The Why and How of Allocating to Asset-Based Lending

Angela Shiu: Hello and welcome to our deep dive into asset-based lending and the exciting opportunities that it presents. My name is Angela Shiu, and with me I have Kyle McCarthy, private credit specialist at PIMCO and an expert in asset-based lending.

Kyle McCarthy: Pleasure to be here.

Angela Shiu: Welcome, Kyle. So in PIMCO's words, asset-based lending is the $20 trillion next frontier of private credit. Some firms have called it “next evolution” or “next generation” of private credit. So, Kyle, what's driving these trends that we're seeing now?

Kyle McCarthy: The trend is actually two-fold. There's a secular trend and a cyclical trend. What I mean by secular is that there's been a structural trend for many, many years.

PIMCO has actually been heavily invested within private ABL for the better part of a decade. We've deployed a little over $165 billion in assets over the past 10-plus years. So, this has been a trend that we've been heavily involved in for a very long time.

What has caused that has been broader bank retrenchment. And so, it's this theme of greater regulatory pressures stemming from the global financial crisis, whether it was Dodd-Frank in the U.S., accounting measures like CECL or IFRS.

Of course, Basel III globally. And then fast forward to today, you have Basel IV or Basel III endgame, as they call it in the U.S. So this trend has continued. Banks have been forced to pull back. It's not that they want to sell these assets, it's that they necessarily have to. It's just less capital efficient because of the capital charges.

So, there's very high quality assets leaving the banking system and heading into the hands of private lenders. And that's the opportunity set that we've been capitalizing on.

Now, the cyclical piece, why you've been seeing so many headlines on this today, is really two components. The first is there's been an acceleration in this banking retrenchment theme. You've had the banking turmoil on the regional banking side in the U.S., which has impacted small to medium-sized lenders over the past 12 to 18 months.

And again, that is causing them as well as the larger banks to also pull back. And so that's creating an even larger opportunity set than even we had anticipated.

And the second component is from the investor demand side. We've seen a maturity within the private credit space. Corporate direct lending has been around for quite some time. A lot of investors have been primarily focused within that market and are looking for ways to continue to grow their private credit allocation, but do so in a diversifying way.

And this is a nice complement in the form of ABL, to grow those exposures in a complementary fashion.

Angela Shiu: Got it. As an investor, how should one think about asset-based lending in the context of a portfolio and their asset allocation?

Kyle McCarthy: Most investors that I speak to will bucket ABL into private credit. But again, they view it as a complement or a diversifier to corporate direct lending, which again has been the primary focus for many investors for a long time.

So, again, it's not a replacement for corporate direct lending. It's viewed as more of a complement. It offers similar return potential, but has that downside mitigation, the structural protections associated with the hard asset backing.

Why is it complementary? Well, it has pretty unique diversifying features. First and foremost, you have diversifying borrowers, collateral types that, again, by definition are not just corporate loans.

And these have relatively low correlated risk factors to the economy, to the business cycle, and in some case completely uncorrelated. So that's a key benefit to ABL.

The second is the cash flows are also very complementary. So, as I think about the typical ABL cash flow profile, it tends to be front-loaded, it tends to be amortizing, meaning that the payments are a combination of interest and principal.

So, the loan balances come down over time. The loans de-risk – said another way, the LTVs [loan-to-value ratios] come down. Very attractive feature for investors.

And then thirdly, what's also very unique about this space is that it's a mix of both fixed and floating rates. So, unlike corporate direct lending – 100% floating – given where we are in the rate cycle with rates likely to be pressured to come down in the years ahead, that could be a nice tailwind for this space as we look going forward.

And of course, from an entry point standpoint, we've talked about banks pulling back, the retrenchment theme, how that's accelerating. Many are viewing this as a very attractive time to be allocating to this space as well.

Angela Shiu: I know we've been doing this a long time, but what is PIMCO's edge in asset-based lending and in the space in general?

Kyle McCarthy: I would say it's team, it's heritage, and it's the use of the data sets. So, in terms of team, clearly, size and scale matter a lot in the space, but also the understanding of the various different asset types as well.

We have a dedicated team of 40 portfolio managers that are purely focused on private asset-based lending.

So, we've been very committed to the space for a long time. Each of these portfolio managers has their own area of expertise and specialized knowledge to underwrite and structure and source and originate all these different asset types. So, that is critical in this space that, again, given how broad and diverse it is, having that expertise per asset type.

The second, is just the broader platform and the heritage. And again, I think PIMCO is probably one of – if not the most – experienced investor within asset-based lending. We've been doing it for a very, very long time. And as you think about, at its core, asset-based lending is really fixed income-like assets. There's a natural extension there from securitized credit, from structured credit, which, again, we've been investing in the hundreds of billions for many, many decades.

It's very similar risk, and we have a lot of experience. That platform and that brand, that knowledge that we've built up over many, many years, gives us a presence that, again, is very attractive to counterparties that are looking to partner with us in this space, whether they're a bank or a non-bank lender.

And then, last but not least, on the data side, again, it's a very different underwrite from your typical corporate loan.

These are large, diversified pools of loans that require data sets in order to underwrite. And we've invested heavily in what I view as world-class analytics systems that allow us to underwrite, that allow us to stress test, and also assess relative value across all these different asset types, that enables us to pivot and also toggle up and down exposures based on where we see value.

So, it really plays to one of PIMCO's key strengths on the data and analytics side. So again, it's the team, it's the platform and presence, and it's the amount of investment we've made in data sets.

Angela Shiu: Well, thank you, Kyle, for sharing your thoughts with us on asset-based lending today. As we've discussed, PIMCO's deep expertise and strategic perspectives really put us in a great position to capture the growing opportunities in this space.

If you would like to explore further with us, please do not hesitate to reach out. And thank you very much for joining us today.

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All investments contain risk and may lose value. Investments in asset-based lending and asset-backed instruments are subject to a variety of risks that may adversely affect the performance and value of the investment. These risks include, but are not limited to, credit risk, liquidity risk, interest rate risk, operational risk, structural risk, sponsor risk, monoline wrapper risk, and other legal risks. Asset-backed securities across various asset classes may not achieve business objectives or generate returns, and their performance can be significantly impacted by fluctuations in interest rates. Investments in residential/commercial mortgage loans and commercial real estate debt are subject to risks that include prepayment, delinquency, foreclosure, risks of loss, servicing risks and adverse regulatory developments, which risks may be heightened in the case of non-performing loans. Mortgage and asset-backed securities are highly complex instruments that may be sensitive to changes in interest rates and subject to early repayment risk. Structured products such as collateralized debt obligations are also highly complex instruments, typically involving a high degree of risk; use of these instruments may involve derivative instruments that could lose more than the principal amount invested. Private credit involves an investment in non-publicly traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Additionally, investments in private credit may be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control. Investing in banks and related entities is a highly complex field subject to extensive regulation, and investments in such entities may give rise to control person liability and other risks.  Investing in distressed loans and bankrupt companies is speculative, and the repayment of default obligations contains significant uncertainties. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

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