Private Debt Investor: Five key trends in specialty finance – consumer debt

Consumer lending, providing secured and unsecured credit to individual borrowers to finance everything from mortgages to credit cards and cars, has been a growing area for private credit since the banks began exiting the space over a decade ago. Fuelled by the growth of fintech platforms and AI-assisted underwriting, it is increasingly seen as an attractive area for debt funds seeking to diversify away from corporate credit.

Contrary to what some might think, managers argue now is a great time to move into consumer debt, even though the macro environment is difficult for many households.

“We have been frankly pretty surprised by how well the consumer has performed,” says Isaiah Toback, partner and deputy co-chief investment officer at Castlelake. “Wage inflation was more uniform over the past few years than it has been in prior high inflation environments, but there are now risks of re[1]flation that becomes more difficult for the consumer to withstand.

“We are seeing more signs of stress with the consumer, but we believe that the reality is that non-bank lenders saw that coming well in advance and have drastically tightened credit underwriting in the last two years.”

He argues consumers may be in for a tough time, but lenders can factor that into terms to extract favourable deals. “The six months to Q1 2023 saw one of the most aggressive credit tightening cycles since the financial crisis and that has not really let up,” says Toback. “The rate of tightening has come down, but everyone generally continues to tighten. In our view, that means new accounts originated today are originated at significantly tighter standards and consumers are paying more for credit. We believe many portfolios are designed as if we were already in the depths of recession.”

David Aidi, partner at Atalaya Capital Management, is equally optimistic on the consumer opportunity: “We have a relatively bullish consumer thesis. The overall state of the consumer is actually quite strong, despite the headlines. The data shows credit scores at all-time highs and debt service ratios at near all-time lows as a percentage of income, so with unemployment around 4 percent, the consumer looks very healthy. Further, we think consumers are going to be well-positioned whenever the next downturn hits, because their position today is stronger than any other set-up seen prior to other recessions.”

Auto loans

KKR has done several deals in the auto loans space, most recently acquiring a $7.2 billion portfolio of super-prime recreational vehicle loans from BMO Bank National Association, which will remain the servicer of the loans and will continue to originate and manage new loans. That transaction followed another deal to purchase a $373 million portfolio of prime auto loans from Synovus Bank.

“We are currently seeing a lot of compelling opportunities in the consumer space because of banks deleveraging,” says Dan Pietrzak, global head of private credit at KKR. “Some of the deals we have been able to do there are not things we would normally get access to. We are happy with what we have been seeing in terms of consumer performance in both the US and the UK. However, we have seen greater resiliency in the finances of homeowners in the US. Inflation impacts everybody but the impact is probably a bit more muted for people that own a house with a 30-year mortgage, and we are starting to see that bifurcation.”

Others sense an opportunity because so many lenders are cautious on consumer lending. At TPG Angelo Gordon, head of structured credit and speciality finance TJ Durkin says: “We believe it is a great time to be lending to the consumer because there is a lot less capital out there. In terms of the credit box for new origination, it is pretty tight compared to 2021 when there was money flowing all over the place, which led to some bad credit decisions.”

He says investors are looking at the underperformance of loans they made in past years and stepping back. The firm is seeing opportunities from reduced lending at regional banks. “It can be nice to originate credit when others in the system are nervous because it provides you the ability to tighten up on terms,” he says. “People get misconstrued on the consumer: if you think earnings are going to be lower a year from now, you adjust the price today.”

A shortage of supply of capital is certainly creating more room for alternative lenders. Aidi says: “In a normal market environment, when banks are flush with deposits, they are typically going to do as much lending as they can. That’s not the case right now, and because they have shrunk the origination funnel there are many consumers and small businesses that would otherwise have got a bank product who are now turning to specialty finance.”

Still, there are nuances to the consumer lending market that cause many managers to be cautious and mean strategies need to be scrutinised carefully by LPs. The bifurcation between higher and lower income consumers is a key point today, for example.

Beach Point is more bullish around loans secured by residential properties, and particularly loans extended to property owners with higher income and credit scores. Hunsaker says that despite the evolution of qualifying mortgage rules over time, banks have not shown increased willingness to be the primary source of lending capital for such loans and new regulatory capital will further discourage their involvement.

He adds: “The US housing market generally remains undersupplied due to years of underbuilding following the global financial crisis. This undersupply has led to significant property price increases over the last decade. However, borrowing against these increased values has not risen in line with historical levels of housing debt relative to housing value. This situation has presented an opportunity for non-bank mortgage originators.”

For those seeking uncorrelated returns, consumer lending presents plenty of avenues to exploit.