Growth and Risks in the Private Asset-Backed Finance

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The Rise of Asset-Backed Finance

The recent bankruptcy of First Brands Group has shed light on an accelerating segment of private credit: asset-backed finance (ABF). Private ABF deals with loans given against a specific asset, income stream, or loan instead of based on a company’s cash flow. Data from KKR reveals that the private ABF market has doubled since 2008, currently standing at over $6 trillion. This is larger than the combined markets of syndicated loan, high-yield bond, and direct lending.

Future Predictions for the ABF Market

According to KKR predictions, the ABF market size could exceed $9 trillion by 2029. In a report, the firm highlighted that ABF is following a similar growth path as direct lending, capturing attention with its historically attractive yields, diversification benefits, and immense market size.

Asset-Backed Finance: Risk Analysis

Many consider asset-backed finance to be less risky than direct lending. Banks have retracted their involvement in ABF since the financial crisis, with private direct lenders taking their place. These lenders often bundle ABF loans into pools, securing a variety of assets such as financial assets, aircraft, warehouses, or even music royalties. This strategy is designed to create a safer loan portfolio with more diversification.

The Perils of Lowered Standards

However, industry experts express concern that the influx of capital into private credit and ABF could lead to lower standards and increasingly exotic assets being pledged as collateral. For instance, auto parts firm First Brands borrowed against its receivables, which resulted in some lenders claiming the company had pledged the same receivables to different lenders.

The Importance of Rigorous Due Diligence

Donald Clarke, president of Asset Based Lending Consultants, emphasizes that ABF is a “high-risk, high-reward” lending strategy that necessitates thorough due diligence. Lenders need to not only comprehend the fundamental business and complete business model, as typically required, but also understand the specific collateral being pledged. Unfortunately, the First Brands case highlighted a lack of due diligence by lenders, both banks and non-banks, in their haste to deploy capital.

Clarke cautions that given the swift expansion of the ABF market and the influx of billions into private credit, more problematic loans may surface, particularly in the event of a credit downturn. “The race to deploy capital must be moderated by the need for proper due diligence on the borrower and proposed collateral,” he warns. “Where there is a lot of money to lend, there is a lot of money to lose.”

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