A short while ago the handful of active trade finance funds were a novelty. Fast forward five years: their numbers have reached double digits – and they are underwriting deals that banks will not or cannot, writes Erika Morphy.

Nara Capital in Geneva is among the small but growing cadre of investors that are seeking exposure to trade finance paper and transactions via a fund. A fund of funds itself, in theory Nara’s approach to the market is by definition much wider that those funds that are originating loans or trading paper on the secondary market: in short its investment guidelines allow it to buy anywhere along the spectrum of trade finance transactions, from working capital to pre-export finance to structured finance to purchase order financing.

In reality though, until recently Nara Capital was limited to a small slice of the trade finance universe. That is because when co-founders Dominique Grandchamp and Louis Zanolin launched Nara several years ago there were at best only a handful of funds dedicated or even focused on trade finance. And of these funds, even fewer delivered the 10%-12% returns Nara requires.

Fast forward five years: the duo has a large and growing menu of funds from which to choose. The two traders say it is difficult to pin down exactly how many trade finance hedge funds are now active – but that number could range between 30 to 45.

“We know many of them – but not all,” Zanolin says. “And new ones are opening their doors as we speak. We learn about a new fund every month.”

And unlike the earlier generation of funds that adhered to rigid credit or investment strategies, these newer funds are carving out different areas of expertise, Zanolin says. “It can be a geographical play or a bias towards a certain asset class, such as pre-export finance,” he says. “Some buy transactions from banks; some only do onshore factoring.”

Currently, Nara has a position in a fund that invests in US or UK-originated factoring transactions. “That is where we perceive the least amount of risk and the highest returns are at the moment, especially in the current economical environment,” Zanolin says.

However, he and Grandchamp fully expect to be investing in funds that allocate investment in pre-export finance transactions and project finance in the near future.

The next generation

Many of the same drivers that launched the first generation of funds, typified by International Investment Group”s Trade Opportunities Fund, for example, are behind the growth in this latest generation. Skyrocketing commodity prices and Basel II regulations that are remaking how banks conduct business seem to be perennial factors.

For instance, Grandchamp says, Latin America is the source of many of the new funds coming to market. That is because corporates in emerging markets such as Brazil are finding it ever more difficult to finance commodity production and export, thanks to rising prices and the inefficiency of the banking sector. Exporters continue to kick in their traditional levels of equity, but as prices rise they need another source of capital to fund the rest of the equity stack.

At the same time recent global macro economic trends have heightened interest in these funds. Institutional investors have wearied of being whipsawed by fluctuating stock markets, real estate and fixed income valuations. They are seeing stability, and non-correlated returns. Trade finance funds, Zanolin says, deliver both.

Most trade finance hedge funds return 8-10-12% a year. These relatively lacklustre numbers have kept investor interest in the funds to a minimum over the last few years, now, though, a 10% return, especially if it is accompanied by low volatility, looks quite good.

Indeed that range of return is what most of these funds promise to deliver. The route they take to get to that end goal, though, varies almost as much as the number of funds that are active in the market.

Middle market play

For instance, when executives at Crecera Finance Company were researching the trade finance market in 2003 they realised that there were a couple of avenues they could take to get to 10-12% net returns.

Financing transactions and companies that were riskier than the company’s comfort level was one option – but quickly discarded, says Robert Klein, president of Crecera.

Instead, it decided to focus on the middle market where coverage from banks was, at the time, limited to only the highest-grade corporates, if that.

Even that strategy would not get the company to the yields it wanted to deliver, so it secured credit lines from multilateral institutions such as FMO and the Inter-American Development Bank (IADB), and then levered that capital further. It was a new endeavour for FMO and IADB, Klein says, which meant a lengthy time to market. Some 15 months later, though, the fund launched. The firm then secured an investment grade rating for its structured debt, which allowed it to raise additional debt capital from five commercial banks.

Besides its middle market orientation, Crecera distinguishes itself as a long-term source of funds to its borrowers. “We can continue to finance companies when their banks are forced to cut credit lines,” Klein says.

EuroFin Asia Group is another example of a company scouring for opportunities in the middle market. Launched as an independent trade and commodity finance arranger in 2003, it supports middle segment producers and merchant of raw materials and commodities. The rationale for setting up the LH Asian Trade Finance Fund in 2006 was partly to capture recurring income as opposed to one-time fee income derived from the arranger activity, but mostly to participate in the transactions originated and structured instead of selling the entire portion to the banks. Francois Dotta, the Singaporean-based director of EuroFin Asia Group which manages the LH Asian Trade Finance Fund, explains: “The middle segment market in Asia Pacific was and is still not covered in a timely and efficient manner by the specialised banks active in the region,” he says. “We saw an opportunity to cater to the needs of those growing companies by providing time to market and flexibility.” Since its launch, regional commodity players have become aware of the fund as an alternative source of financing, he says.

A focus on distribution

Increasingly trade finance funds, both new entrants and established players, are incorporating distribution strategies into their investment approach. Of course some funds, like Tricon Trade Management, have been pure distribution plays since its inception.

