Private asset-based finance as a diversification tool

Key takeaways 

• Asset-based finance (ABF) encompasses a range of investment opportunities, often backed by assets used by businesses and individuals on a daily basis. 
• ABF investments might be appropriate for individual and institutional investors seeking diversification, risk mitigation and target risk/reward characteristics. 
• Private ABF offers a wide variety of investment opportunities, including single- and multi-sector solutions, in areas such as equipment finance, real estate, traditional infrastructure or digital infrastructure, allowing investors to formulate the best solution for their individual portfolio needs.

As banks retreated from traditional lending markets in the years following the 2008 Global Financial Crisis (GFC), the door opened for private credit managers to fill the void.

The private credit asset class has now grown to $1.8 trillion in assets under management,¹ primarily representing assets of corporate credit investment strategies, including direct lending, mezzanine and distressed and special situations. For investors looking to diversify their portfolios, private asset-based finance (ABF) offers the potential for uncorrelated returns to existing corporate-focused fixed income allocations across private and liquid markets.

Financing our everyday lives

Asset-based finance encompasses a broad spectrum of investment opportunities, often backed by assets used on a daily basis by businesses and individuals. The underlying collateral supporting such financings ranges from machinery and equipment that produce the goods we use to the infrastructure that generates our electricity, to the buildings in which we live and work and the media content we consume.

A major growth vector in private markets

Traditional financing solutions offered by banks and securitization markets have long existed to provide asset-based financing. However, bank appetite for balance sheet exposure is becoming more limited and availability of securitization capital often fluctuates depending on market conditions.² As a result, private credit is emerging as a viable alternative capital provider to borrowers seeking capital stability and customized financing solutions. We believe these private asset-based opportunities will emerge as a growth vector in private markets for the following reasons: 

Scalable and growing investment opportunity: ABF represents a large investment opportunity, with an addressable global market that HPS estimates to be $26 trillion, which is larger than the estimated $14 trillion corporate credit market, as shown below. However, private credit only holds an estimated 3% market share in ABF compared to 12% in corporate credit. Over the next several years, we expect private credit to increase its presence in the ABF market with its ability to provide scaled and flexible financing solutions, expanding its market share, similar to private credit’s trajectory in the corporate credit market over the last decade. 

Private credit’s share of corporate credit and ABF markets

Tailwinds at the asset level should be supportive of credit quality: Certain sectors within ABF are benefiting from positive tailwinds. Several asset-intensive sectors of the global economy, including the energy, power and digital infrastructure sectors, are projected to see increases in capital expenditures over the next several years.³ For example, artificial intelligence (AI) and related digital infrastructure capital expenditures alone are projected to be approximately $7 trillion over the next six years.⁴ Additionally, power demand is inflecting higher due to growth in AI and data center development, as well as reshoring of manufacturing capabilities, which is supportive of power prices for existing generation assets and driving demand for new assets.^{3, 4} Further, in the U.S., residential housing stock is undersupplied by an estimated 3-4 million units, which has resulted in higher housing prices over the last several years.⁵

Regulatory pressures could result in continued bank disintermediation: Following the GFC, many banks addressed increasing levels of regulation by scaling back capital-inefficient lending units while prioritizing customers with longstanding relationships.⁶ In our view, even a potentially looser near-term regulatory environment is unlikely to fully reverse the retreat of banks from select lending markets as a result of these constraints. 

Portfolio construction benefits and considerations 

We believe the addition of private ABF investments to investor portfolios may be advantageous from a portfolio construction perspective. While the actual impact will depend on each investor’s specific allocation, we believe investing in ABF could provide the following benefits, among others:

Diversification: The inclusion of ABF in a portfolio can offer diversification benefits across several dimensions. Exposure is typically oriented toward non-corporate assets, which can provide differentiated return drivers from traditional corporate credit allocations. Within a multi-strategy ABF portfolio, underlying subsectors and asset types are often not highly correlated with one another, with individual investments frequently backed by a collateral pool comprised of individual cashflow streams supported by a large number, in some cases thousands, of distinct assets. To create the collateral pools, managers typically seek to include assets with varying underlying characteristics, which can provide inherent diversification within a single investment. Additionally, the performance of these assets is generally tied more to idiosyncratic asset-level factors than macroeconomic changes. With ABF assets generally supported by hard asset collateral, we believe these assets can generally be viewed as a natural inflation hedge. Taken together, these ABF characteristics generally contribute to lower correlation relative to other public and private investments, as highlighted in the table below. 

ABF exhibits lower correlation to other asset classes

Risk mitigation: ABF investments are often structured through bankruptcy-remote special purpose vehicles, such that performance is tied to the underlying assets rather than the parent company. Transactions also generally incorporate bespoke covenants and other lender protections designed to enhance downside resilience. In addition, because the collateral is typically a hard asset with an observable market value, lenders may, in the event of a default, have the ability to take possession of and sell the asset to support a partial or full recovery of principal.

Targeted risk and return characteristics: Many ABF investments are supported by long-dated contractual cashflows and for certain investments, self-amortizing or front-loaded repayment profiles, with principal typically repaid over time through contracted payment streams such as mortgage payments, lease payments or royalty fees from a diversified base of underlying obligors. This cashflow visibility can enable managers to tailor transaction structures to specific risk and return objectives. For example, a collateral pool may be tranched into senior and junior securities to create differentiated investment outcomes.

A potential investment solution for many investors 

As noted above, ABF investments can be structured to meet a wide range of investor risk and return objectives. As a result, a variety of investor types, both individual and institutional, may benefit from introducing private ABF to their portfolios.

For example, investors seeking a yield premium to existing liquid corporate loan and bond investments, like insurance companies, may find investment-grade opportunities in the private ABF market to be a potential source of return premium and reduced correlation. Yield-conscious investors, from individuals to pensions and other institutions, may also find private ABF a diversified income solution. Even total return investors may find the non-investment-grade opportunities to provide potentially attractive risk-adjusted returns to complement corporate private credit exposures.

Given private ABF offers a wide variety of investment opportunities, including single- and multi-sector solutions, in areas such as equipment finance, real estate, traditional infrastructure or digital infrastructure, investors have a diverse set of options to formulate the best solution for their individual portfolio needs.

Conclusion 

We expect private ABF to grow and become a meaningful part of the overall private credit universe. This market has the potential to offer investors a large, diversified set of investment opportunities, which could provide risk and return benefits to a portfolio. However, given the broad and diverse investment universe, sourcing and structuring capabilities will be important factors for investors to assess when considering investments in private ABF opportunities.

This article features insights and represents the views of HPS, a part of BlackRock.