The Takeaway: A Q&A With Brent Ferrin and David Villa on Projections for the Specialty Finance Sector

How has the specialty finance sector performed over the past year, and how do you anticipate the sector to perform in 2023?

Over the past year, the specialty finance sector has experienced mixed performance. Headwinds, including inflation and higher financing costs, have posed challenges. However, the disruption in the banking sector created opportunities for specialty finance companies to fill the void in certain lending areas. As we move forward into the rest of 2023, the sector is expected to benefit from increasing loan demand and potentially attracting higher-credit borrowers, contributing to a positive outlook for its performance in the latter half of the year.

What are the biggest challenges and opportunities facing your sector?

One of the primary challenges in the sector is the persistent issue of rising financing costs. The Federal Reserve’s series of interest rate hikes, which began in March 2022, has led to a notable increase in the benchmark rate from 0% to 5.25%–5.50%. Consequently, companies in the specialty finance sector have experienced mounting pressure on their net interest margins. To address liquidity concerns stemming from these rising costs, several companies have resorted to debt restructuring transactions, with some even employing payment-in-kind arrangements as a temporary measure to replace cash interest expenses.

The sector presents significant opportunities primarily driven by unmet demand from borrowers. Specialty finance companies hold a unique advantage in their ability to offer alternative financing solutions to clients, especially when compared to traditional bank financing. As banks continue to tighten their underwriting criteria and navigate regulatory capital constraints, borrowers increasingly seek out specialty finance companies to fill the void. We expect the sector will benefit from a more stable interest rate environment and higher yields on newly originated loans.

What are the major trends driving M&A activity within the sector?

In the first half of 2023, M&A activity experienced some impact due to the early-year bank failures. However, we anticipate that the second half of the year will witness a pick-up in activity. Private equity sponsors will be actively evaluating the seasoning of their portfolio companies and identifying investments that are approaching the typical hold period. This evaluation process is likely to drive dealmaking as sponsors seek to capitalize on attractive exit opportunities.

The slowdown observed in the first half of the year has created scarcity value for high-quality targets that come to market. This scarcity, coupled with pent-up demand for quality assets, is expected to spur increased M&A activity as investors seek to acquire these valuable businesses. Financing costs may play a pivotal role in driving these M&A opportunities within the sector. Companies seeking to achieve scale and diversify their funding sources may find M&A as an attractive avenue to accomplish these goals. This pursuit of scale and funding diversification is motivated by the need to navigate the changing economic landscape and optimize financial efficiency.

What is the current level of interest from financial sponsors in this sector?

Financial sponsors continue to show significant interest in the specialty finance sector. Both specialized financial services sponsors and generalist investors are actively seeking high-quality opportunities within this space. When considering potential investments, sponsors often face the decision between acquiring an existing platform or providing capital to fund the creation of a lending operation. Sponsors are becoming more flexible with their capital allocation strategies and are exploring options beyond their traditional private equity control-style buyouts such as setting up separate funds or vehicles to engage in minority deals, debt investments, or other more adaptable funding approaches.

Overall, the level of interest from financial sponsors in the sector remains robust, driven by the potential for attractive returns and the opportunities for strategic growth and consolidation. Financial sponsors are adapting their investment strategies to remain competitive in the specialty finance sector and capitalize on emerging opportunities, even amid the challenges posed by higher financing costs.

What are buyers prioritizing right now when considering a specialty finance company as a potential acquisition target?

Buyers in the specialty finance sector are currently prioritizing sustainable profitability when evaluating potential acquisition targets. A clear and credible path to profitability is crucial, and although some buyers may consider a well-defined plan as an alternative, the expectations for demonstrating viability are very high. Given the evolving macro and sector dynamics, there is heightened scrutiny around financial forecasts, requiring sellers to provide robust and reliable projections. Day one valuation is receiving greater attention, and earnout arrangements are becoming more prevalent as a means to bridge the gap between sellers and buyers and align interests.

While demonstrating sustainable profitability and providing accurate financial forecasts are the most important factors for attracting potential buyers, an important supplementary differentiator for specialty finance companies is the incorporation of emerging technologies and digital innovations into their business practices. Companies that are seeking new technology solutions to prioritize automation and user-friendly capabilities to deliver seamless, fully integrated customer experiences will stand out to buyers. Ensuring a frictionless customer journey holds significant importance and delivering exceptional customer experiences through digital innovations is a key factor in attracting interest from discerning buyers.

So, what’s The Takeaway?

The specialty finance sector maintains a positive outlook as it capitalizes on unmet borrower demand and flexible capital allocation strategies for M&A activity, which are driving growth and attracting significant interest from both financial sponsors and potential strategic partners.