The ABCs of Asset-Based Credit

Anu Rajakumar: Private credit is evolving, and asset-based credit is emerging as a game changer, offering fresh opportunities to rethink how investors approach diversification and yield. With banks retrenching from certain lending markets and consumer behaviors rapidly evolving, investors are looking for innovative ways to diversify their portfolios and capture higher yields. What exactly is asset-based credit? Why is it gaining traction as a compelling alternative? How can investors navigate its complexities and identify the right opportunities while managing risks? My name is Anu Rajakumar, and joining me today is Sachin Patel, managing director on the specialty finance team. Sachin, welcome to Disruptive Forces.

Sachin Patel: Thanks for having me, Anu.

Anu: Sachin, just to level set at the beginning of this conversation, I mentioned you're part of the specialty finance team, but help me walk through some of the terminology here. There's specialty finance, asset-based credit, asset-based finance. Explain the different words and which ones are appropriate for this conversation.

Sachin: That's a great point. I think the first thing to say is they all mean the same thing, which is helpfully confusing. We tend to find that specialty finance is the term most commonly used in the US. Here in Europe, we call it asset-based or asset-backed credit.

Anu: All right. Terrific. I'm glad that we got that squared off. I'll largely use asset-based credit, but for the listeners, they're interchangeable. Sachin, let's talk about this space then. It's been gaining lots of attention lately, particularly in a time of volatile markets. Obviously, diversification, risk management has become increasingly important to investors. Start off by explaining what asset-based credit is and why it's becoming so popular.

Sachin: A very British idiom comes to mind to answer that, which is it does what it says on the tin. By that, I mean that asset-based credit is private credit investments, which are backed by hard or financial assets, which themselves generate contractual cash flows. The result is that portfolios are very high-yielding, very short-duration, and uncorrelated to corporate credit. I think it's these three reasons why the asset class has become so popular with investors. If you look under the hood of most investors' portfolios, direct lending was and frankly is their main private credit holding. I think that always will be the case.

Most investors now are looking to diversify that, and they're looking to diversify away from corporate exposure, but also shorten the duration of their portfolios. That's where asset-based credit comes in. The latter point is quite important. 5 or 10 years ago, if you looked across public or private markets, as an investor, really had no choice but to invest out along the curve to get some yield, because the curves are so flat. These days, that's simply not the case. You can get the same if not higher yield at much shorter durations, and so why not?

Anu: Absolutely. Just to recap, asset-based credit, short duration and diversifying from corporate credit and from direct lending exposures, which obviously investors have been shifting into the last few years. One thing that's really important about the space is consumer behavior. With technological innovations, changing financial landscapes, we've seen consumer behavior really shift a lot. How has consumer behavior really evolved, why is that important in this space?

Sachin: Over the last 10 years, I think there's been a huge shift in consumer behavior. I'll just take myself as an example. 10 years ago, I had a mortgage. I had a credit card, maybe a car loan, but that was pretty much it. I used these three very blunt tools to manage all the various financial liabilities. For example, most folks would over-borrow on their mortgage to keep some cash aside for a rainy day and pay school fees, et cetera. There's three things that have materially changed since then. The first is the banks have retrenched from everything but the very safest loans to their existing customers. There's probably about a thousand white papers out there that explain why and how, and investors know that, so I won't dwell on that.

You've got to combine that with technological innovation, but also regulatory innovation. I'm thinking of, say, open banking here, and that's created a plethora of financial instruments and products which are highly optimized to cater for very specific borrowing needs. You no longer need such blunt tools, but you can finance individual use cases as they come up and do so at the optimal price for the credit risk.

Now, finally, I think the major shift has been driven by us as consumers. We very much strongly prefer a digital first experience. I, for one, can't remember the last time I stepped into a bank branch, and I'm hugely grateful for that. Who's got the time to queue these days?

Anu: Absolutely. Now, just to clarify, do you consider this asset class to really be a consumer story? Or how tied to the health of the consumer would you consider asset-based credit?

Sachin: It's an important point. We talk about the consumer markets because it touches us several times a day, and it's the most tangible part of this asset class. Asset-based credit is so much broader than just consumer lending. You've got small business lending in all its various flavors, whether that's for equipment financing, for auto financing, for working capital, for offering employees earned wage access. These are all different sub-asset classes of small business financing that we play in, but you also have things like media productions, data centers, cell towers. Frankly, anything that can generate an attractive and reliable contractual cash flow can theoretically be in scope and is in scope. We find that even our portfolios are incredibly diversified amongst individual deals with collateral pools of thousands of line items, but then you've got up to 20 sub-asset classes in any one portfolio, and that portfolio dynamically shifts over time, so there's a lot of asset classes in scope.

