Muted return expectations, increasing difficulty in sourcing traditional financing, and advancements in technology have paved the way for alternative financing options. As borrowers seek more flexible ways to secure capital, and investors hunt for new sources of alpha and differentiated returns, new and evolving asset classes are emerging as a viable solution to support funding demands and provide new fuel for investment.

Despite inflationary pressures and global uncertainties, private credit has proven to be incredibly resilient, presenting strong returns in the face of rising interest rates and higher yields beyond traditional assets. Because of the asset’s strength during periods of uncertainty, the market has seen an increase in the number of private debt funds. As GPs push for more product diversity, LPs are increasing allocations to private credit. According to a Goldman’s Sachs October 2024 survey, 46% of LP respondents said they were under-allocated in private credit.¹

As competition and demand for greater product variety heats up, the private markets have seen a noticeable shift toward asset-based finance, a form of lending that uses a company's assets as collateral.

Known for its versatility and potential for strong risk-adjusted returns, asset-based financing has attracted investors seeking stability and opportunity amidst changing market conditions. As stricter regulations and tighter credit requirements lead traditional lenders such as banks to tighten their lending standards, alternative lending options have emerged to provide more accessible financing options.

As more investors and businesses explore asset-based financing, it's crucial to understand the growth dynamics, key considerations, and operational impacts of this asset class.

Read our Whitepaper: The Future Outlook of Asset-Based Finance

Advantages and drawbacks of asset-based financing

At its core, asset-based financing enables borrowers to secure funding using assets such as receivables, inventory, or equipment as collateral. The appeal lies in its structured approach: lenders evaluate the intrinsic value and liquidity of the underlying assets rather than relying solely on the borrower’s credit profile. This financing model offers a dual advantage: borrowers gain access to capital while investors invest in a pool of loans backed by tangible assets. But like any allocation, investing in asset-based financing requires thorough due diligence so that investors understand both the advantages and obstacles:

Improved access to capital

Requirements for credit history and financial track record can prove to be a roadblock for many companies, especially startups and those in high-growth phases. Asset-based financing removes this barrier by focusing on asset valuations rather than a borrower's credit score. For their part, investors like the asset class because the loan is backed by tangible assets.

Investment diversification

The diversity and granularity of asset-based finance strategies offers allocators new sources of uncorrelated return, downside protection, and a steady income stream. The asset class is also appealing because of its exposure to a variety of underlying assets covering sectors and geographies. This diversification helps reduce overall risk to any one particular asset class or company, giving lenders a more balanced investment strategy and opportunity to diversify their loan portfolios.

Protection from economic headwinds

Economic uncertainty can create pockets of market dislocation that occur when stressful conditions lead to large, widespread asset mispricings in the financial markets. Because alternative credit tends to be uncorrelated to market swings, investors can expect asset-based financing to generate stable returns. What’s more, asset-based finance is typically structured to deliver a consistent cash flow from its underlying assets.

Asset and collateral risk

The borrower assumes a greater risk if the loan defaults as the lender can repose collateralized assets. What’s more, the value of the collateral or underlying assets can fluctuate, meaning that the lender may not recover the full amount in the event of a default.

Complex monitoring

Managing asset-based financing products can be costly, time consuming, and complex because they require constant monitoring. Collateral valuations can also be resource intensive and complex due to the constant need to run borrowing base calculations.

Growth drivers of asset-based finance

Pooled consumer loans, which aggregate individual consumer loans into a single financial instrument, have gained significant traction in recent years. These loans offer investors a diversified portfolio of assets, reducing the risk associated with individual loans.

Market demand

The increasing demand for alternative financing options has also fueled the growth of asset-based finance. The ability to secure funding quickly, with fewer conditions, has made asset-based lending an increasingly popular financing choice for many companies. This growing acceptance is expanding the pool of available assets and providing investors with a more liquid and tradable investment option.

Opportunity to mitigate risk

By using assets as collateral, lenders can mitigate their risk. If a borrower defaults, the lender can seize the assets to recover the loan amount. Asset-based financing presents a potentially safer option for lenders, which in turn can lead to more favorable terms for borrowers.

Arcesium Toolkit: Solving the Challenges of Asset-Based Finance

Key considerations for investors exploring asset-based finance

While the benefits of asset-based finance are clear, investors must be aware of several considerations, including asset valuation, regulatory obligations, market conditions, operational readiness, and much more.

Market conditions

Economic conditions and market trends can impact the value of the assets and borrower's ability to repay the loan. Investors should monitor these conditions closely and be prepared to adjust their strategies accordingly. For example, during economic downturns, the value of certain assets may decline, affecting the collateral's value. While asset-based finance can offer more flexible terms, it often comes with higher interest rates compared to traditional loans.

Asset valuation

The value of the assets used as collateral is a critical factor. Investors need to ensure assets are accurately valued and that their value is stable or increasing. This requires a thorough understanding of the asset types and the markets in which they operate. To accurately value assets, lenders and borrowers will need to perform borrowing base calculations to determine the amount of money the lender is willing to give a borrower and how much available credit a borrower has. Several intricacies influence these calculations based on the type of asset, industry, and lender policies. Regular revaluation and monitoring are also essential to maintaining the integrity of the collateral. While the assets provide a layer of security, the creditworthiness of the borrower remains important. Thorough due diligence to assess a borrower's financial health, management team, and business model is essential to enhance the overall security of the investment.

Legal and regulatory framework

The legal and regulatory environment surrounding asset-based finance can vary significantly by jurisdiction. Investors must be familiar with the laws and regulations that govern the regions where they are investing. This includes understanding the rights of lenders in case of default and the processes for asset seizure and liquidation.

Operational readiness

Asset-based finance can be more operationally intensive than traditional lending due to the need to manage and track collateral, provide accurate NAV calculations, and monitor market conditions. Connectivity should pull in data and validate it from a number of sources when dealing with multiple borrowers and data for the underlying collateral. Having the right operational and data infrastructure in place to support new asset classes across lifecycle events, including systems for asset valuation, monitoring, and reporting, is crucial. Some firms may find that moving to more scalable, less resource-intensive solutions can drive efficiency and reduce operational costs.

Specialized knowledge and expertise

The need for specialized knowledge and expertise in asset-based finance is essential to effectively manage and mitigate operational risks. As with any investment in a new asset class, firms must make sure they have the skills and operational processes in place to support new requirements for data collection and reporting. Centralizing performance analytics across all asset classes and lending platforms can provide a comprehensive view of the portfolio and improve decision-making. Technology capable of managing complex loans and experienced professionals who understand the asset class are invaluable.

Case Study: Enhancing Asset-Based Financing Operations with Technology

The outlook for asset-based finance

The continued growth of asset-backed financing is expected to drive further innovation and expansion in the market, supported by advancements in technology and the development of new asset classes. While new asset classes can provide diversification and potentially higher returns, they also come with unique challenges and risks. Investors and businesses must be prepared to develop the right expertise to manage these assets effectively.

By understanding the key factors driving the interest in asset-based finance, investors can make more informed decisions and navigate its complexities. Advanced technology and robust data management systems will be essential for realizing these benefits and ensuring long-term success in the asset-based finance market. By staying ahead of the curve and leveraging the right tools and platforms, investors and businesses can position themselves for success as the asset class continues to rise.

Sources:

1. 2024 Private Markets Diagnostic Survey, Goldman Sachs, October 2024

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