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Economic and Market Commentary

Unlocking Alternatives: Seeking Opportunities in Specialty Finance

Explore specialty finance, including why it may offer diverse opportunities, its potential benefits and its prospective role in a broader asset allocation with Kyle McCarthy, alternative credit strategist.

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Text on screen: What is specialty finance?

Text on screen: Kyle McCarthy, Alternative Credit Strategist

Kyle McCarthy: Specialty finance refers to any kind of private lending that is outside the scope of corporate and commercial real estate markets. It is often secured by an asset, typically hard collateral supporting the cash flows of the investment itself.

This could be a house, a car, aircraft, equipment, even business receivables and intellectual property, just to name a few. Practically speaking though,

Text on screen: Specialty finance refers to unique assets in the private lending markets that are cash flow-producing

Images on screen: Home exterior, car driving down a road, airplane taking off, microphone inside a studio

within the private credit and private lending markets, it really refers to more unique, unconventional, idiosyncratic or diversifying assets that are cash flow producing. So this falls within the broader category of performing credit, rather than stressed and distressed type investment strategies.

These collateral types are typically less widely held and often lead to pretty complex investments that require a great degree of structuring expertise, strong sourcing relationships and portfolio manager specialisation. This is a very broad reaching heterogeneous space overall.

Today, the investment universe is actually quite scalable and it has continued to grow as a result of a number of factors:

Text on screen: TITLE – Reasons why the specialty finance market has grown: BULLETS – Stringent regulation, Balance sheet constraints, Adoption from institutional investors, Demand for diversification

Stringent regulation, continued balance sheet constraints, greater adoption from institutional investors, as well as increased demand from investors seeking greater diversification and other high quality sources of income as we see private debt allocations more broadly continue to mature across investor portfolios.

It’s worth noting that the terms specialty finance, specialty lending and asset-based lending are all essentially synonymous with one another and are used interchangeably throughout the industry.

Text on screen: How diverse are the opportunities in specialty finance?

One way of thinking about the entire universe of specialty finance is to break it down into three main sub-components:

IMAGE: TITLE – Specialty lending opportunities: LIST – Consumer: consumer loans, credit card receivables, auto loans, student loans, residential credit. Commercial: Small business loans, aviation finance, equipment finance, tech infrastructure, trade finance, NPL portfolios. Esoteric: Music royalties, drug royalties, litigation, life settlements, collateralized reinsurance, capital relief.

those being consumer, commercial, and then esoteric or niche.

The consumer category is relatively straightforward. It includes a lot of consumer-oriented credit and debt such as autos, credit card receivables, student loans, and residential mortgage credit.

The next category is commercial or non-consumer, and these are more corporate-related assets. So things like aviation finance, or aircraft leasing, equipment finance, small business loans, or even trade finance.

The last category – the esoteric or more niche-type investments – tend to be less trafficked asset types. They also tend to not have direct ties to the broader business cycle and as a result may be quite uncorrelated to financial markets: like equities, interest rates, even traditional credit. So these include investments like music royalties, litigation finance, reinsurance, and even portfolio solutions or portfolio finance.

Text on screen: What are the key benefits specialty finance may offer to investors?

Text on screen: TITLE – Potential benefits: BULLETS – Attractive yield, Diversification, Downside risk mitigation

First and foremost, relatively attractive yields overall. These tend to be high income producing assets, where you're really trying to focus on capturing that private market illiquidity premium.

The second potential benefit is diversification. Given the idiosyncratic nature of the underlying assets themselves, these can really be complementary to an investor's portfolio with little to no overlap with credit exposures elsewhere within their broader asset allocation, given how unique and uniquely sourced many of these assets are.

And then last but not least, potential downside risk mitigation, just given the cash flow profiles that are secured by the collateral and oftentimes these assets have structural seniority at the top of the capital structure.

Text on screen: What role can specialty finance play in a broader asset allocation?

The most common placement that we typically see is within a broader private credit allocation.

Text on screen: Role 1: Complement to corporate direct lending

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So here it's used as a complement to corporate direct lending, which has tended to be the primary focus for a lot of clients in recent years. There are a lot of similarities here to what you would typically see within private credit: so high income potential, senior secured placement within the broader capital structure, but focused entirely on more unconventional, non-corporate related assets and markets as we discussed earlier. And in many cases, with very limited competition and a lot less crowding than we typically see in the corporate credit space.

Text on screen: Role 2: Extension to fixed income

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Secondarily, some clients view specialty finance as a natural extension to traditional fixed income – it has many similar attributes such as producing income and offering downside risk mitigation, but with different exposures from traditional fixed income.

Here at PIMCO, we approach the space in a diversified opportunistic way. So we're applying a relative value lens across the different asset classes, focusing on those areas that we believe offer the best risk-adjusted returns while avoiding those where we think fundamentals are less attractive.

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