Anu: Yes. I think that's an important clarification to make in case people thought this was very consumer health-oriented. Now, in terms of implementation and accessing the asset class, as I understand it, there are both beta strategies and alpha strategies. Could you help break down the differences between those two and why that would matter to investors?

Sachin: Sure. Neuberger is one of the longest-established businesses in this space. We started in 2017, and there weren't many competitors at the time. The reason is because it's a very complex and expensive business to build within an asset manager. You don't just need the right people with the right expertise, but you need to invest in the technology and the data science, the data scientists that let you manage these highly granular portfolios. To be clear, you can have thousands, and we have hundreds of thousands of line items in every one of our portfolios. It's a very complex portfolio to manage.

Now the asset class has matured, and we've seen a fair number of new entrants come in over the last few years. I personally categorize them in two broad buckets. You've got alpha players and beta players. We at NB see ourselves very much as an alpha player. The beta strategies offer investors a product that returns broadly the same as direct lending, but will be less correlated direct lending and will have a shorter duration to direct lending. Alpha strategies aim to offer investors a product that's both higher-yielding than direct lending, but also with a materially lower duration. For example, our portfolios have a duration of just 18 months.

Where does this difference come from? Beta strategies typically have quite large allocations to, say, mortgages, real estate, and public ABS. These are much larger asset classes and you can put a lot more money to work there and they can fill much larger funds, but they do generally have longer durations and lower yield, and/or require more leverage to get higher returns. The alpha funds tend to focus on just the shorter-duration assets, and that would exclude these mortgages and much of the public ABS markets. They also tend to have a high proportion of private assets, where you can extract the most illiquidity and complexity premium, and that really drives the majority of this alpha.

Anu: Now I understand that in your strategy, you really integrate a lot of fundamentals with some significant quantitative power through data science. Could you just speak a little bit about that in your investment process?

Sachin: Sure. It's a very important part of our investment process, and actually the way that we manage the portfolio as an ongoing basis. We have a dedicated quantitative analytics and data science team in San Francisco, and all they do full-time is analyze collateral pools of deals that we're assessing. We have a very high rejection rate, but we love to see the collateral performance of all the companies we're speaking to and it helps us really understand what the economy's doing in that part of the world, how different parts of the market are behaving through different parts of the cycle, but also allows us to compare and contrast different collateral originators and really take a view on who's a top quartile performer. You can also then analyze who's got the best risk-adjusted returns, and then it really informs how we structure the transaction because we're designing highly bespoke triggers and covenants for every single one of our transactions, and that's very much a quantitative exercise.

That's on the underwriting stage, but then on the ongoing portfolio management side is also very important. For many of our deals, we actually get real-time updates on how the collateral is performing. We've developed very sophisticated data storage analysis systems that allow us to monitor this collateral performance in real time. What that means is you can really nip in the bud any underperformance at a very early stage. That's a large part of, I think, the alpha that we can add to investors.

Anu: Great. Maybe just quickly in summary, if I think about the alpha strategies, like what we manage here at Neuberger Berman, they are higher yielding, shorter duration, and without those large allocations, a beta strategy might have to-- you said mortgages, real estate, ABS, and it sounds like with the benefit of massive amounts of quantitative power through your data science capabilities that help with decision making and portfolio management. Did I summarize that okay, Sachin?

Sachin: Absolutely.

Anu: Just curious, when investors are choosing between alpha and beta, what are some of the considerations they're making, or why would they pick a beta strategy over an alpha strategy?

Sachin: The beta strategies, one of the main differentiators of them, yes, they have generally lower returns and slightly longer durations than alpha strategies, but they tend to also be managed in much larger funds. The reason for that is that they usually have exposure to asset classes like mortgages to very high allocation of public asset-backed securities, and other asset classes which have lower yields but much longer duration. I'm thinking of real estate, for example, infrastructure.

You can put a lot of money to work in these other asset classes, but the quid pro quo is you're getting a lower yield and/or you need to apply a lot more leverage to get to the returns you need. The alpha strategies tend not to have much, if any, mortgages. A much lower allocation to public ABS and usually only use the public markets to arbitrage the public private spread differential both ways. Then very rarely do I see them doing real estate and infrastructure.

