Specialty Finance / LendTech

Specialty Finance 

Specialty finance is one of the most active (and attractive) sectors in our coverage areas, and not just for core fund raising and M&A services for specialty finance companies. Investment banks, like ours, rely heavily on the sector to help lend, finance, and restructure our other clients in payments, fintech and B2B software. The rise of specialty finance is a direct result of the rise in private credit and the innovation in fintech over the past few years, as the world transitioned out of the pandemic. As with any economic dislocation (the pandemic years), traditional lenders (banks) de-risked and pulled back from riskier lending. This left a massive hole in the market which private credit poured into. Not only was there an explosion in private credit as an asset class, but also in the number of technologies that facilitate its deployment. New technologies leveraging advanced decisioning algorithms, machine learning, open banking, KYC and identity verification have unlocked troves of new data sources for better credit scoring, opening up financing to new market participants, and outperforming traditional credit reporting companies and methodologies.

There now exist a slew of new financial products, including direct lending from private credit, asset based lending (against loans), revenue based financing, and factoring against future receivables. Entire new business models have been born, such as buy-now-pay-later (BNPL), which have replaced the old pay on layaway model. New specialty finance modes are more flexible and can be tailored to a specific borrower’s needs. And for early stage startups and scaleups, specialty finance is a great solution to facilitate rapid scaling without the barriers and constraints of traditional bank loans. 

Private Credit:

Private credit consists of pooled funds raised from endowments, pension funds, asset managers, family offices, large corporations, insurance companies, hedge funds and high net worth individuals. The total market size for the asset class ballooned to $2 trillion at the end of 2023. The pooled monies are distributed directly (acquisition financing, private equity LBOs, and distressed, special situations), or indirectly through fintech originators. As it pertains to enterprise and SMB borrowers, here are some of the distinct advantages of private credit:

• Access to capital: Private credit allows a business to access capital without the high bar of creditworthiness or delays it would otherwise encounter if it applied for a loan through a traditional bank. This allows the business to take advantage of opportunistic growth opportunities quickly and with less friction.

• Flexible terms: Traditional bank loans are rigid whereas private credit agreements are flexible, and often tailored to fit a business’s specific needs. Private credit lenders are able to tailor repayment schedules, interest rates and covenants.
• Ownership preservation: Both private credit funds and traditional banks offer businesses non-dilutive options which help preserve founder ownership.

Asset Backed Lending: 

Asset backed lending (ABL) involves loans secured by business collateral such as inventory or accounts receivable, or funding to fintechs who have originated loans (assets) to businesses. When a business or fintech originator has substantial assets, ABL can provide access to significant financing with a covenant-light and flexible structure. 

A specific type of ABL is the forward-flow agreement, where an investor or lender will agree to continually purchase a stream of assets (loans, receivables, or other financial instruments) over a set period under predetermined terms. This is in contrast to a one-time loan against assets because a forward flow agreement is an ongoing commitment where the lender agrees to buy assets as they are generated by the borrower or originator.

Another financing technique in ABL is securitization, where a lender pools together a portfolio of loans, receivables, or other financial assets, and sells them as securities (typically bonds)to investors, also known as asset pooling. At the heart of ABL securitization is transforming illiquid assets (loans, receivables, leases, inventory) into marketable securities that investors can buy. This benefits lenders because they are able to free up capital, reduce risk and continue lending. 

Factoring

Factoring, also known as accounts receivable factoring or invoice factoring, is a financial service that allows businesses to sell their invoices to a third party in exchange for cash. Factoring is used to purchase inventory, expand operations, and support cash flow needs. Upon selling its receivables, a factor will then provide a cash advance to the business with a slight haircut. The benefit to the business is improved cash flow (immediate cash inflow) as opposed to having to wait 10, 15, or 30-days for payment. A factoring deal is also easier for a business to get than a traditional loan because there’s no collateral or credit check involved.

There are different types of factoring:

• Recourse Factoring: This is the most common type of factoring, and is defined by the business being liable if the receivables aren’t paid by its customer. This translates into lower fees (smaller haircut) because the factor takes less risk.

• Non-Recourse Factoring: This is the opposite of recourse factoring and more expensive as the factor is taking the risk for customer non-payment.

• Spot Factoring: This is one time factoring, where the business will sell just one invoice instead of a batch.

• Whole Ledger Factoring: This is also known as ongoing factoring and represents a forward flow concept where a business sells all its invoices to the factor on a regular basis.

Warehouse Facilities

A warehouse line of credit, or warehouse facility, is a type of short term financing that private credit funds and banks use to fund originators. Essentially it’s a credit line to lenders used to fund their origination of loans or receivables, before they securitize or sell them to investors (essentially, lending to lenders). It works like this: lenders will borrow against a pool of loans they’ve originated, and as they sell, or securitize, those loans, they repay the facility. The funding is then replenished so that they can originate new loans.

