What is specialty finance?
Specialty finance companies typically make loans to consumers or businesses that are underserved by traditional banking institutions. That's why you'll also hear specialty finance companies referred to as "specialty lenders." According to Preqin and Fintex Capital, specialty finance lending accounts for about 10% of the total direct lending market globally, or $100 billion of the $1 trillion private debt market. Specialty finance isn't a niche activity; it's how many consumers and businesses access funds to grow!
Why might specialty finance companies or lenders extend financing to individuals and businesses that banks ignore? As the investment firm Magnetar points out, banks usually have rigid processes and structures when it comes to lending. Sure, you are likely to be able to obtain a loan if you have an excellent credit score, or if your business has a long track record of performance, but if you have a limited credit history (either as an individual or as a business) or unconventional revenue model, you are unlikely to be able to find funding, even if you have ample income and a high ability to repay. Instead of banks, you'll look for specialty finance lenders that understand your specific revenue model or assets.
In other words, specialty lenders fill the financing gap left by banks. Specialty lenders tend to be experts in specific industries or revenue models, and to understand their specific customer base better than one-size-fits-all financial institutions do.
Why is specialty finance important?
Specialty finance plays an important role in the economy by helping non-traditional consumer and corporate borrowers access funding.
Let's take the example of two hypothetical individuals: Brenna and Bryan. Both are 40-year-olds living in Chicago, and both would like to take out loans to start new small businesses. Brenna has worked as an attorney for 12 years, and has a steady and predictable income year after year. Bryan is an inventor who invented a novel medical device that has begun to see rapid adoption by major hospitals. The licensing deals for these devices are anticipated to generate significant revenue in the coming years.
Banks would likely extend credit to Brenna, as they are familiar with her financial situation and career profile, but they'd be unlikely to extend credit to Bryan, as they have limited experience with intellectual property-related revenue streams, and do not have a model for assessing future or expected revenue when assessing creditworthiness. As a result, Bryan might go to a medical device-focused specialty lender to see if he can obtain a loan based on the expected licensing revenue from his invention.
Specialty finance companies look for opportunities to extend credit to individuals or businesses that are creditworthy, even if traditional standards might exclude those individuals and businesses from bank lending. Examples of specialty finance companies include consumer lenders that extend loans to non-prime or sub-prime consumers, business lenders that specialize in invoice factoring or equipment financing, and other esoteric or niche lenders, which may provide financing backed by royalty streams, tax credits, and other types of receivables.
Banks look to build and operate credit models that can adequately serve the large majority of consumers and businesses, while specialty lenders look to serve unconventional borrowers in specific industries. In that sense, banks are like foxes, which must do a little bit of everything, while specialty lenders are like hedgehogs, which must instead understand one customer type very well.
Why is specialty finance a compelling space for investors?
Investors see a number of opportunities in the specialty finance space: the opportunity to generate a higher return than they might be able to in traditional investments, portfolio diversification (specialty finance investments often exhibit low correlation with economic cycles), and the collateral-backed nature of the loans.
As specialty finance continues to grow, capital providers for specialty finance lenders, such as Upper90, are also finding ways to provide efficient and flexible financing to those specialty finance lenders, often aided by technology.
How is technology changing specialty finance?
The traditional "credit box," or loans available to borrowers, does not capture the many situations in which the collateral or the financing objective of the borrower might be unconventional.
The key reason for this, traditionally, has been the lack of technology for determining and updating the value of the collateral underlying a specialty finance loan.
For example, the website of J.P. Morgan's Private Bank page on Specialty Lending lists, as examples of collateral or investment opportunities, fine art, aircraft, superyachts, and sports teams.
These are all assets that are hard to price or monitor programmatically, and thus difficult to lend against! As a lender, I might recognize that an airplane is valuable collateral, but I might have a hard time knowing whether I should extend $1 million in loans against it, or $2 million. Another way of saying this is that the borrower's "borrowing base" is hard to calculate and monitor, which can make it difficult for the lender to assess collateral adequacy and risk.
So where does technology come in? One of the insights that has underpinned the growth of fintech is that many novel types of revenue streams, from IP-related revenue streams to YouTube influencer revenue, can be modeled accurately and predictably, and can thus form the basis of performant underwriting, especially when combined with other data sources from the modern lending tech stack (e.g., bank data, accounting data, etc.).
That's led to a fascinating and underappreciated development: many of today's leading financial technology companies are actually specialty finance companies, which is a space that dates back at least 80 years! Examples range from fintech startups that offer financing for game developers to startups that offer financing for creators. At their core, these companies are solving the same problem as, say, litigation finance or tax credit specialty finance companies: the provisioning of credit to non-traditional borrowers, based on proprietary risk models.
In future posts, we'll cover why specialty finance knowledge is often lacking at fintech companies, as well as why technological expertise is often lacking at specialty finance companies. We'll also provide tips on how to make sure your specialty finance company has the right balance of credit risk know-how and technological expertise.
Want to learn more?
Finley is software that helps specialty finance and other companies with asset-backed loans save time and money by automating routine debt capital management tasks like borrowing base reporting, verification, and alerting. Today, Finley manages over $2 billion in debt capital for customers like Ramp, Parafin, and Arc. If you're interested in learning more about software that can help you streamline your debt capital raise and management, just schedule a demo or take a self-guided product tour. We'd love to chat!