Securitization has long been one of the most transformational innovations of the financial markets. The pooling of assets in a securitization not only facilitates the flow of capital to illiquid, complex, and highly granulated assets--but also allows investors to gain access to higher-returning investments while maintaining a clear line of sight on the risk involved vis a vis the credit rating. Today's securitization market is largely built on providing access to both public and private lending, either traditional corporates or asset-based loans (i.e. asset-backed funding).

The rise of private credit funds holding leveraged loans has been meteoric in the last 30 years. This exponential expansion facilitated the growth of the broadly syndicated market alongside the shift in the balance of power from bank funding to institutional investor funding. Historically, the primary securitized funding structure has been the collateralized loan obligation (CLO)--first for the BSL market, and now middle-market CLOs. In today's market, financial innovation continues to drive change in this area as private credit funds look to provide credit tranching for some of their capital structures, making them more comparable to CLOs (see "ABS Frontiers: The Blurring Of Private Credit Funds And CLOs," published Jan. 30, 2024.)

Additionally, ABF has long been a critical structure supporting private credit. The private ABF market generally involves an entity that directly originates loans or purchases a portfolio of loans that would traditionally be associated with the public asset-backed securities (ABS) market. As alternative asset managers have grown in size and scale, they've also become more vertically integrated--managing platforms that encompass origination and distribution. Through these platforms, they can offer borrowers a direct channel from origination to the placement of assets with various investors. Many of these managers have tie-ups with insurance companies, which provide a source of long-term capital (although the managers may also work with third-party insurance companies). Insurers have shown an appetite for holding such asset-based deals, where the asset can be structured to fit the desired risk profile, attractive risk-adjusted spread, and cash flow needs of the insurance company.

ABF Offers Private Credit An Avenue For Further Expansion

The potential for private funding in ABF is enormous and largely untapped. While the consumer credit market currently has approximately $5 trillion in underlying debt obligations alone, the esoteric ABS space is emerging as a priority for private markets because it includes a perpetually proliferating pool of underlying collateral--spanning royalties (from entertainment as well as pharmaceutical) to asset leasing and loans (such as aircraft, containers, and time shares) and beyond.

Because this array of assets is constantly growing and diversifying, it's difficult to gauge the esoteric ABS market's size. Some market participants estimate the total potential addressable credit in this sector could be as large as $20 trillion - $40 trillion. Given limited transparency on the private market's holdings here, our analysis uses public ABS market and bank and government balance sheets as a proxy. Through the third quarter of 2024, U.S. public ABS issuance totaled $274 billion--nearly equal to $281 billion in 2023 and exceeding $257 billion in 2022. While the mix in private markets will ultimately be different, even in public markets (which are anchored by traditional consumer credit for autos and personal loans), esoteric assets have jumped to $75 billion year to date through the third quarter, from $50 billion in 2023 and $63 billion in 2022.

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The broader estimates on the total size of consumer debt are much larger, with more than $5 trillion of outstanding consumer debt as of the second quarter of this year, according to the Federal Reserve. More than half (or roughly $2.7 trillion) was held at U.S. chartered depository institutions or credit unions, and close to another $1.5 trillion is on government balance sheets (most of which are student loans). Only approximately 10% of the total consumer debt pool is currently securitized, according to Bank of America's research--leaving ample room for private credit to grow in this asset class. This will be particularly relevant for the future of private markets, as potential regulatory changes for banks (including Basel III) are likely to prompt them to derisk, which creates an opportunity for alternative funding sources to step in.

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While the potential for alternative investment funds in ABS is hard to estimate with precision, it's significant. This presents an opportunity that may outstrip traditional credit markets, which are overcrowded and highly competitive. Many of today's private credit firms are longstanding issuers of CLOs and strongly positioned to scale up their presence in direct lending, considering their preexisting familiarity with both the risks and market participants. Securitization has been heavily used in the leveraged loan space, with estimates of more than two-thirds of the total $1.4 trillion (as of Q3 2024) in underlying collateral already in existing CLOs. Private credit firms are now looking further afield to bigger, more lucrative opportunities in direct origination for ABF after spending the last decade scaling up in size and sophistication to be able to step into this role.