For investors, it's really a decision for them. I think some investors prefer the much broader brush approach. They want to have exposure to all these various things. They may well not have much existing exposure to real estate or infrastructure, and so they're quite happy to have it all blended in one. Most of our investors, they usually have quite large allocations already to real estate, be it with other parts of Neuberger, be it physical real estate.

Many of our investors own massive office buildings across various capital cities. They don't want us then layering onto that with additional real estate exposure because they have that elsewhere in their portfolio. Likewise, infrastructure, they have dedicated managers for that, including Neuberger. What they want from us is all the asset classes they don't already have access to, and that is that real economy financing we discussed earlier.

Anu: That's very helpful to know. I'm curious, when it comes to asset-based credit, I'm sure perspectives differ across regions. How do the approaches vary between, let's say, the US and European opportunities, and what would you say drives those differences?

Sachin: Well, look, it's a very general observation. US investors are generally more advanced in their understanding and experience of investing in asset-based credit. The main reason is because it's the largest non-bank lending market in the world, and also the largest public asset-based securities market in the world. On both sides, on the investor side and the investment side, the US is the largest market for most folks. That's followed closely by EMEA where demand on both sides has really taken off in recent years.

I remember a few years ago we were very much spending our time educating clients on the asset class, whereas now I find when I meet them that they've already made up their mind to invest and it's just a question of when and with whom. One interesting feature when I talk to global investors is the reaction to fintech. Now we at Neuberger partner with both banks and non-banks. The non-banks are mostly fintechs. In the US, it's seen as a very positive thing. I think most folks there understand that today's technologies allow fintechs to better understand and credit assess the customers in real time, and just provide a better user experience, and allows them to target better customer segments. That's very well understood.

I think in EMEA, I still find folks who can feel a bit nervous around the use of the term fintech and seeing them as actually high-risk investments. Now look, that may well definitely have been the case 10 years ago, but it's simply no longer true. We usually just address the point by talking the person through the apps on their phone and it dawns on them that pretty much all of their personal finance is fintech, and the bits that aren't and rely on paper are just really annoying.

Anu: From a growth perspective, do you see the growth then in EMEA, which is a less mature market?

Sachin: Absolutely. I think both on public ABS side and the private ABS side. The public ABS side has struggled due to regulations and post GFC regulations, which have made it very, very hard for issuers to build sustainable programs and also new asset classes to be created. That is changing I think, slowly, but absolutely is changing.

On the private side, there's a lot more to do as a consequence actually. I think investors are much more okay with asset-based credit. On the investment side, when I talk to CFOs and board members, they have a much better understanding of how the deals and structures work, but also how it can be a really complimentary form of financing alongside their corporate loans and working capital lines from the banks.

Anu: Sure. Now, I imagine that as potential investors look to access this investment space, there are probably some hurdles that they're going to need to work through. What are some of the biggest challenges or complexities that investors may face as they're assessing asset-based credit and how would you respond to some of those challenges?

Sachin: It's an interesting question, and again, one we get a lot. I think it's worth starting with one contradiction in our space, and that is that while the underlying collateral is very simple and, frankly, quite vanilla, the actual investments that we make within the funds can be incredibly complex. Let's just unpack that a bit. The collateral is pools of very granular, very diverse small business or consumer loans, trade receivables, autos equipment. That's easy to understand, we see it every day, but then the best managers will go and layer on very sophisticated financial engineering and structuring on top of that, mainly to protect the downside and try and minimize and even mitigate the macroeconomic exposure of those investments. That's the bit I think that investors find very much more complex than you would get with a regular corporate loan. If you want to get under the bonnet and really understand the machine, it does require a fair bit of work.

That is in stark contrast to, say, direct lending, where most managers underwrite deals in similar ways and the structures are pretty homogenous, but investors need to then choose who's got the best platform and access to the best deal flow. Now, the positive news, I think, is that once they get into it, investors find it super interesting, and they actually enjoy understanding and learning about the asset class because so much of it relates to how we live our daily lives. Just before I walked into this room, I actually got an email from one of our investors, and she's actually on vacation, but she sent me a picture of her and her husband in front of an advertising billboard advertising a company that we and her are lenders to. I find this all the time, that once investors really understand the asset class, they start seeing it every day when they're out and about, and it just clicks that this is how the real economy is funded and they are funding it.

