From aircraft to music rights: The unconventional way to add alpha to your portfolio

Note: This interview was taped on Wednesday 18 September 2024.

Jet leases, student loans, music IP and healthcare royalties.

These are not what you would typically think of when investing but that doesn’t mean they’re not lucrative. They form a market segment known as asset-based finance and possess some important characteristics – such as diversification and inflation hedging – which are particularly compelling in today’s environment.

To explore the opportunity further, I recently sat down with KKR’s Varun Khanna, who is a partner in KKR’s private credit business.

The strategy focuses on investing in large, diversified portfolios of assets - such as those mentioned above – as well as mortgage loans and, consumer loans. These portfolios are typically originated by banks or non-bank lenders, providing an opportunity for investors to gain exposure to diverse sectors of the real economy.

Growth of Asset-Based Finance (ABF)

Khanna attributes the significant growth of ABF to increased regulation of banks since the 2008 Global Financial Crisis. As banks face stricter regulatory requirements, non-bank financial markets have flourished, particularly in the US, which has led the charge in the development of non-bank finance markets. 

This trend has spread to other regions such as Europe, Australia, and parts of the Asia Pacific, and Khanna believes it will continue in the future.

“I think it's a trend that's here to stay,” says Khanna.

ABF’s role in diversification

According to Khanna, ABF investments provide a unique diversification opportunity, particularly in fixed income allocations.

Khanna explained that ABF offers exposure to sectors outside of medium and large-sized corporates, such as consumer finance and transportation.

“With that comes greater diversification because, conceptually, corporate cash flows behave differently to portfolios of mortgages and equipment finance assets”, adds Khanna.

For example, portfolios of mortgages or equipment finance assets exhibit different cash flow characteristics than corporate cash flows, providing a valuable diversification tool.

Inflation hedge

In today’s inflationary environment, Khanna highlights that ABF investments can act as a potential inflation hedge.

This is because many of the assets in ABF portfolios—such as homes, cars, and planes—tend to appreciate in line with inflation.

As a result, the underlying value of these assets grows with inflation, providing protection against rising prices.

As Khanna explains, he believes this feature makes ABF particularly attractive as a potential safeguard against inflationary pressures.

Comparison to other asset classes

Khanna also distinguished ABF from corporate credit and infrastructure investments. Corporate credit focuses on lending to individual companies, while infrastructure investing is tied to specific assets, like ports and airports.

In contrast, ABF is a portfolio-based strategy that involves financing or investing in diversified pools of assets.

For example, when investing in a portfolio of mortgages, KKR might manage loans from tens of thousands of individual borrowers, providing extensive diversification. This differs from corporate credit or infrastructure, where the investment typically hinges on the performance of a single asset or company.

KKR’s investment sectors

KKR’s ABF business focuses on four key sectors:

• consumer finance and mortgages
• commercial finance
• hard assets, and
• contractual cash flows

Consumer finance and mortgages cover areas like auto loans, student loans, and credit card receivables.

Commercial finance focuses on portfolios of loans to small and medium enterprises. 

Hard assets include portfolios of physical assets such as aircraft.

Finally, the contractual cash flow segment involves assets like music intellectual property or healthcare royalties.

While KKR aims to have representation across all four sectors, the allocation to each sector varies depending on the current economic environment and risk assessments. 

Risk management in ABF

Risk management is critical to ABF investing. Khanna emphasises the importance of selecting the right assets and understanding the creditworthiness of the borrowers. In consumer finance, for instance, the risk profile of a portfolio can vary significantly depending on whether the borrowers are high-income individuals or lower-income borrowers.

Additionally, KKR seeks to invest in portfolios backed by assets with well-established historical data, such as mortgages and car loans, which provide more predictable valuations over time.

“So think about portfolios of mortgages backed by homes or portfolios of car loans backed by cars, where there's a lot of data through the cycle on how valuations can trend over time.

“We try to stay away from asset portfolios where values are harder to come by with conviction, but also can be volatile through the cycle”, says Khanna.

Case study: Student loan portfolio

Khanna concluded by discussing a recent ABF investment in the US, where KKR acquired a $10 billion portfolio of student loans. 

This acquisition highlights KKR’s focus on finding opportunities in the ABF space, especially as banks face pressure to offload assets in the wake of regulatory challenges.