Stockholm (HedgeNordic) – Private credit has gained significant traction since the 2008 financial crisis, as regulatory and accounting changes led traditional banks to scale back lending. This pullback has opened the door for alternative, non-bank lenders to step in. Private credit, primarily involving corporate loans not traded on public exchanges, has attracted investors with its potential for diversification, income generation, reduced volatility, and superior returns compared to public markets. A rapidly growing segment of this space is specialty finance, which focuses on non-corporate markets such as consumer loans, equipment leasing, and aviation finance, offering additional diversification to traditional private credit exposure.

“Specialty finance typically involves an asset-based form of lending, though not exclusively,” explains Kristofer Kraus, who co-leads PIMCO’s asset-based finance business. What distinguishes specialty finance from traditional corporate direct lending is often its more diversified, granular pool of self-amortizing, contractual obligations. “Specialty finance largely consists of portfolios of consumer credit, whether that’s mortgages, personal loans, or solar loans. The distinction lies in the portfolio approach to managing these loans,” Kraus explains. “We factor in a certain level of loss when calculating expected returns.” This contrasts with corporate direct lending, where the success of the investment hinges on a single large borrower. “While this doesn’t make one better than the other, it’s an important distinction.”

“Specialty finance largely consists of portfolios of consumer credit, whether that’s mortgages, personal loans, or solar loans. The distinction lies in the portfolio approach to managing these loans.”

Kristofer Kraus, Portfolio Manager and Co-Head of Specialty Finance at PIMCO.

Specialty finance also tends to involve shorter durations, usually around two years compared to the four to seven years typical of private credit. “What we like a lot about specialty finance is that their cash flows tend to be more front-end in nature, shorter duration in nature,” reiterates Kraus. “You see the payments coming through monthly or quarterly, which include both principal and interest. This structure allows the investment to de-risk and de-leverage faster than typical corporate loans. We don’t have to wait years to get our principal back.” The assets’ principal pays down over time rather than in a bullet payment at maturity, de-risking the investment, shortening the duration, and allowing for efficient redeployment of capital based on available opportunities.

The return profile for specialty finance can exceed that of corporate lending, with potentially lower volatility. “The expected return is a function of where the investments sit in the implied capital structure,” Kraus explains. “We have built senior secured portfolios at the top of an implied capital structure generating upper single-digit loss-adjusted unlevered returns,” he continues.  Some clients can benefit from potential additional upside through securitization structures. “Returns can start in the high single digits and depending upon the risk appetite of the client, we can take it up from there,” says Kraus. Expected returns can reach the mid-to high-teens for clients with higher risk appetites, given today’s base interest rates.

Granular Insights on Consumer Debt

Successful specialty finance investments require a granular understanding of the consumer and their financial health. The consumer is not monolithic, suggests Kraus. PIMCO maintains a comprehensive database covering approximately ten percent of the U.S. population. On average this includes ten credit lines per person, across auto loans, credit cards, mortgages, and student loans, among others. This database, which spans over 20 years, provides about 200 million loan-level data points monthly, giving PIMCO a unique edge in analyzing consumer credit markets.

This data helps PIMCO identify pockets of value in many consumer-related assets, including residential mortgages, home improvement, solar and student loans, or unsecured consumer loans and credit card receivables. “You can’t just helicopter in this business and expect to succeed and perform well across cycles,” emphasizes Kraus. “You need experience and a robust data infrastructure and analytics to unpack and identify which investments will outperform in different economic cycles, especially in a recessionary environment.”

“Specialty finance offers significant diversification away from the corporate exposures many investors already hold, and it also provides a strong income component that begins de-risking the investment from the start.”

Kristofer Kraus, Portfolio Manager and Co-Head of Specialty Finance at PIMCO.

While corporate direct lending remains the core private credit allocation for many investors, Kraus recommends adding exposure to specialty finance as a complement, given its distinct risk-return profile. “Specialty finance offers significant diversification away from the corporate exposures many investors already hold, and it also provides a strong income component that begins de-risking the investment from the start,” Kraus explains. “For investors heavily allocated to corporate lending, specialty finance can serve as an important diversifier.”

Gaining Momentum

“Historically, economies have relied on banks as the main source of credit for individuals, corporations, and governments,” says Kraus. “That changed dramatically with the GFC. Regulations that followed deliberately aimed to shift risk away from the banking system and de-risk the system overall,” he explains. With banks pulling back from lending, non-bank lenders such as PIMCO have stepped in as capital providers. Private non-bank lenders with access to long term institutional capital are in many ways better suited to holding this risk than traditional banks that are funded by retail deposits.

Kraus expects no slowdown in the growth of non-bank lending. “I don’t see the participation of non-bank lenders slowing down anytime soon – if anything, it’s gaining momentum,” he notes. However, he emphasizes that this does not spell the end for banks. “We often partner with them rather than trying to displace them.”

“I don’t see the participation of non-bank lenders slowing down anytime soon – if anything, it’s gaining momentum.”

Kristofer Kraus, Portfolio Manager and Co-Head of Specialty Finance at PIMCO.

The evolution of private credit has also expanded its definition. “A few years ago, private credit was almost exclusively about corporate direct lending,” Kraus explains. While the core private credit allocation for many investors remains corporate direct lending, the universe has evolved to “include several different areas of opportunities that fall under that umbrella, including specialty finance,” according to Kraus. “I’d even go as far as to call it private fixed income.”

PIMCO is a global leader in private asset-based lending with over $165bn deployed across mortgage, consumer, and asset-backed sectors. They have a long history of detailed loan-level underwriting, analytics, and downside risk management, and have built a far-reaching global network of sourcing channels including 60+ origination partners.*

* As of 31 December 2023