If you were to invest in just the collateral and buy the assets at market value, you'd have little to no correlation to corporate credit, but you would have correlation to macro GDP. We are, after all, financing the real economy, but the structuring takes that away

A large proportion of the portfolios are also self-amortizing, where we're paid back principle and interest every single month. Then you've got the short duration on top of that. This is very important if you look at how these portfolios will behave through a recession. Let's use the 2008-level recession as an example. 2008, for those of us who look at Bloomberg screens every day, was horrible because we saw the markets imploding in real time. For the average person on the street in the real economy, the impact wasn't really felt until 2010. That's when companies had retrenched and job losses came through, and government spending had reduced, et cetera, et cetera. There is generally a 12 to 36-month lag between the financial markets deteriorating severely and the impact being felt on Main Street.

Now, given our assets are on average 18 months in duration, what that means is as long as you can see the storm coming and you can batten down the hatches or tighten the credit box, in our case, by the time the storm actually hits, most of the risk we originated pre-storm has actually amortized away. The challenge for us is to make sure we've always got one eye on the horizon. We're always making sure that we can see the macroeconomic environment ebbing and flowing and that we're adjusting our credit box in time for the eventual impact on the real economy.

Anu: That's great. Because you used the phrase keeping the eye on the horizon. I'd love to just wrap up this episode with just some final thoughts about your outlook going forward. For folks who are considering this asset class, what would you say in terms of what you see on the horizon?

Sachin: Interesting times as ever. I think there's never been a dull year since 2008. I could spend hours unpacking what's going on in different parts of the world. I think for us, the key is that whilst we absolutely have a view on what's going to happen, and we have real-time access to consumer, small business data from all parts of the world, it is actually quite interesting when we get together with our quantum data science team just to understand not just how different parts of the world are behaving and people and businesses in those parts of the world, but how different segments within the consumer small business markets are behaving. Because you can really drill down to very granular levels and see by region, by sector, by geography, by demographic how the macroeconomic environment is impacting and also advancing different parts of the economy. That's super interesting. For us, we're trying not to take that view. I think regardless of how sophisticated and smart you are, if you were to take a view on what's going to happen the next 12 months over the last five years, you'd have been consistently wrong. If you were right, it was probably just luck. We've taken the view that we want to make sure that we've got great quality assets. Then our structures will protect us in any reasonable scenario, be it upside or downside, then everyone sleeps well at night.

Anu: Terrific. That is a great place to wrap this episode, Sachin. I can't let you go, however, without a quick bonus question. We are right in the middle of summer. I would love to hear about whether there are any summer traditions, either from your childhood or now, that you especially look forward to every year.

Sachin: Oh, that's a cracker. I do, actually. Every summer, my wife goes away for a weekend with her friends. I've got two daughters, 7 and 10, and we go camping or glamping. There's something out in the middle of nowhere. The rule is there can be very poor or no phone reception. That's the rule [unintelligible 00:21:03]

Anu: That's the rule. [chuckles]

Sachin: I didn't make that one up, let's be very clear.

Anu: Oh, impressive.

Sachin: That was from the kids, mainly because then they get my attention. Over the last three to four years we've done this, something has always gone horribly wrong, usually caused by me.

Anu: Give us a good example of what was gone horribly wrong.

Sachin: My cooking, that's a consistent failure. A storm one year, and then the yurt we were in just sprung a bunch of leaks directly on top of us. We couldn't start a fire one year, and we just froze. It's almost got to the point now where we expect a huge calamity. That's actually become the fun of it, because when it happens, we hunker down as a team and get through it together. It brings us closer together. I'm a big believer that actually the very best things in life are free, genuinely. I do think spending time with the family is one of them. That's coming up the weekend after next. I can't wait.

Anu: Oh, I can't wait to hear what goes horribly wrong. That does sound like fantastic, cool memories for your family. Thank you very much for sharing those. Sachin, it's been great to have you on the show. Today, we explored a number of things. You talked about the characteristics of asset-based credit, the defensive features, the high yield, the short duration, self-amortizing, and structural elements, like the first loss capital provisions.

We also talked about how this relates to consumer behaviors and how asset-based credit is not solely linked to the consumer's health, which is, I think, an important misconception that folks may have. We spoke about the distinctions between alpha and beta strategies, with the alpha strategies being higher yielding, shorter duration, and without those kind of large structural allocations to areas like mortgages, real estate, ABS, et cetera.

You also spoke about some of the regional differences between the US and Europe and the rest of the world, amongst many other things that we spoke about today. Thank you so much for sharing all the information and for being here today on Disruptive Forces.

Sachin: Thank you for having me.

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