Asset-backed finance: Hiding in plain sight

Over the past decade, private credit has grown from a $400bn niche industry into a $1.6tr market that competes with more traditional asset classes for significant investor allocations.

The most well-known component of this growth has been direct lending; as banks stepped back from numerous lending activities in the aftermath of the global financial crisis, asset managers and other investors stepped in to provide corporate loans to firms that would previously have asked their favourite bank. However, an unprecedented period of ultra-low interest rates and central bank liquidity meant that in many areas, banks retained a competitive advantage over non-banks in terms of both funding and capital. Now the cheap money era has been brought to a close, the growth of private credit has accelerated and investors have a new opportunity to acquire or take exposure to asset pools that would traditionally have been held by banks, targeting attractive returns in the process.

In Europe, this opportunity is hiding in plain sight in the form of asset-backed finance, or ABF. The highly regulated and homogenous nature of consumer lending markets such as mortgages and car loans makes for high quality bank-originated asset pools to which investors can gain exposure. Corporate assets such as loans to investment grade companies or core small and medium-sized enterprises (SMEs) are another source of high quality credit risk.

The defining characteristic of ABF investments is that they are secured (backed) by a pool of assets; the performance and total return on the investment are solely dependent on the cashflows generated by the asset pool, rather than the external market factors that can create volatility in public markets such as stocks and bonds.

For investors, ABF can provide a predictable, uncorrelated income, in addition to limiting downside as asset pools typically repay quickly. ABF now represents a large and differential credit investment. The regulatory challenges facing banks are creating a considerable opportunity for private credit investors, and the specialist and private nature of ABF transactions means investors with the right expertise can target far higher returns than could be expected from more mainstream fixed income markets.

1. The ABF universe

ABF is not a niche industry. In fact, it dwarfs the rest of private credit (see Exhibit 1). Citi estimates the global ABF market currently totals $5.2tr, and it is expected to grow to $7.7tr by 2027.

The vast majority of the ABF opportunity falls under either consumer or corporate debt.

The European ABF investment universe makes up around 20% of the global total. However, there are certain characteristics that in our view make European loan pools ideal “raw material” for ABF transactions. 

Consumer assets: highly regulated and homogenous

Outstanding consumer lending across major jurisdictions in Europe totals €9.3tr compared to €14.1tr in the US.¹

From an investor perspective we believe successful ABF transactions exhibit a common set of characteristics, and the European market is well aligned with these.

Consumer lending across Europe is highly regulated and homogenous. Asset pools are therefore granular and comprise thousands of individual loans. They tend to be short dated and the range of asset pools available offers diversity across countries, lenders and risk categories.

These characteristics have historically resulted in superior asset performance when compared with the same markets in the US. For example, Exhibit 4 shows the historical divergence in credit card performance between the UK and the US.

Corporate assets: better credit performance

Historically, corporate lending and asset ownership in Europe has been dominated by banks. With European companies being more regionalised, they have been better covered by domestic banks, which when added to differences in legal and regulatory regimes between countries (and to a degree more fragmented capital markets) has prevented the development of an efficient syndication process like that of the US. While these drivers remain present, the accumulation of large pools of capital outside of the banking system, plus the capital and funding challenges for banks mentioned above, mean that we expect the tectonic plates to shift slightly in Europe, further opening up the opportunity.

While a heavy dependence on banks for lending is a well-documented source of unease for European policy makers, one benefit has been a culture of conservative risk appetite and corresponding credit performance. European corporate performance in several markets exhibits lower default and loss rates than comparable US assets.

However, one of the benefits of ABF is that the alternative capital doesn’t need to replace banks entirely. Instead, ABF enables investors to either partner with banks on exposures or assume credit risk over their assets. This reduces the need for investors to “compete” with banks on credit quality in many cases, which is a tactic central to the direct lending thesis.

Typifying this would be portfolios of loans to investment grade corporates or core domestic SMEs, where there are longstanding track records and relationships between banks and the corporate borrowers. Despite private credit representing a threat to banks as an alternative source of funding, banks’ relationships with their borrowers often go beyond lending. Cash management, FX, derivatives, insurance, advisory or even M&A services are all strong sources of business for banks, and transferring portions of credit risk to investors via ABF does not disrupt these relationships. In fact, “well banked” clients are attractive assets for ABF transactions as they often represent stronger credit risk.