Revenue Based Financing:

Revenue based financing (RBF) is a funding method where a business receives capital upfront from an originator or private credit fund, in exchange for a fixed percentage of its future revenues. This is used as an alternative to fixed monthly loan payments or giving up equity. Businesses repay investors as a percentage of revenue, so payments may fluctuate based on income. A big difference between RBF and traditional financing is there is no fixed repayment schedule since payments increase in good months and decrease in slow months.

Esoteric Finance: 

Esoteric finance refers to highly specialized, non-traditional financial instruments and investment strategies that do not fit into conventional banking, lending, or capital markets. These assets are often complex, illiquid and require deep domain expertise. In specialty finance, esoteric finance provides funding solutions for unconventional assets that banks and many private credit funds will avoid: assets with non-traditional cash flows, hard to value cashflows, or businesses with unique legal and regulatory risks. 

Key areas of esoteric finance include:

• Litigation finance / lawsuit funding
• Life settlements (buying life insurance policies)
• Royalty and intellectual property finance
• Trade finance (supply chain and export lending)
• Cannabis and gaming finance (regulatory, restricted industries)

LendTech

In the simplest of terms, lending technology, or lendtech, encompasses the new and innovative technologies that act as the machinery that enables the entire specialty finance ecosystem to function. For the most part this entails data-centric software applications that provide end-to-end market efficiencies to connect private credit and traditional lending to its most productive ends, be it enterprise businesses, SMBs or consumers. It’s the cross-catalyzation of lendtech with specialty finance that’s been responsible for the breathtaking growth in the sector. 

When we think of lendtech, we really ought to think of it through the lens of automation: automated processes that speed up, streamlines and optimizes the flow of capital to borrowers. As noted earlier, much of this automation is conducted through data-driven software, including machine learning models. The deployment of AI helps with every aspect of the lending process, from marketing (using financial data to identify and solicit creditworthy borrowers), onboarding and application (including secure document management), risk scoring and underwriting, origination, loan servicing, and collections. By automating these key processes, lendtech enables banks, credit unions, and private lenders to efficiently connect with borrowers while reducing operational costs and decision-making time.

Automated Loan Application

Traditionally, when a borrower wants to apply for a loan, they would have to fill out a lengthy form and submit their documents manually. With lendtech, a borrower can securely enter their personal information online, and then AI powered algorithms can instantly verify their identity and assess their creditworthiness. This is a fully digital, AI-driven process that allows borrowers to apply for loans instantly without the hassle of manual paperwork, in-person visits, or long wait times. This technology effectively leverages AI, big data, APIs and cloud computing to analyze a borrower’s eligibility in real time. 

Decisioning & Risk Scoring Software

A key component in the automated loan application process is identity verification, where borrowers, instead of submitting documents manually, can use biometric verification to confirm their identity. The system will then automatically collect the borrower’s financial data, such as bank transactions, utility bill payments, rent payments, and online spending, to generate a profile. Their profile is matched against known credit profiles using an AI-driven clustering algorithm which identifies spending patterns and income stability. Next comes the loan decisioning process, where AI will instantly process the aggregated data while machine learning models will predict the likelihood of repayment. The system will either approve or reject the loans. If approved, the system will provide terms, and if approved but qualified, an alternative loan amount.  

Loan Servicing Software

AI not only powers loan decisions, but it also can determine which loan terms fit the borrower the best. AI is able to customize the loan amount based on what the borrower can afford, a risk adjusted interest rate, and a repayment plan which comports to a borrower’s cash flow. Having tailored loan terms greatly reduces risk because it is based on the borrower’s real financial situation. Technology further accelerates the loan process by allowing the borrower to electronically sign the loan agreement, at which point funds are transferred instantly to the borrower’s digital wallet or bank account. AI also helps manage the loan repayment process. AI sends automated reminders of payments before due dates, and can predict when a borrower may struggle with their payments. If the borrower is at risk of defaulting, AI is able to suggest flexible or alternative repayment options. This reduces late payments and defaults, benefitting the borrower and the lender.

Marketing  

Using publicly known or permission-directed financial information, advanced algorithms and machine learning can also be effectively deployed to target would-be borrowers who, at least superficially, meet baseline fintech originator underwriting criteria. This type of lendtech turns the traditional lending model on its head, changing it from a passive, responsive dynamic to a proactive, targeted one, allowing originators to get very aggressive on outreach and capital deployment. At a very high level, this technology, which is very new, should create greater competition among lenders, ultimately to the benefit of enterprise, SMB, and consumer borrowers alike.