Why invest in specialty finance?

Specialty finance can be broadly defined as any financing activity that takes place outside the traditional banking system. Following the recession, banks and larger financial institutions were forced by a combination of market conditions and increased regulations to significantly tighten their lending standards. This financial conservatism has essentially closed off the traditional credit market to many consumers and small businesses. This has opened the door to specialty finance firms to play a larger role in providing structured finance options to these borrowers.

What is specialty finance?

Typically, specialty finance firms are non-bank lenders that make loans to consumers and small to mid-size businesses that may otherwise find it difficult to obtain financing. Retail point-of-sale consumer installment lending, auto lending, payroll deduction loans, small ticket equipment lending and leasing, accounts receivable factoring, trade finance, supply chain finance, merchant cash advances, and peer-to-peer lending all fall into this category.

What do specialty finance firms do?

Specialty finance firms provide funding to consumers and businesses for a variety of uses. These lenders assess each loan request, looking at hard data such as intention to pay, ability to pay, and the asset value of pledged collateral as opposed to the more ratio driven, formulaic approach that traditional banks usually follow. Specialty finance firms are typically much flatter organizations than traditional banks, with accessible investment committees and a willingness to perform a “deep dive” to assess a loan request. Unlike banks, specialty finance firms tend to rely on their own due diligence of the opportunity rather than ensuring that a borrower fits into the traditionally defined “credit box” upon which many larger financial institutions rely.

Who do specialty finance firms work with?

While the borrowers (consumers or businesses) may not fit into the traditional “credit box,” they may still exhibit characteristics that make them attractive candidates to receive financing. Many commercial borrowers are growing, have a diversified customer and supplier base, multiple products and end markets, good technology to support operations and reporting, a high degree of recurring revenue, and experienced management teams. However, due to leverage levels, length of time in business, or other factors, they may no longer meet the credit requirements of larger financial institutions. 

Among consumer borrowers, a low FICO score or too much debt often results in turndowns from banks. Specialty finance firms are able to invest in these borrowers because of the time they invest in understanding each situation and, in many instances, their ability to determine the liquidation value of the collateral pledged to secure the loan. This level of  underwriting allows specialty finance companies to provide financing to borrowers, or in situations declined by traditional lenders while obtaining a premium price to cover the work and the risk.

In today’s uncertain credit market, driven by the impact of the Covid-19 pandemic on consumers and small businesses, specialty finance companies can play an active role in addressing the funding needs of more consumers and businesses that do not qualify for more traditional financing as credit underwriting requirements have tightened at many large financial institutions.

What are specialty finance investments like?

Specialty finance investments are opportunities that offer a potentially higher rate of return than traditional investments might. Yieldstreet seeks to reduce (but of course could never eliminate) the higher risk in specialty finance investments through various means, such as carefully evaluating underwriting standards, reviewing historic performance, setting advance rates to cover projected loss rates with a cushion, focusing on collection practices to stay on top of borrowers’ payments, and establishing expectations for performance to measure results in real time. 

There are many potential advantages to specialty finance loans:

• They tend to provide a higher rate of return than traditional investments.
• Specialty finance loans are often backed with collateral.
• Specialty finance loan portfolios are often diversified where no single transaction would have a significant negative impact on the whole. 
• Specialty finance loans are largely uncorrelated with the broader economy, including other equity and debt investments that are available to most investors.
• They can generate a predictable cash flow stream that can be utilized to pay principal and interest on an investment. To date, these deals have generally been reserved for hedge funds, institutional investors and family offices. With the emergence of new technology platforms, accredited investors may also invest in these specialty finance opportunities like real estate investments (hard money and mezzanine debt), litigation finance (pre-settlement funding and post-settlement funding), consumer installment lending (auto, home, medical, and other), and commercial (small business loans and equipment leases). Typically, specialty finance presents a potentially valuable opportunity for investors and finance pros to diversify and aim to protect their portfolios from downturns in the broader market while striving to earn potentially above market yields.

Have questions about specialty finance or Yieldstreet in general? Reach out to us at [email protected].

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