Europe’s simple market

One element absent from the European ABF opportunity – at least in comparison to the US – is esoteric assets, though we regard this as a positive. These are assets with differing characteristics (deals backed by music royalties, for example) and are largely newer in nature with less track record as to performance and stability of cashflow. Credit risk of this nature is not one easily quantified under our data-driven quantitative modelling approach.

The net result is that while the ABF market in Europe is smaller and less diverse than it is in the US, the benefits are weighted towards higher quality, simple and longstanding asset types.

2. Europe’s ABF market is mature, and growing

The ABF market in Europe is mature, with its roots dating back to early UK public securitisations in the late 1980s. This technology was adopted from the peer US market and grew substantially through the period leading up to the global financial crisis. During that period, and particularly during the subsequent years of deleveraging across the financial system, the private ABF market found its feet.

Why do ABF opportunities arise?

The catalyst for ABF in the wake of 2008 was the need for banks and other traditional asset owners to free up capital by selling portfolios of assets, spinning off non-core businesses or finding new partnerships to transfer credit risk and reduce their risk-weighted assets (RWAs). Alternative capital providers experienced in ABF were the beneficiaries, but the broader systemic benefit and resulting opportunity for non-bank capital providers became evident.

In fact, in 2014 the European Central Bank (ECB) and Bank of England (BoE) published a joint paper² acknowledging the role of ABF in supporting the growth of lending to businesses and consumers, as well as the benefit to financial stability from creating a market for the transfer of illiquid assets to new or alternative sources of capital. While we and other ABF investors welcomed this unusual level of public endorsement, the opportunity was neglected and only the end of quantitative easing in Europe served to hasten the need for bigger and more developed capital markets, to pick up the slack left by central banks scaling back cheap funding. ABF remains a key pillar of this objective.

What drives the ABF opportunity today?

Wind forward and regulatory changes are once again a key driver, specifically the impending finalisation of the post-2008 banking regulations, widely known as Basel IV or the Basel endgame. Greater clarity is now emerging around the capital that financial institutions will be required to hold against various assets on their balance sheets, which is expected to ultimately reduce profitability. In anticipation of this, we have seen a marked increase in ABF deals that aim to share the credit risk attached to certain bank assets with third-party investors, mostly in the form of Significant Risk Transfer (SRT) transactions. Under an SRT transaction, banks are permitted to reduce the RWA value assigned to a specific pool of assets (reducing capital intensity) by placing notes with ABF investors and demonstrating to their regulator that they have “shared” sufficient credit risk.

Basel IV is expected to be much more targeted when determining the capital that must be held against specific assets, and also set a minimum level of capital known as the “output floor”. Banks with greater holdings of the lowest risk assets may therefore see a disproportionate impact. More broadly, these changes come at a time when the surge in the cost of issuing equity and Additional Tier 1 (AT1) that followed the collapse of Credit Suisse is fresh in the memory. The opportunity for SRT investors will continue to grow, covering an increasing number of banks outside the European Union (which has a mature market) and a greater range of asset pool types.

There are also signs of positive future momentum from another body, the Financial Stability Board (FSB), which has recently concluded a consultation aimed at evaluating securitisation regulation to facilitate sustainable growth of the market.³

Beyond this defined opportunity, the end of quantitative easing has brought higher funding and capital costs for banks and non-banks alike. For ABF investors, that should mean wider margins on assets and a growing opportunity to acquire assets or partner with lenders in their traditionally core markets. Later we will explore the toolkit we use to achieve this.

One fundamental difference between today and the post-2008 opportunity, however, is the quality and performance of the assets. The 2009-2014 period saw many asset sales from “bad banks”, ringfenced and often non-performing assets likely of a standard that did not meet the newly formed standards for lending as the financial system found its feet. Take for example the UK’s 2010 Mortgage Market Review, which introduced a new standard for testing affordability, or the Dutch Code of Conduct taking effect in 2013 dictating strict minimum standards for new lending. Europe’s heavily regulated lending practices are conducive to long-term ABF performance, in our view.

3. ABF default performance

ABF default performance is best viewed through the lens of public ABS, where a developed market in Europe has existed for three decades. When compared with comparable rated credit markets (see Exhibit 5), defaults and resulting losses in public ABS have been minimal with loss rates peaking at around 0.75% in 2009.

