It’s tough out there for trade finance funds. But those that have made it through the hardest two years in the industry’s short history think the worst is finally behind them, writes Helen Castell.
Last year was “about as tough as you can imagine” for trade finance hedge funds, says James Parsons, portfolio manager at Bluecrest Capital Management in London. The time-lagged effects of the 2008 collapse dragged on asset values while the economic slump hit even decent credits.
“There’s a little bit of secondary activity, but the deals that come out are maybe for risks that pay less than what we might be interested in anyway,” says Jane Belova-Barr, director – distribution at Rosemount Capital Management in New York. “And then prices are being squeezed on top of that because the number of people fighting over those deals brings the price down again.”
“I don’t think anyone had a good year,” agrees Christian Stauffer, managing director and founder of EuroFin Asia in Singapore. Everything is relative, however, and considering the market carnage in recent years, the fact that the fund has not been suspended or gated is good news, he notes.
Indeed, as Fritz vom Scheidt, managing director at Tricon Forfaiting says, with the trade finance body count still mounting, “if you’re still in this market, that’s something”.
Although Tricon is still waiting for the last of Ukraine’s bank restructurings to be resolved, it has been holding much more cash than usual. And though downsized, its performance has been stable.
Nevertheless, there is still solid demand for fund financing – especially while bank lending remains restrictive. And investor interest is slowly returning.
Compared with just after Lehman Brothers’ collapse in 2008 – when trade volumes slumped and banks were cautious about committing to deals before they knew what shape Basel III would take – bank financing for trade is starting to flow again.
And with the direction, if not the details, of Basel III now becoming clearer, funds like Bluecrest, which takes risk from banks, providing them with regulatory capital relief, should see more demand from banks looking to transfer risk to the non-bank market.
The shorter-term, higher-churn deals that Basel III will encourage should also help funds make money out of trade finance. The fact that trade finance is not screen-traded means there are always pricing inefficiencies that buyers, such as mutual funds, can seek to leverage on.
That said, competition between departments for what liquidity a bank has may force teams to compete to be more profitable than each other. “If you’re a buyer from banks, that may not work in your advantage in that they may shave margins that you receive to maintain their own internal rates of return,” adds vom Scheidt.
Indeed, the health of the banking sector and its appetite, not only for financing corporates but for selling risk to funds or investing in them, has an obvious impact on the trade fund industry – but one that is very different depending on each fund’s strategy.
For a fund like Rosemount, which provides finance for trade deals but also seeks bank involvement as investors, a risk-averse banking industry can hold both positives and negatives.
“In a way we can pick up where other people can’t,” says Belova-Barr. “Some of the bigger European banks are now having to step back from being MLA for a while, and that’s where we can step in.”
“However, people who we might sell to are also saying ‘we can’t do it now either’. So we’ve got to be conscious of both sides,” she adds.
As a result, the fund is pitching more to institutional investors, looking – in the short term at least – at more security or quasi-security type transactions. “If it’s well-structured and well-priced, they’ve got plenty of liquidity, and the ability to lend – albeit not cheaply,” says James Klatsky, Rosemount’s senior managing director and partner.
Funds gain ground
During the early boom days of the trade fund industry – when a different fund was being launched every few months – trade funds were viewed as a threat, ready to steal a march on trade banks and win a bigger share of the overall trade finance business.
As it was, recession struck and both banks and funds have struggled amid risk-aversion and credit tightness.
However, this doesn’t mean though that funds aren’t still gaining ground.
With so many banks shrinking their trade finance teams, merging them with other parts of the bank or pulling out of the business altogether, there is actually a widening supply-demand gap for trade finance that funds can plug.
“It’s certainly much more difficult these days to obtain trade finance facilities in Europe than it was 24 months ago,” Eurofin Asia’s Stauffer argues.
Underfunding in the trade finance market has increased over the past year as trade finance supply struggles to keep up with slowly recovering demand, agrees Tricon’s vom Scheidt. This is an opportunity for trade funds which have a number of advantages over banks, not least their less cumbersome structure. Compared with banks – which have to channel all new lending through increasingly cautious credit committees – funds can make faster lending decisions, says James Prusky, partner at Crecera Finance Company in New York.
Funds are also more flexible than banks in terms of deal structure. “We can look to secure different pieces of a company’s overall business that maybe a bank wouldn’t look at or wouldn’t be able to do, just because of the rigidity of their credit process,” argues Prusky.
This creates a complementary relationship between a client and a fund, especially in cases where a company is seeking trade finance on top of existing lending.
In current conditions, banks that are already exposed to a company are often unable, or at least slow, to provide the same firm with additional trade finance. And if that firm cannot secure trade finance, the risk rises that it will default on its other, often bigger, bank lending.
By not refinancing or extending additional trade finance, banks put their other loans to the company in jeopardy of a restructuring, explains Mead Welles, founder and CEO at Octagon Asset Management in New York.
“It doesn’t matter who fills the void and provides that much-needed trade financing – it shores up the capital structure of the company.”
Funds like Octagon also often work with companies that are on the verge of becoming eligible for bank funding. “We groom them to be stronger credits, not only from a prompt payment standpoint, but also from a reporting one, which is a very important requirement for any major lender.”
If trade funds have certain advantages over banks, they also have their unique problems, not least a lack of control over their own liquidity as redemptions prove the plague of the fund industry overall.
“There’s an entire phonebook of psychological and real issues that investors have had to go through,” notes Stauffer at EuroFin Asia. The poor performance of some fund of hedge funds for example has spooked investors, causing some to indiscriminately redeem all their hedge fund holdings and occasionally all their investments.
