Why Invest in Specialty Finance?
KIRIBILLI PRIVATE MEDIA – JUNE 2018
Following the 2008 GFC, banks and larger financial institutions were forced by a combination of market conditions and increased regulations to significantly tighten their lending standards. This financial conservatism has essentially closed off the traditional credit market to smaller companies. This has opened the door to specialty finance firms to play a larger role in providing structured finance options.
Specialty finance can be broadly defined as any financing activity that takes place outside the traditional banking system. Typically, specialty finance firms are non-bank lenders that make loans to consumers and small to midsize businesses that may otherwise find it difficult to obtain financing. Peer to peer lending falls in this category
Specialty finance firms provide funding to consumers and businesses for a variety of uses. These lenders assess each company’s situation, looking at hard data such as value and cash flows as opposed to the formulaic approach that traditional banks usually follow. Specialty finance firms are typically much flatter organizations than traditional banks with accessible investment committees and a willingness to perform “deep dive” to assess potential financing opportunities. Unlike banks, specialty finance firms tend to rely on their own due diligence of the opportunity rather than ensuring that a borrower fits into the traditionally defined “credit box” upon which many larger financial institutions rely.
While the borrowers (consumers or companies) may not fit into the traditional “credit box,” they may still exhibit characteristics that make them attractive candidates to receive financing. Many of these borrowers have a diversified customer and supplier base, multiple products and end markets, strong market share, a high degree of recurring revenue and strong management teams. However, due to performance issues or other factors, they may no longer meet the credit requirements of larger financial institutions. Specialty finance firms are able to invest in these companies because of the time they invest in understanding a turnaround situation. This level of diligence allows specialty finance companies to be flexible and creative in the deal structuring phase to arrive at a mutually beneficial structure and pricing.
While the borrowers (consumers or companies) may not fit into the traditional “credit box,” they may still exhibit characteristics that make them attractive candidates to receive financing.
In today’s volatile and unpredictable credit market, specialty finance companies can play an active role in addressing the funding needs of small to mid-sized companies and others looking to finance opportunities in alternative assets.
Specialty finance investments are potentially lucrative opportunities that offer a higher rate of return than traditional investments might. We believe that specialty finance investments have a higher perceived risk than actual risk. It is imperative to work with an experienced and diligent originator or fund manager to ensure the potential risks for these opportunities are appropriately managed.
Specialty finance loans capitalize on the concept of arbitrage – the simultaneous purchase and sale of an asset that generates a profit by exploiting price differences among various markets or financial instruments. The high perceived risk of these loans derives from the unwillingness of banks to lend to these borrowers – this unwillingness results from the inflexibility of traditional banks due to regulatory or other formulaic underwriting approaches rather than the actual risk inherent in the loan.
There are many advantages to specialty finance loans:
- They tend to provide a higher rate of return than traditional investments
- Specialty finance loans are often well secured by an abundance of diversification tactics
- protecting your investment
- Specialty finance loans are largely uncorrelated with the broader economy, including other
- equity and debt investments that are available to most investors.
- They are generally backed by cash flow or revenue, enabling borrowers to make regular
- interest payments.
To date, these deals have generally been reserved for hedge funds, institutional investors and family offices. With the emergence of new technology platforms, accredited investors may also invest in these specialty finance opportunities like real estate investments (hard money and mezzanine debt), litigation finance (pre settlement funding and post settlement funding), and commercial (small business loans and crowdfunding). Typically, specialty finance presents a valuable opportunity for beginner investors and finance pros to diversify and protect their portfolios from downturns while earning high yields.
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