Asset-backed financing is growing rapidly and is under increasing scrutiny

A version of this article appeared in CNBC’s Inside Alts newsletter, a guide to the fast-growing world of alternative investments, from private equity and private credit to hedge funds and venture capital. subscription To receive future issues, directly to your inbox.

The First Brands Group bankruptcy has put the spotlight on one of the fastest-growing pillars of private credit: asset-backed financing.

Asset-backed financing, or ABF, involves lending against a specific asset, income stream, or loan rather than lending to a company based on its cash flows. According to KKR, the private ABF market has doubled since 2008 to more than $6 trillion today – larger than the syndicated loan, high-yield bond and direct lending markets combined.

The ABF market is expected to reach $9 trillion by 2029, according to KKR. While direct lending may have fueled private lending growth in the past decade, ABF is now “taking a similar path, attracting the spotlight with its historically attractive returns, diversification benefits and massive market size,” the global investment firm said in a report.

Asset-backed financing is often described as less risky than direct lending. While banks have withdrawn from ABF since the financial crisis, private direct lenders have flocked in. The lender often groups ABF loans into pools, collateralizing everything from financial assets (accounts receivable or consumer loans) or fixed assets such as aircraft, warehouses or even music royalties. The combined approach aims to provide a safer loan portfolio, with greater diversification.

However, some experts say the influx of capital into private credit and ABF strategies has led to lower standards and increasingly exotic assets being pledged as collateral. First Brands, an auto parts company, borrowed against its receivables, or money owed by its customers. In bankruptcy filings and lender statements, some lenders say the company may have underwritten the same receivables to different lenders.

While many private credit companies, such as Apollo, spotted potential problems at First Brands and even shorted the credit before the company filed for bankruptcy, others failed to notice the red flags.

Donald Clark, head of Asset Based Lending Consultants, said ABF is “high-risk, high-reward” lending and requires particularly stringent due diligence.

Not only do lenders need to understand the underlying business and complete business model, like typical lenders, but they also need to understand the specific collateral being pledged.

“The First Brands debacle demonstrated a lack of due diligence by lenders – banks and non-banks alike – who rushed to deploy capital,” Clark said.

Given ABF’s rapid expansion and billions flowing into private credit, he said he expects more non-performing loans to emerge – especially if there is a credit downturn.

“The race to deploy capital should be moderated by the need for appropriate borrower due diligence and the proposed collateral,” he said. “Where there is a lot of money to lend, there is a lot of money to lose.”