Arguably the most powerful representation of the full lifecycle performance of ABF is a loss study conducted in 2021 by the ratings agency Fitch.⁴ The report looked at 20 years (2000-2020) of securitisations rated by Fitch, showing which deals have repaid and any losses realised before splitting all transactions still outstanding into debt expected to repay or incur a loss. In this analysis, of the €3.7tr issued, just €13.6bn (0.4%) has experienced a loss to date and a mere €2bn (0.1%) is expected to be impaired over its remaining life.

When looking at the consumer assets which back most of that universe, it follows that they have a history of performing through severe economic cycles. For example, UK mortgage default rates peaked at just 0.77% in 1991, a period which unemployment reached 10.7% and interest rates almost 15%; surprisingly, performance during the global financial crisis was stronger with defaults peaking at 0.43%. This fact is not widely appreciated by credit investors, and this general lack of understanding around securitisations like ABF creates a meaningful research premium for those investors with the required expertise.

4.    Europe vs. the US: higher quality assets mean better performance

Europe is a scalable and high quality market for ABF investments, typically providing higher yields and stronger through-the-cycle performance than equivalent US sectors.

When comparing European ABF to its US counterpart from an investment perspective, there are several factors that can make the European market more attractive. These differences often stem from variations in regulatory frameworks, market structures, risk profiles, and economic environments.

Stricter regulatory frameworks and a bank-centric market: Since the global financial crisis, both European and US regulators have implemented significant reforms to strengthen their ABF markets. However, Europe remains a more bank-centric market than the US and increasingly intensive regulation of the banking sector has put pressure on costs and funding, prompting banks to scale back their lending activities. According to the European Banking Authority (EBA), consumer lending across the EU has decreased by approximately 30% to 40% since 2007. This has resulted in “orphaned” borrowers and asset sales, presenting an opportunity for private strategies to gain additional market share in Europe at an attractive premium. 

Standardisation and transparency: European financial markets are generally subject to more stringent regulations than the US. This includes stronger consumer protection laws and more rigorous oversight of financial products. The ECB and national regulators enforce tight controls, which can reduce the downstream credit risk associated with asset pools in Europe. In addition, Europe’s securitisation regulations ensure transactions meet high standards for simplicity, transparency, and comparability. Core to this is an alignment of interest between issuers and investors, with issuers forced to retain 5% of the economic risk of any transaction.

Lower defaults and higher recoveries: European ABS has historically exhibited lower default rates than US ABS. This is particularly evident in sectors like residential mortgage-backed securities (RMBS) and auto ABS. For instance, during the 2008 financial crisis, the European RMBS market demonstrated extraordinary resilience, with significantly lower losses than the US (see Exhibit 6). Realised losses in deals issued in 2007 peaked at just 0.1% for European RMBS, according to Fitch, while for North America RMBS they reached 12.6%.⁵ European ABS has also shown higher recovery rates in the event of default than US ABS. This can be attributed to the more stringent legal and regulatory frameworks in Europe, which provide friendlier terms for investors and facilitate more efficient recovery processes. In particular, standardised full recourse to the assets for creditors is viewed as one of the main reasons for outperformance in Europe.

5. TwentyFour’s ABF approach

We believe strong countercyclical asset performance is a core strength of ABF, and understanding it is where we start.

Our philosophy focuses on identifying, selecting, sourcing and then funding high quality asset pools which we are confident will perform through the cycle. The team spends significant time and resource meeting lenders across Europe to understanding local strengths, nuances and performance metrics that are fundamental to the robustness of the asset pool’s future cashflows. We combine this asset-first investment process with a flexible approach to accessing the assets, using our team’s expertise and experience to find optimal structures and avoid limiting the potential universe.

Sourcing the assets

ABF is a complex area of private credit where an investor’s relationships can be extremely valuable. Relationships with banks, specialist lenders and other loan originators are essential to sourcing asset pools either through acquisition, partnerships or structured exposures, as well as potentially disposing of assets when required. Investors often take an active role in structuring and funding asset pools in the capital markets, so strong relationships can help investors add value to ABF transactions by tailoring deals to their structure and risk preferences.

Relationships are formed through repeated engagements over an extended period of time. When looking for partner investors, lenders look for scalable, long-term, stable and responsible custodians of assets. This gives investors with an observable track record in the market an advantage in sourcing assets, and also serves as a meaningful barrier to entry.

