popularity of the SRT and private credit panels, this is starting to be recognised.

The panel speaker believed that private credit markets would likely consolidate with four to five winners over time. Further, small players are unlikely to exist due to the cost structure and regulations. This is because, historically, finance follows patterns of consolidation. Small players in credit investing have no scale advantage and will be consolidated. The importance of infrastructure and a long track record helps to maintain a competitive advantage in credit investing. Changes to the European Union’s Solvency II legislation for insurance companies are needed to support the European market. These regulations are very restrictive and force insurers to take on too much liability risk. Change would help to support the securitisation markets, according to the speaker.

Rise of Nonbank Lenders in Fund Finance

The second panel of the day focused on the growing market of fund financing. The product was previously a niche product, but has since become more mainstream. Nonbank lenders have become more consistent in this market, with a rising interest in supporting the space. While bank lenders are still present, the growth in nonbank lenders has shifted the dynamic into their favour. Prior to the recent growth in the market, funds borrowing was viewed as a last resort. Now, it is a key part of their strategies and management.

Panellists noted that given the growth in the market, lenders have started to pinpoint key focus areas versus being involved in everything. The real estate sector has gained broad acceptance for the product with nonbank lenders preferred over bank financing. Further, investors are looking to step in to the product, but there is an education process for new investors. A panellist noted that in the US, it has taken a while to get through the legal process. Some individuals are comparing the product with collateralized loan obligations and other securitisation products. But it is really a unique product which has developed into its own market. Increasingly, standard processes and structures have been developed, which supports the ability to deploy funds and help to grow the market.

According to the panel, the private equity market has been a driver for market growth. With valuations challenged and a slowdown in new opportunities, private equity sponsors are struggling to recycle their funds. As a result, they have been turning to fund finance to help bridge the gap between the current market environment and an availability of new opportunities.

Global ABF: Asset-Backed Finance, the Next Frontier for Private Credit?

The panel of experienced lenders in the market noted the depth of the history of asset-based finance and that it was only recently going through a transition as new investors are entering the market. Product development, new technology, and a changing bank finance market have all helped to support the growth of this type of lending. Investors are attracted to the strong yields in the market and its already large size and history. Panellists mostly described the product as a granular, self-amortising portfolio.

One panelist noted the advantage of having scale invested into asset-based finance allows flexibility to scale up and scale down their lending into certain segments of the market. This allows them to migrate away from sectors that may be experiencing external stresses or regions that may be struggling, and into areas of opportunity. This provides them with an advantage over bank lenders who are committed by their need to maintain relationships with borrowers.

The panel classified the market into three segments: publicly rated, privately rated, and unrated. The choice to fund through these three markets is based on the demands of the investor base. The investors are driven between the three, mainly by regulation and capital requirements. Investors are global in nature, but the asset-based financing market is mainly focused on western markets. This is due to the infrastructure and legal framework support. Generally speaking, North America is a very liquid and transparent market with a lot of data and information, while Europe is more heterogeneous with data, legal, and reporting all different across the various countries. As a result, North American market prices tighter to the European market, according to the panel. However, this offers investors the opportunity to add more value.

The panel noted that the market offers value to support the real economy. Small and midsized enterprises are the largest user base of asset-based finance. Technology has allowed private lenders to access the market with greater ease. Financial technology companies are a growing part of the market, with many acting in partnership with banks in a symbiotic relationship. Investors on the panel said they are not looking to disintermediate the banks from their clients and feel that instead they offer a broadening of the offering for businesses to finance their activities.

Exploring the Middle Market: Considerations & the Latest Developments in Specialty Finance and Direct Lending

The panel included KBRA’s Gabriele Gramazio and covered the topic of middle market and direct lending. Some of the panellists highlighted the difference in lending into the European market versus the US. For starters, the US has developed into a liquid middle market CLO market, while Europe is still struggling with bringing a transaction to the market. However, the panel was hopeful that this would happen soon. The challenges to bringing a transaction are largely driven by the structure of the European market.

In Europe, the panel noted that most lending can occur on a first lien basis with borrowers, whereas the US market is more competitive. As a result, lending tends to be done on a second lien basis, and the investor could be a part of a syndicate of lenders offering the financing. In Europe, this offers investors an opportunity to provide higher quality lending at good returns. The availability of the opportunity in Europe is strong, but for investors, there are challenges that come with this opportunity. For example, it is helpful to have the appropriate language skills and knowledge of the legal frameworks. Further, knowledge of the sector one is lending into and the position of the business within it. As a result, investors are developing local teams to support their lending.

One sector the panel highlighted as a growing opportunity is lending to recurring revenue companies. This has developed into a business in the US and is being explored in Europe, but the pool of candidates remains limited at the moment. The US market is a rated one and KBRA has been active for this type of product. The structure in the US has been developed and could be replicated within Europe. This is also the case for the other CLO products as the US has provided a growing standardisation of the structures, which could be replicated within Europe. Challenges remain such as hedging for currency risk, although panellists agreed there are available solutions. The documentation is key to protect investors and develop the market.