Banks’ reduced lending capacities have encouraged private funds to tap into the trade finance market, but the lack of awareness among investors remains an issue. Melodie Michel reports.
As commodity traders are forced to diversify their sources of financing, and banks restricted by looming Basel III regulations look to share assets, trade finance funds are seeing growing business opportunities.
Their relationship with banks is evolving from competitive to complementary, and the volatility in the bank market has engendered higher yields for those institutions still able to finance trade. But despite growing interest in trade transactions, funds are still finding it difficult to attract investors.
Evolving relationship with banks
Whereas in the past, banks may have viewed trade finance funds as competitors, reduced lending limits have prompted them to reconsider that position. It can be argued that funds are now helping banks keep their business by covering the areas of a transaction no longer justifiable on their books.
François Dotta, head of trade and commodity finance at Eurofin – an Asia-focused trade finance fund – says relationships with banks are getting better and better. “Everyone in the banking industry and on the corporate side now understands that non-bank financial institutions are not competitors for the banks: the sheer size and product lines that commercial banks can offer to trading companies mean that we would never be able to compete, so we come as a complement to the banking offer.
“All our clients already have five to 10 credit lines, but there are specific parts of the trade which a bank by structure may not want to touch. In terms of reactivity, as we are in the business of financing metric tonnes, when you have a surge in prices, the banks’ credit lines don’t necessarily follow as fast as the price increase, so there’s always space for non-bank financial institutions to capture that portion, and also to work as a complement of the existing bank lines. It’s better for them to share transactions with us than to send them to competitors,” he says.
Yields have gone up due to the shortage of credit for banks to provide trade finance, and the situation is likely to get even worse when Basel III comes into force. “Banks are still doing trade finance, and they need as much as possible to syndicate it,” says Tricon’s managing director Fritz vom Scheidt.
But this improved relationship doesn’t only come from low lending limits; funds have changed the way they source business and tend to collaborate more with banks than in the past. Barclays’ head of trade finance and working capitals Tan Kah Chye points out: “A lot of these funds are coming to the realisation that they will have better success if they source assets and business via banks than directly from corporate clients, which is what they did in the earlier days.
“From a bank’s perspective, if funds source business directly from corporate clients, they are in the competitor space, but if they source business through a bank, they are great partners. If we work together we are all better off, not just funds and banks, but more importantly our clients,” he says.
Some market players have also noticed a tendency for securitisation, which has resulted in a lot of secondary market transactions for the fund. Dalia Kay, portfolio manager, structured trade credit at GML Capital, explains: “A large number of banks are deleveraging their books so we provide a new source of capital for them.
Maybe before, we were small buyers so they would not have given us a chance on those assets but now we’ve seen quite high interest from banks sharing those assets.”
She adds that with tenors getting longer on the primary market, it is easier for funds to pick up transactions on the secondary market, which are already seasoned and have a much shorter average life.
“When you’re an investment fund you don’t want to have too much cash sitting in the fund because it affects your evaluation, and being able to pick up secondary assets on the market immediately without having to wait for the whole process of syndication, means that sometimes we prefer secondary market transactions,” Kay tells GTR.
But despite the opportunities that the restrictions imposed on banks have provided investment funds with, they are worried about the repercussions a full-fledged banking crisis could have on their own business. Lower credit availability means reduced working capital cashflows for corporates, which increases non-payment risk. Moreover, the collapse of the banking industry would create a systemic credit risk on all financial institutions, including funds.
Opportunities in commodities
Unsurprisingly, commodity-focused funds have seen the biggest growth in demand, following the withdrawal of traditional European players from the market. Robert Klein, president of Crecera, a fund specialising in Latin American business, explains: “Before the crisis there were quite a few European banks involved in the business that have now either had to leave the market altogether or drastically cut their available capital to lend to corporates, so there’s been quite a lot of demand from existing clients as well as new clients.”
Other funds are taking advantage of the gap left by European banks in the commodity market. Eurofin, which until now only focused on Asian trade, is launching a Europe/CIS commodity finance fund by the end of the year.
Dotta tells GTR that demand for the new fund is mostly driven by tighter access to credit for middle segment trading companies with a foot in Europe, the UK and the CIS markets.
Although the fund finances a balanced mix of commodities, Dotta adds that the agricultural sector has experienced tremendous growth.
“There’s a big push in the agricultural sector for two reasons: first, the price increase is unprecedented, and second, banks are not agri-friendly in general. It’s back-office intensive, it’s perishable goods, it’s a fragmented market with a lot of trading programmes that need to provide inventory finance at origin and destination, which is not the primary focus for banks, especially if they are in a retreat mode – then they’re better off going to the oil, metal and mineral market,” he says.
Focusing on soft commodities has other advantages for funds. As Klein points out, despite slowing growth in most economies, including China, there will always be a need for basic agricultural produce.
“We don’t see dramatic declines in demand for the types of products that we focus on like what you would see for manufactured products such as Asian electronics for example.
During the last crisis in 2008/09 we saw the volumes of exports on electronics drop dramatically by 35 to 50% over that period of time. We saw a decline in agricultural products, but within the range of 1-2%. People still need to eat and animals still need feed in order to grow,” he adds.
Of course, the downside is the volatility in commodity prices, which has prompted funds to enhance the precautionary measures they take when doing business. They need to be more cautious in the way they structure their transactions in order to manage price-related risks. At Crecera, transactions need to have a minimum of 125 or 130% value of the collateral over the loan value to create a security margin in case the price declines.