TwentyFour is a known presence in European structured finance, active in both public and private markets right across the risk spectrum, which greatly enhances our new opportunity pipeline. It is common that a successful public ABS investment paves the way for a private ABF investment, and vice versa, so for an investor, having multiple touch points with a lender is a distinct advantage. A common example would be a new lender that has built an asset pool and gains funding via a public ABS deal in which TwentyFour participates; this can lead to subsequent ABF opportunities as the new lender explores other options for raising capital and funding its asset growth.

Competition for assets in Europe varies, but when compared to the US we regard it as being less commoditised. Some investments in Europe can be syndicated with a varying degree of investor breadth, but in general European lenders continue to favour reliability over price, particularly in more recent volatile periods. Again, this favours investors with a strong track record and established relationships in the market. Other opportunities are bilateral through existing or new relationships, or tendered through banks or advisors. Keeping key market participants familiar with our risk appetite and asset preferences is an important factor in maximising pipeline opportunities.

We would also differentiate market participants by size. TwentyFour operates in the middle of the market in terms of asset pool size, with €300m-500m portfolios typically suiting our asset preferences (see below). We believe this size bracket is optimal for maximising the range of opportunities and ability to create a diverse portfolio, while also partially reducing competition for our preferred assets; in some cases the very largest players prefer jumbo opportunities that fit their platform size, especially when making a European investment in an otherwise US focused strategy.

Selecting the assets

The selection of assets is integral to our day-to-day sourcing engagements, which provide the basis for our first stage filter and due diligence. Asset pools themselves vary in size, typically ranging from €200m to several billion, with each comprised of thousands of individual loans or exposures.

Our preference is to focus on mainstream, performing assets in core European countries. In our view, this approach lends itself to finding  scalable and diverse opportunities that also come with hard performance data, the most robust underwriting frameworks and the greatest level of transparency.

ABF allows us to utilise a top-down selection of assets we want exposure to, without the sort of commingled exposure that is inherent when investing directly in a bank, for example. Asset selection follows a distinct process that also ensures diversification and risk management.

Accessing the assets

Exposure to our target assets can be gained in several ways. This could be through asset purchase, a credit-linked exposure, conventional bond structure, a loan, or a guarantee. In some instances, ABF investments may require extensive negotiation or direct structuring.

We consider five primary routes to access ABF investments:

1. Outright purchase – Either bilaterally or in competition, typical sellers include banks and specialist lenders.
2. Forward flow – A partnership which may be exclusive and over multiple years to purchase loans upon origination to an agreed pricing and quality.
3. Securitisation purchase – Take exposure in an existing or new securitisation where existing assets have been pooled.
4. Credit protection – It is possible to provide protection on asset pools that reside on a bank’s balance sheet. This does not require ownership but gives exposure to cashflows, creditworthiness and returns.
5. Indirect exposure – Through the provision of mezzanine debt to an asset owner.

One form of exposure we do not consider is taking equity ownership in lenders themselves, which grants investors a similar stream of origination to forward flow. This is most commonly used by investors with a private equity heritage, and adds an additional layer of complexity. We prefer more flexibility in our choice of lender, and maintain alignment of interest through fees and covenants.

6.    ABF data transparency offers high degree of predictability

ABF asset pools typically contain a granular population of individual exposures with a similar set of characteristics. This is an attractive feature of the market, since the assets are well suited to quantitative analysis.

Several elements make this possible:

Powerful standardised data: ABF issuers use a loan-level data provision template created by the ECB and BoE. This provides deep insights into the characteristics of each individual loan in the pool. The data on a mortgage, for example, would include each borrower’s age, credit score, income and payment history. This is supplemented by historical data on delinquencies, defaults and recoveries on similar assets over different vintages, often going back 20 to 30 years. This data is critical to investors’ understanding of asset quality, building a picture of likely performance in different environments and benchmarking lenders and asset pools against one another in the investment process. 

Analytical tools: These allow the team to harness data and build cash flow projections with a high degree of confidence. We use three modelling tools: Intex and Bloomberg are useful off-the-shelf solutions which complement our own internal modelling to ensure we have the right breadth of analytics for each opportunity.

Embedded performance: ABF investments and their expected yields factor in a level of asset non-performance. It is inevitable that in an ABF pool of several thousand car loans, for example, a certain number of borrowers will default each year. Given this, base case cash flow forecasts assume a level of distress, and projected returns for investments therefore factor in a degree of losses. This is arguably a more transparent and conservative approach than other asset classes, which advertise a yield and leave investors to decide what level of impairment might occur.

