Specialty Finance: The $20 Trillion Next Frontier of Private Credit
A liquidity gap is growing as banks curtail specialty lending, providing specialty finance investors opportunities for potential better risk-adjusted returns than we’ve seen since the GFC.
Bank retrenchment and the emergence of private lending has been a dominant theme for much of the post-GFC environment. During this period, private credit markets have grown dramatically, providing the potential for attractive diversification, enhanced income, and reduced volatility.1 A confluence of tightening lending conditions, ongoing regulatory and accounting changes, and an unwinding of bank balance sheets has created a unique entry point for specialty finance investors and catapulted this asset class into focus. We believe the private credit market is set for its next phase of growth with specialty finance, as investors need to diversify their private credit allocations beyond middle market direct lending. Here, we sit down with Harin de Silva and Kris Kraus, who co-lead PIMCO’s specialty finance, and Jason Steiner, who leads PIMCO’s residential mortgage credit team, to unpack what the broader credit tightening means for investors, and how it is creating potentially compelling investment opportunities across these markets.
Q: Specialty finance has grown rapidly since the global financial crisis and become a focused asset class, especially after the regional bank turmoil we saw earlier this year. What is specialty finance and how big is the market?
de Silva: PIMCO defines specialty finance, also known as asset-based finance, as lending that occurs outside traditional banking and commercial real estate channels that is secured by financial or hard assets. It provides critical funding across global economies, including consumer-related debt such as residential mortgages, credit cards, student, home improvement, and solar loans, to non-consumer assets, such as equipment-based lending and aircraft leasing. In addition, technology advancements have created niche specialty finance asset classes, including sectors linked to royalty streams on intellectual property.
In the U.S., we estimate the specialty finance market is approximately $20 trillion. For context, that’s more than four times the size of the U.S. and European leveraged finance and private corporate direct lending markets. While banks remain active players, there has steadily been a migration of financing activity into a newer ecosystem dominated by specialty finance lenders. We believe this is a persistent secular change that will fuel industry growth for decades to come. The specialty finance market is deepest in the U.S., but the asset class in the U.K. and Europe – where lending is more bank-dominated – has recently grown rapidly.
Q: There are several forces that have transformed capital markets since the GFC, one of which is the rise of private credit. Can you tell us how specialty finance emerged and how PIMCO approaches this market?
Steiner: Prior to the global financial crisis, banks controlled much of the origination and securitization of consumer and commercials assets. The crisis resulted in sweeping new bank regulations that imposed higher regulatory costs and prompted banks to prioritize some business lines and pull back from or exit others. Under Dodd-Frank, many large banks curtailed lending to consumers and small and midsize businesses to focus on higher-quality borrowers and larger, more standardized transactions. This reduced bank origination activity across asset types, but especially in residential mortgage markets, causing the securitization market to shrink dramatically. That led to opportunities for alternative credit investors, like PIMCO, to step in and provide liquidity. Since the GFC, the role of banks, which dominated capital markets, has changed tremendously and the composition of lenders is much more diverse. Investors often don’t appreciate the close degree of partnership that occurs across all these participants, including banks, insurance companies, and other non-bank lenders to provide credit to the economy.
With that said, there are periods in recent history when securitization markets can break down, and we saw that earlier this year on the back of a dramatic increase in interest rates. When stress and volatility creep into markets, this leads to credit contraction. Over the last several years, this dynamic directly contributed to the rise of non-bank or specialty finance lenders to fill the void, which evidences the close linkage between the ABS markets and the private specialty lending markets.