Supply chain finance could turn out to be far more than just a tool for corporates to lower the funding costs of their supplier base. It could also prove to be a useful tool to help investors assess the quality of trade receivables, writes Justin Pugsley.
Investors are gradually discovering the benefits of investing in trade receivables. As an investment class, they have some admirable qualities, which have been highlighted by the recent credit crunch. They’re typically very short-term loans, maybe up to 120 days only, and have proved to be remarkably stable, despite the intense volatility across most financial markets.
“The risk of default is minimal in the short-term,” explains Bob Kramer, vice-president, working capital solutions, with trade services platform provider, PrimeRevenue. “You’re also talking about exposures to big household names in retailing and manufacturing. It’s an ideal risk profile.”
Another attraction is they’re not so affected by changes in interest rates. The capital value of a bond with a long tenor can be quite sensitive to changes in base rates and inflation, both real and anticipated. For an investor just looking for straight returns, the short-term nature of trade finance assets makes them potentially attractive.
James Klatsky, senior managing director of Rosemont Capital Management, a specialist fund that invests in trade finance assets, says that he has never experienced a default yet. That reflects the relatively safe nature of these assets as well as rigorous selection criteria.
Unlike say sub-prime mortgages, which have helped unleash the credit crisis, trade receivables have been experiencing very low default rates. For investors its an opportunity to achieve relatively safe yields, which are higher than similarly rated assets.
There is a sense of security from bundling thousands of credit card or car loans as few defaults shouldn’t spoil the whole investment. Indeed, they’re typically securitised and tranched with the equity and mezzanine slices taking any hits first. They act as a buffer for the investment grade paper.
Pooled trade receivables will be smaller in number, but comprise much larger transactions. It is therefore possible to spend more time analysing individual deals. It is also worth pointing out that the market for consumer finance loans is simply huge and dwarfs that of trade finance. Nonetheless, investing in trade finance assets is a potentially very attractive niche.
The simple life
The growth of supply chain finance may well be about to make life easier for investors, who want to analyse the transactions they invest in.
The virtues of supply chain finance are well known and documented. It delivers greater transparency to the finance side of the supply chain. It also enables better tailored financial solutions and for suppliers to leverage off the often superior credit rating of the buyer. For them that means better terms of finance and for the corporate it’s often an opportunity to extend credit terms.
Generally, it’s the bank that bridges the financing gap between the two parties.
There are suppliers wanting to be paid as soon as possible and buyers wanting to extend terms as far out as they can get away with.
Supply chain finance also changes the dynamics of lending. The focus shifts from funding the buyer and the suppliers separately. Normally, a buyer will have its own funding arrangements with its bank. The suppliers will have a similar set up with their own banks.
However, if funding the supply chain is going to be off the back of the credit rating of the buyer, there’s a high chance the buyer’s bank will effectively be advancing finance to the suppliers.
Suddenly, the volume of business from a single name could rocket for that bank. Also, funding the supply chain off the superior credit rating of the buyer should in theory mean there’s more high quality paper to invest in. That at least should widen the potential pool of investors.
This is all fine unless the company at the top of the supply chain happens to be for example, a Wall-Mart or a Ford. These corporate giants have a very large number of suppliers and huge turnovers to match. At which point a bank could start to get uncomfortable with such a high level of exposure to one corporate.
“That is potentially an issue. Credit committees could get uncomfortable with high levels of exposure to one name. It’s useful to be able to parcel out some of that debt to others,” explains John Ahearn, global head of trade services and financial institutions, with Citi. “When you start talking about SCF you’re really starting to talk about financing a corporate’s trade flows.”
He adds that SCF by making transactions more transparent should be able to create paper marketable to insurance companies and pension funds.
This implies more syndicating of receivables as supply chain finance grows and becomes more and more established. Indeed, this really means more collaboration – an overriding theme in supply chain finance. However, these collaborations often extend to non-traditional players. A case in point is outside parties such as hedge, mutual and even pension funds are getting more interested in trade receivables.
For a bank, which finds itself a little too exposed to a single credit this is potentially great news. It can retain its client’s business, while farming out a portion of its loans to investors. And highly specialised funds have been gradually making an appearance with the object of investing in trade receivables.
These funds are also ideal partners in that they are regulated differently to banks and have different criteria when selecting paper to buy.
“We focus mainly on emerging market trade receivables,” explains Fritz Vom Scheidt, managing director of Tricon Trade Management. “We use various analytical tools to analyse transactions before we invest in them.”
He adds that investing in emerging market trade receivables is not as risky as it might first appear. However, they can produce returns of 200-300 basis points over Libor. Given their short duration of up to 120 days or one to two years for bilateral loans and structured transactions, this is a very attractive return. It can beat emerging market bond returns.