The job of an ABF investor is therefore to determine a base case and then factor in other scenarios, to determine the level of stress required to cause a depletion in return or a partial capital writedown. In Exhibit 9 below, the base case stress can be compared easily to the performance the lender saw during the global financial crisis or other stressful economic environments, providing investors a strong benchmark for cashflow and return stability. It is then possible to model more extreme scenarios. ‘Class G Break’ shows the level of stress required for the debt exposure to take a capital writedown; this is the point at which the first euro of capital is lost but returns remain positive because of income. ‘Class G 0% Yield’ shows the level of stress required to take total returns on the debt exposure down to zero, which in this instance occurs at a stress level 1.5x that seen during the global financial crisis. 

7. Liquidity and risks in ABF

Credit risk and seasoning: Common risks in ABF differ somewhat from other private credit markets. In direct lending to corporates, for example, investors are exposed to changing credit risk on the borrower throughout the term of the loan, thanks to external variables such as customer preferences, competition in the borrower’s market, supply chain issues and so on. ABF asset pools tend to de-lever through regular repayments, which reduces credit risk over the life of the deal. The effect this has on asset performance is reflected in the difference in default rates between public ABS and investment grade corporates shown by Exhibit 5.

High seasoning: The length of time since a loan was originated – of loan portfolios is also a clear but underappreciated strength of ABF. As a practical example, statistically an auto loan borrower is most likely to default during the first 12 months of a typical 60-month loan. However, as regular payments are made and the loan balance amortises towards zero, performance tends to be stronger and more predictable even through a major economic downturn. 

Organic liquidity and market risk: ABF investments tend to be shorter than other private credit opportunities. This is because, in a representative portfolio, following a period of drawdown and reinvestment, the underlying investments pay material interest and  capital through the strategy lifecycle (see Exhibit 10). While this creates a degree of reinvestment risk for the investors getting their capital back, it comes with two major benefits in the form of reduced credit risk from continual deleveraging, and organic liquidity, which also reduces the need to dispose of assets at the end of life. Market risk in ABF is therefore low when compared with other private credit products.

Alignment of interest: Well-structured ABF investments ensure lenders, owners and other stakeholders are aligned on asset quality, performance and strategy. ABF investments tend to fall under the European and UK securitisation regulatory framework, which requires issuers to retain a minimum exposure to their deals of 5%. Well-structured ABF investments also have strong key person, fee and covenant alignment.

SRT call risks: SRT investments, which make up a portion of the ABF universe, have always contained language that allows banks to redeem outstanding notes in the event that the capital relief sought through the issuance is either not obtained or rendered ineffective through future regulation. This risk has manifested in European transactions at times and can only be partially mitigated through documentation. For this reason, we tend to prefer SRT deals from established issuers with a track record of acting fairly towards investors. This is also a key reason why we do not limit our investment strategy to SRT alone, instead preferring a more broadly diversified set of exposures.

8. ABF and direct lending

As the private credit market has grown to over $1.6tr, direct lending has become the dominant allocation for many investors.

This is largely down to the relative ease of understanding the risk, the size of the market and the ability to assert control through covenants in an adverse scenario, added to an attractive level of floating rate income.

ABF also provides an attractive level of floating rate income, but with a material premium over direct lending thanks to the opportunity investors have to select assets and influence individual deal structures (see Exhibit 12). ABF also offers a different set of characteristics that can complement direct lending allocations.

9. The ABF opportunity today

When an unprecedented period of ultra-low interest rates and market stimulus was brought to a close in 2022, the competitive advantage that banks and other incumbent lenders had enjoyed through favourable funding and capital costs for more than a decade also began to disappear.

With stricter post-crisis regulation set for finalisation in the coming months, the pressure on banks to optimise their balance sheets and direct precious capital to higher priority businesses is growing. This creates an opportunity for private credit investors that recalls the wave of deleveraging and asset disposals we witnessed in the wake of the global financial crisis.

ABF can provide a predictable, uncorrelated income, in addition to limiting downside as asset pools typically repay quickly. European ABF is a particularly attractive opportunity given tighter regulation, more conservative lending practices and superior through-the-cycle asset performance.

For investors with the expertise to analyse and source high quality asset pools, and the strength of relationships to maximise their opportunities, the levelling of the playing field between traditional lenders and alternative capital providers is a significant opportunity. That is to target attractive levels of income and total return at a premium to more widely allocated parts of private credit such as direct lending.