(Bloomberg) — After pouring billions into asset-backed finance, private credit managers and investors are starting to scrutinize what exactly they get back if their bets sour.

With types of collateral ranging from mortgages, to music royalties, to physical assets like aircraft, the answer to that question can mean the difference between an easy recovery and being stuck with something hard to sell. The manufacturing equipment might be bolted to a factory floor. The fine wine backing the loan may have spoiled. Or the company’s output could be so specialized that it’s nearly impossible to offload.

Investors are becoming more discerning after a period of rapid growth in the sector, fueled by demand from insurance companies for investment-grade rated strategies. KKR & Co., which recently amassed about $6.5 billion of capital in one fundraise to invest in asset-based finance, estimates that the market could grow to more than $9 trillion by 2029.

“Collateral is only as valuable as the lender’s ability to enforce on it when required, or indeed its liquidity should the lender need to take possession,” said Tamsin Coleman, head of private credit, Europe, at Mercer, which helps investors develop and implement their strategies.

Private credit firms, having raised huge of sums of money to invest in corporate loans, are now looking to diversify as spreads tighten for their traditional targets. At the same time, large investors are searching for extra yield and can invest in higher-rated areas like asset-backed finance. These two dynamics — just as banks retreat from certain sectors — have led to swift growth, putting the question of recoveries under the spotlight.

When Kartesia Asset Finance — acquired by Kartesia Management in 2023 when it was known as Flexam Asset Management — first had to take over assets, it found itself holding factory equipment so specialized for a single client’s production that reselling it would have been extremely difficult.

These days, the firm only lends against mobile assets — like helicopters — and it keeps a bank of video monitors trained on every piece of collateral backing up its investments to make sure they don’t get lost or stolen. 

“I can see where any asset I finance is in the world at any time,” managing partner Fabrice Fraikin said in an interview. “The few situations where we’ve been faced with having to recover assets, we have learned from those experiences.”

Asset-backed finance is considered safer than traditional direct lending because lenders have stronger security. Often, collateral will be put in a bankruptcy-remote vehicle that’s accessible if the borrower stops paying its loans. This is unlike lending directly to a company where investors don’t usually have any direct ownership over what they’re owed. 

In most cases, corporate lenders get repaid from the businesses’ cashflow when times are good. But when an investment sours, a lender may have to negotiate with shareholders, take ownership of the entire business or even go to court to get its money back. 

Loss rates in ABF are typically reported in basis points —  usually around 10 to 20, according to ICapital, an alternative investment technology firm — rather than percentage points, an indicator of how little investors have lost in recent years. Kartesia Asset Finance, for example, reported an annualized loss rate of 19 basis points since inception, as of March 2024.

Nevertheless, investors are flagging that as demand for ABF has spiked, so too has the variety of the assets that underpin debt packages. 

Recovery rates vary even within different classes of collateral. Real estate is an asset that’s commonly used to back up debt, but residential homes can be much easier to sell than an unfinished mall, according to Georges Gedeon, the co-portfolio manager of the Lombard Odier Asset Backed Loan Fund.

Similarly, while some physical goods — like pharmaceuticals — have a relatively long shelf life, perishable items do not. In that situation, a much more valuable form of collateral would be the receivables owed to the distributor, Gedeon said.

For Mercer’s Coleman, the relative novelty of the asset class is reason to tread warily with untested investment managers.

“As strange as it may sound, you do want to see some restructurings,” she said. “These are the moments that reveal the true quality of a manager’s track record.” 

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