“We ran some default models on this and concluded that should something like an Asian style crisis occurred, these countries are unlikely to default on the payment of imports for items such as food.”
Indeed, during the last Asian crisis many of these countries did continue to perform on trade finance. With emerging market countries generally heavily reliant on international trade, they’re likely to pull out all the stops to keep it going, even in times of crisis. This should give investors considerable comfort.
The other factor is that Tricon invests across a wide range of trade receivables to mitigate risk. Tricon currently has around US$200mn under management in a hybrid shariah-compliant fund. This has been bought into by investors from Saudi Arabia and the United Arab Emirates. However, it is looking to raise US$200mn-300mn for another fund dedicated to investing in trade receivables.
Vom Scheidt adds that the transparency offered by supply chain finance should in theory help with evaluating loans. However, he says he is yet to have seen any such paper in the market.
Rosemont Capital’s fund is also geared towards emerging market trade receivables. The focus of this fund is to look more at liquidity rather than just high yields.
Both funds buy trade receivables directly and do not invest in bonds backed by trade receivables.
However, remaining 90-100% invested at all times can be hard work for the manager. Vom Scheidt reckons there’s a 50% turnover in the fund’s assets every year. That’s far higher than would be seen with for example an emerging market bond fund. As trade receivables mature and become cash again, replacement investments have to be found.
But with relatively few funds in the market, finding assets shouldn’t be too difficult. Also, the credit crunch may have created a bit more of a buyer’s market. Many banks are preferring to hoard cash at the moment.
There are other funds which also specialise in investing in trade finance assets. They include IIG Capital and Eden Rock Capital Management. Each has its own investment style, approach and benchmarks.
However, some banks may prefer to hang on to more of their trade receivables. “Firstly, the returns on trade receivables can be attractive and secondly we work hard to get the business that generates them,” explains Bruce Proctor, senior vice-president, global trade services head with JPMorganChase.
He adds that sometimes clients, especially if they’re smaller corporates, might not understand why their bank is selling off paper. “They might interpret that as the bank not trusting the quality of their paper,” he states.
Even for banks happy to park trade-related paper on their books, help is potentially at hand from third party specialist funds. One such hedge fund specialises in credit default swaps (CDS).
“Simply taking out a CDS can work out cheaper and easier than securitising the loan and selling it off,” explains a hedge fund manager who asked to remain anonymous. “By using CDS a bank can increase the credit rating of their trade portfolio and benefit from the capital adequacy framework set out in the Basel II regulations.”
In effect, the hedge fund can offer to guarantee losses, equivalent to say 10% of the pool of the assets. This acts as a buffer to the remaining 90%, which can be sliced into tranches with different credit grades. The hedge fund is effectively acting as an insurance provider.
He adds that there’s the equivalent of about US$10bn in trade finance risk asset value currently available from hedge funds. “It’s a quick and efficient way for banks to transfer risk and CDS are a flexible solution,” he explains. Also, with trade documentation being well standardised, it makes structuring transactions easier.
Indeed, CDS may grow in popularity quite quickly. The recent credit crunch has made investors temporarily weary of securitisations.
“The concept of securitisation is still sound and remains proven,” explains Averina Miller, senior vice-president, with supply chain finance specialist Demica. “We have seen a drop off in the number of securitisations; liquidity has dried up for the time being.” Even some hedge funds are reported to have stayed away. This is possibly because of some of the high profile problems with hedge funds investing in securitised bonds backed by sub-prime mortgages. It is however an unfair comparison. Trade finance is a very different type of asset to residential mortgages.
However, once the credit crisis passes and margins come back down, securitisation of all kinds of assets is likely to pick up again. Also, with the Federal Reserve cutting interest rates the hunt could once again be on for yields. For investors with a disposition towards fixed income or cash type assets, trade receivables should be an attractive alternative.
And there are many potential sources of funding. There’s proprietary funds from banks, pension funds, private investors and possibly the most exciting category of all – sovereign wealth funds.
Investing in trade receivables may turn out to be a very attractive proposition for some of the Gulf funds. As a spokesman for the Dubai International Financial Centre (DIFC) explains, investors in the Gulf like to invest in real things. Trade and its financing is certainly an area that is well understood in that part of the world.
These funds are less likely to invest directly in trade receivables – most would prefer to invest in a specialised fund that has the expertise. Alternatively, they can buy loans securitised against pools of trade receivables.
The market is still a long way off from seeing a torrent of trade receivables spun out of supply chain finance programmes. Many banks are still figuring out how best to implement it.
Also, many corporates are yet to convince their suppliers to sign up to their funding programmes. But, as supply chain finance grows it seems logical to assume that there will be a greater need to syndicate loans to third parties – whether they be traditional financial institutions or to other types of investors.
In the meantime, it is also very much a case of educating potential investors to the merits and attractions of trade receivables as an asset class.