Funding Needs Are Converging With Opportunities

Traditionally, an ABF transaction would originate at a bank or a specialty lender, which would work with the borrower to structure a deal that could then be distributed by a bank or investment bank among a broad mix of investors. These conventional originations can also extend into more private markets through private placements, which involve the private sales and distribution of the instruments across a limited base of end-investors.

By contrast, in a direct origination of a private market ABF, the alternative asset manager arranges the transaction from origination to placement across its credit platform. Alternative investment managers have not only grown in size during the last decade, but they have scaled up in sophistication and increased their capacity to fund larger and larger transactions. Through acquisitions, partnerships, and joint ventures, several of these companies also have arms that provide origination, while they also manage funds that can invest in this credit. With arms for origination, and distribution channels that place the new issues within related funds and insurance portfolios, some alternative asset managers today resemble a vertically integrated credit shop. This positions them well to step into the ABF market, as banks look to step back due to regulatory changes. In fact, private markets offer some potential benefits over banks in that they can provide faster and more efficient execution, with a more direct relationship between the borrower and lender.

Faster execution comes from smaller lending groups in private markets. With fewer counterparties involved in the direct origination, the time to complete a private ABF is shorter than a traditional one. There are less intermediaries involved in the origination, and just one investor (or small group) must be lined up, as opposed to the dozens that could be needed for a broad distribution. Furthermore, some borrowers prefer that smaller lending groups improve their ability to maintain confidentiality and limit disclosure.

Despite the fewer parties involved in direct origination, alternative asset managers provide highly diversified funding sources, which can make execution more efficient and lower the cost of funding. The broader pool of investors is due to the appeal of the opportunities presented by private credit for ABF. Moreover, repayment of the obligation is provided by contractual cash flows from a discrete pool of collateral, rather than the general obligations of traditional corporate lending. ABF not only provides diversification, it also has the potential to deliver the alpha that investors and portfolio managers are seeking, versus the highly competitive traditional private credit market.

For borrowers, the larger, more diverse sources of funding mean that there are more potential lenders, which increases price efficiency through competition. It also allows for greater specialization among lenders, where some can develop a better understanding of credit risks and intricacies of various esoteric assets.

Ultimately, this can strengthen the relationship between a borrower and lender in a transaction because their interests are well aligned. The insurers, pension funds, and other institutional and retail investors that are adding to the capital available in private credit have diverse investment objectives. For instance, life insurers with large annuity books and pension funds have long-term commitments of capital and liabilities. The direct originator of ABF may be able to better match the investment horizon, or risk/return objectives for the end-investor of the debt facility.

Growth Potential Is Not Without Risks

Whether public or private--structuring, managing, and investing in ABS is challenging. One benefit of the traditional market for ABS is transparency. Where systemic transparency is built into public markets, such as through public ratings, transparency is more situational in the private markets.

Among rated ABS transactions, we have generally seen stable credit performance over time with respect to the public ABS market--although the recent strength of the consumer was likely a factor driving recent growth. In our most recent global structured finance default study, we report that the 10-year average cumulative default rate on U.S. ABS (conditional on survival) was relatively mild (2.53%) during 1983-2023 (see "2023 Annual Global Structured Finance Default And Rating Transition Study", published March 18, 2024). A historically low unemployment rate was also likely driving some entrants to consumer loans during this period, although we have seen some rising delinquencies in recent months with respect to auto loans, especially with regard to the cohort of obligors with more sensitivity to higher inflation rates in recent years.

While the presence of private credit in consumer and other ABF is likely to lead to growth, it is also likely to amplify credit risk given a recession or any other conditions that feature a spike in unemployment and weakening consumer spending. This would be intensified in parts of the untested unsecured consumer loan space. Nonetheless, we wouldn't expect uniform results across lenders--whose platforms, standards, and obligor credit scores may vary widely. Because private credit transactions may cover a spectrum of financing structures, all structural protections familiar to public ABS investors cannot be assumed as present.