There is also a market clause in the contract that states that if the price of that commodity does decline over the period when the loan is outstanding, the obligor needs to pay back by adding a different product as collateral. Klein explains: “You definitely have to be more conservative when you value collateral. If the current price of a product is over 10 to 15% above that of the long-term average, we will value the initial inventory at the price of the long-term average so that our actual coverage is higher.”
Eiger, a commodity trade finance fund with a Middle East focus, is also taking extra precautions to protect itself against price volatility. Head of trade finance origination Ken Owen tells GTR: “You look at the length of your transaction, in terms of volatility, how the contracts are priced, and substitutes, in case the price goes down. If you don’t get the ticks on all the boxes you don’t get the trade.”
For other funds, the risks associated with price volatility make it not worth the trade. GML for example has decided to limit its Latin American exposures due to the fact that most of the trade there is based on soft commodities. Kay says that the business she still does in Latin America relies a lot on the structure of the transaction (with special clauses covering the lenders in case of a price drop) and the quality of the offtakers.
“We take more comfort in the industries of oil and gas and energy, rather than soft commodities; that is definitely an overall feel. We see things go wrong in soft commodities and there’s an element of security when you invest in oil energy,” she adds.
When it comes to investor interest, trade finance seems to have grown in popularity since the collapse of other asset classes in the financial crisis. Eiger’s Owen explains: “When it is properly structured and managed, trade finance is a short-term product that generates not huge profits, but profits, and therefore it’s a class of asset that has attracted attention following the loss of faith in some of the other products that are around.”
Crecera’s Klein agrees, adding that investors now prefer lower risks with lower returns. “The performance of the asset class has been very strong compared to other types of corporate lending; the default rates have been lower and the recovery rates on those defaults have been higher, so the types of returns that it provides are very attractive. You’re not getting 20% returns but no one is, so returns between 7 and 10% are attractive with this level of volatility,” he says.
In fact, Crecera has seen increased interest from tax-exempt institutions and pension funds, which need steady returns with low volatility. GML has also seen interest from this new type of investor, but Kay adds that their extended approval process is an obstacle, meaning that nothing has been signed yet.
Despite renewed optimism, some funds have not yet recovered from the withdrawal of investors following the crisis. At Tricon, vom Scheidt explains that as they suffered the collapse of their investments in equities and real estate, investors pulled their money out of the fund, resulting in a significant decline in assets in 2010. “They are slowly coming back to the market now, as they have a very large overhead of unproductive cash,” he adds.
The pull of Islamic finance
As part of its strategy to rebuild its asset base, Tricon is in the process of finalising a placement with three Middle East banks, which will originate trade finance transactions from importers and exporters in Islamic countries that will be guaranteed by the Islamic Corporation for the Insurance of Investments and Export Credit (ICIEC), a division of the Islamic Development Bank (IDB).
This portfolio of credit-enhanced trade finance assets is expected to attract institutional investors, as they will have been credit-enhanced to an equivalent of the IDB’s credit rating (Moody’s – Aa3).
Eurofin also sees the appeal of the Islamic finance market to attract investors, and will launch a shariah-compliant fund by the end of 2012. Head of trade and commodity finance François Dotta tells GTR that as opposed to Eurofin’s European commodity fund, also due to launch by the end of the year, the creation of the Islamic fund was prompted by demand from investors, not from the market: “The appetite for this new fund really comes from Middle Eastern investors, who have a strong focus on preservation of capital. On top of that, the Middle East has an excess of US dollars available.”
Eiger is developing an Islamic trade finance fund of its own, and Ken Owen, head of trade finance origination, explains that demand for this product comes from both ends of the transaction. “You have Islamic investors who are looking for opportunities to place excess funds in the short-term market, and there has been a reduction in the availability of banking facilities of the conventional nature to trading companies.
“The conventional banking market is tight, so where can they go to obtain the additional financing? The Islamic market has the cash, therefore there is an opportunity there, and whilst trading companies a few years ago would not have made the effort to look at the documentation that is required to complete an Islamic trade finance transaction, because they are concerned and need alternative sources of financing, they are now prepared to look at that documentation,” he says.
Islamic trade finance presents particular advantages for the commodity sector, as the concept of ownership involved in this type of funding removes the jurisdictional difficulties in affecting collateral and deflates corporates’ balance sheets. “There are ways of using [Islamic trade finance] products to assist companies with their balance sheet and securities, and ownership is perhaps the easiest answer,” Owen continues.
But no matter where they look for investors, trade finance funds have a lot of work to do to raise awareness on the asset class. In the Middle East in particular, institutions have not been used to doing this type of business, and educating them is one of the “big hurdles” when approaching the Mena region, according to Owen.
Tricon’s managing director Fritz vom Scheidt explains that despite being satisfied with the yield, consistency and safety of trade finance assets, investors still need a lot of education to understand how the business works.
However, he is confident that the situation is bound to improve as money managers look for ways to place their cash surplus.
“We’re extremely optimistic, because investors have a surplus of cash and there is no yield anywhere, and trade finance is one of the best types of investments. The other thing is trade finance has proven to be largely non-correlated to the overall moves in the markets. As bonds and equities fall, there is no place to run or hide except trade finance,” he concludes.