This is the reason why “a lot of [trade funds] don’t exist anymore”, he adds.
Fund of funds have been the biggest problem, agrees Crecera’s Prusky. Many were highly leveraged as the crisis hit and on suddenly losing that leverage had to return capital to investors – and therefore redeem their fund investments en masse.
“It didn’t make a difference whether it was trade, equity or other types of arbitrage,” he notes. “It was strategy agnostic.”
Redemptions aside, returns on trade funds have been steady and certainly better than most other assets in recent years. Not that portfolios have been immune to the slowdown – snail-pace restructurings and problematic deals have inevitably taken their toll.
Crecera is on track this year to meet its long-term target of 9-12% net annual return. That strategy – to “keep things very stable and solid over time,” rather than shoot for, say, 15-20% growth – has performed well, “even during 2008 when most investment fund strategies, forget trade finance, were down by 20% or more”, says Prusky.
Bluecrest is barred from publicising its returns, but the fund has been up every year since its inception in 2006, with the rate of growth – in terms of both size and performance – accelerating this year on last.
Octagon expects around 7.5% this year, which would be the same as in 2009 and slightly down on 2008’s 8.5%.
The fund’s returns were affected by it having to take reserves against “a couple of transactions” that – mainly because of circumstances beyond the borrowers’ control – proved problematic, Welles says.
One such deal was in Brazil, where banks, themselves in desperate need of liquidity, unilaterally seized working capital deposits belonging to a company Octagon had financed. The banks’ justification was that the company had working capital loans from them that were set to mature in six months, meaning they could net these off against the seized deposits. As a result, the company was unable to pay its staff or suppliers and had to seek protection under local bankruptcy laws.
Ultimately, the commodity finance facility that Octagon had provided to the company was guaranteed by the company’s owner who agreed to pay it off in full with interest over time.
Frustratingly slow restructurings in Ukraine have been the thorn in Tricon’s side this year. The workout of Nadra Bank was particularly so, as complex layers of bureaucracy – including the use of multiple law firms, the bank’s temporary administrators, the National Bank of Ukraine and the ministry of finance – slowed the process.
“When you’re in large syndications for trade finance, and there’s all of the other major trade finance banks in the world participating, you have very little control over your small piece,” he says.
That said, Tricon has been satisfied with the final outcome of those Ukraine restructurings that have already completed. The fund has been “provided with reasonable rates of return over realistic restructuring periods,” Fritz vom Scheidt notes.
EuroFin Asia expects net returns of 5-6% this year – lower than the 6.25% and 8% rates it enjoyed in 2008 and 2007, but a rebound on last year, when because of a conservative allocation of funds, returns were just over 4%.
While figures like those are great during a downturn, the difficulty for trade funds is to sell their slow and steady approach during bull markets, and especially to investors who typically want the impossible mix of no risk and high returns.
Though 6% doesn’t impress investors in a bull market, “when the market goes down the drain, everybody would like to be in a strategy like that because it’s resilient – it doesn’t have negative months – and in our case does not include leverage,” notes Stauffer. “The challenge is to demystify trade finance.”
Trade finance is indeed a poorly understood asset class, and the fact that it is traditionally doled out by banks and that there are still so few trade finance funds to compare with each other means that few investors are aware of the positive “risk versus reward” trade funds can provide, or how to tell the good from the bad, says Crecera’s Prusky.
This is slowly changing though, and Crecera has started receiving more unsolicited calls from investors canvassing about trade finance strategies.
In a post-crisis environment, trade finance funds are also altering the types of clients they are targeting.
For Octagon, distressed companies represent a new opportunity, says Welles. “Good companies with bad capital structures can benefit significantly from new capital that comes in,” and Octagon is positioning itself to fill this void. The financing is used to clean up the firm’s balance sheet and in return Octagon receives high yields plus equity warrants.
Although still focusing on emerging markets, Tricon is increasingly attracted by the yields on paper from G-8 countries and from “near-developed” countries with investment-grade foreign currency ratings. “They won’t float the entire portfolio, but they do definitely provide stable assets to anchor it,” says vom Scheidt.
Bilateral commodities deals – rather than big syndications – are looking more attractive, while the relative resilience of Ukraine’s agriculture sector is also showing potential.
Trade funds are optimistic about the year ahead, despite the many unknowns swirling around the world economy.
“Obviously, the concerns in Europe were a big issue this Spring,” says Prusky, noting that Crecera had recently raised debt financing from European banks. Generally speaking, Crecera feels “very comfortable and are optimistic”.
Investor interest in trade is on the increase and Crecera has recently finalised debt facilities, plus seen new market entrants into facilities it has with the Inter-American Development Bank, Prusky says. “We’re excited about the growth possibilities.”
EuroFin Asia points to new money entering the fund and Stauffer says that “2010 is definitely overall a better year”.
“The tide’s beginning to change right now,” says Octagon’s Welles. “As money starts looking for absolute return strategies that have very little correlation to the major markets, trade finance is an ideal asset class.”
Yet, macro-economic threats still loom over this market, with the threat of deflation remaining a worry for trade funds. In such a scenario, funds would see the value of the collateral they hold decrease at the very time that trade volumes would likely fall amid economic stagnation and increased protectionism. In contrast, inflation could prove a shot in the arm for trade finance.
“There are just very significant consequences for the outcomes, either way, that will profoundly affect trade finance,” Parsons at BlueCrest notes. “We’re definitely in uncharted territory.” GTR