The ABCs of ABF: Part 1 — Asset Purchases

Putting the FAB in ABF

The surge in private credit activity in recent years has sparked interest in the private asset-based finance (ABF) market. ABF encompasses a broad range of financial assets including auto loans and leases, residential mortgages, credit cards, unsecured consumer loans, royalties and other esoterics, and more. Although these assets – and the financing of these assets – are nothing new, ABF’s recent rapid growth shows few signs of slowing.

After the Global Financial Crisis, as banks faced higher regulatory and capital constraints, they reduced lending, leaving a gap that non-bank lenders and specialty finance companies quickly filled.  Simultaneously, regulatory changes made public or 144A securitizations less attractive, leading these lenders to seek out alternative financing options.

Enter private capital. ABF is attractive to investors seeking higher yields, diversification and predictable cash flows. Innovations in financial technology have streamlined the process of valuing, monitoring and managing assets, making investing in ABF more efficient.

Although large asset managers are increasingly using strategic partnerships or acquisitions to originate or source these assets directly (similar to the direct lending platforms discussed in this article from THE CRED), for now, private credit funds primarily access the ABF market by acquiring assets, on a portfolio or forward-flow basis, from originators or other investors. The purchase approach allows investors to:

• Quickly Establish Operations: By acquiring existing portfolios or entering into forward-flow agreements with established asset origination platforms, funds can rapidly establish their asset base.
• Enhance Returns: Leveraging or securitizing acquired assets can enhance returns by optimizing capital efficiency.
• Diversify Risk: Acquiring a diverse range of assets helps in spreading risk and improving portfolio stability.

In portfolio purchase transactions, an investor purchases seasoned assets either directly from an origination platform or from a bank or other third-party purchaser looking to shed these assets from their balance sheet (particularly relevant for banks as they work to meet capital requirements). In addition to providing for the immediate deployment of capital into established assets, the purchase of a seasoned portfolio is accompanied by historical performance data that may more accurately predict future cash flows, assisting with valuation. However, this approach sacrifices scalability and, in the case of purchases from non-originators, adds complexity to the transaction based on the involvement of additional parties (for example, if the origination platform has retained servicing rights to the portfolio). In addition, this approach frequently limits investor diligence opportunities and recourse to the origination platform.

In a forward flow arrangement, an investor enters into an agreement with an origination platform to acquire newly-originated assets satisfying specified eligibility requirements on an ongoing basis. While there is a ramp-up period for capital deployment, this approach provides scalability as new assets are continuously added and flexibility to adjust terms based on market conditions and performance. Risks include ongoing credit risk as new assets are added and exposure to market volatility affecting asset quality. Additionally, forward flow arrangements require continuous monitoring and management, including ongoing assessments of underwriting quality.

Both arrangements require diligent assessment of counterparty risk as well as due diligence of the underlying assets. Depending on the asset class and jurisdiction, there may be regulatory compliance issues to consider. Additionally, it is imperative that the contractual terms are clear and provide the investor with the ability to manage the assets as well as to finance or further sell the assets, including terms relating to eligibility and concentration criteria, assignments, titling, further assurances and true sale requirements.

Stay tuned to THE CRED for more of our multi-part series on this hot-but-not-new sector of private credit. Next up: financing structures, from classic to innovative. Also to come: considerations in acquiring and financing specific asset classes.