Fritz vom Scheidt, a Toronto-based managing director of Tricon, for instance, explains that as a rule the fund never did any origination. “But we are often included by originators with whom we deal on a regular basis into a club of players when they are developing a transaction within an emerging market that meets our investment criteria.”

Tricon’s typical investment strategy, rather, is to buy trade finance paper on the secondary market. “It is not uncommon for people who are originating paper to offer it to us prior to origination. We started as a buyer in the secondary market and have advanced to a syndicate participant in a great many deals, but, within our current structure, you would not see us as a bookrunner.”

The portfolio, which vom Scheidt sizes to be roughly US$250mn, is invested almost completely in emerging market trade finance paper. “We run a long only portfolio with buy and hold strategy that is based on seeking and acquiring alpha at the time we buy the paper,” he says.

Crecera, by contrast, has not traded much in the secondary market since its inception. However that is about to change now that the company has brought on board Diana Bustamante, as head of distribution. Bustamante was previously director of distribution at Rosemount Capital, and has held positions at many trade finance banks including ABN Amro.

Unlike some funds that trade on the secondary markets, Crecera doesn’t want to flip the paper it holds on its books merely to eek out additional yield. Rather it wants to be able to accommodate clients that are asking larger credit lines than Crecera can currently give by arranging quasi-club or syndicated deals.

Then there are funds like BlueCrest Mercantile, whose raison d’être is to service trade finance banks’ own distribution needs.

Launched in November 2006, BlueCrest is a market neutral structured credit fund that has approximately US$2bn nominal of risk assets on its books. Unlike most of its competitor hedge funds, BlueCrest deals only with or through banks, which sell paper to the fund either to transfer risk off of their own balance sheets or to get capital relief, an ever-present issue in the Basel II era and one that James Parsons, portfolio manager of the fund, says will likely fuel a number of transactions in the second half of this year as banks begin to reconcile their books to the standard. The fund takes first loss on the assets and is willing to buy just about any type of trade-related paper, from letters of credit confirmation to commodity finance to plain vanilla pre-export finance.

For example, BlueCrest took risk of some US$250mn of the multibillion dollar pre-export facilities that has been arranged for Russian and CIS energy and metals corporates at the beginning of the year.

BlueCrest does not take title to the transactions, those remain with the bank. In fact, Parsons says, “we don’t want the title or to have our role even disclosed to borrowers or obligors.”

The reason is twofold: the fund doesn’t have the operational infrastructure to take title and would have to outsource its management to a custody bank. And frankly, he adds, the fund doesn’t want borrowers contacting it. “We are not a lender.” There is also a theory that borrowers are more likely to default if they are aware their paper has been moved off of their relationship bank’s balance sheet, he adds. “No one really knows to what extent that is the case, but we don’t want to test the theory.”

As a long-short fund that tends not to sell off its own risk into the secondary markets, there are a variety of hedging instruments BlueCrest uses to maintain equilibrium. To use a simple example, if it finds itself holding exposure to Rosneft, it would manage its Russian country risk by buying Russian sovereign credit default swaps.

Such strategies don’t have a precise correlation to the assets in question, of course, and returns can be volatile as a result. “We are a mark-to-market fund – every day there is a movement in our net asset value.”

Deals can be either single names or portfolio transactions that a bank sold off for capital relief, in which case the fund has likely taken first loss. These transactions tend to reside in the credit range of B to BBB – that spot on the credit spectrum, of course, where a majority banks want to offload their risk. The fund doesn’t go much below that range because banks do not.

Financing deals

The majority of funds on the market, however, focus on originating deals.

Based in New York, Octagon is a long-standing trade finance fund manager. Its flagship fund, Octave-1, launched in 1999, closed to new investors last year. The firm then introduced Octave Trade, which is dedicated to structured trade and commodity finance.

Octave Trade, like its older sibling, offers end-to-end financing to exporters in emerging markets. “Our goal is to provide a trade finance solution while the goods are in the warehouse of the country of origin and then continue to finance the goods all the way through the supply chain,” says C Mead Welles, founder and CEO of Octagon Asset Management. Octagon can underwrite a transaction whether it moves by barge, truck or rail, he continues, using the receivable from the buyer as the mechanism for its repayment.

The credit environment of the last year has increased demand for such structured financing, Welles says. “The credit markets, coupled with high commodity prices and high freight costs, has meant that the average exporter needs almost twice the amount of financing to do the same amount of business.”

Octagon finances deals that range from US$2.5mn to US$45mn, although it tries to stay in the US$2mn to $15mn range. Last year, Welles says, it had approximately US$100mn invested for both funds. Its goal is to get absolute returns of between 10% to 12%, net of fees.

Another example is Rosemount Capital Management in New York, which launched three years ago by a team of industry professionals including veteran Bruce Fields and continues to be an active player in this space.

In many ways Rosemount’s portfolio is similar to that of a typical trade finance bank, with a heavy emphasis on South America and Eastern Europe. In Eastern Europe, Fields says, the fund is primarily lending to financial institutions. In South America, though, it is actively participating in deals, particularly structured soft commodities in Brazil.

In May, for example, the fund closed a US$25mn loan for the Brazilian poultry exporter Diplomata, the third deal for the corporate. “We have brought this company to the international market, first by lending to them on a bilateral basis,” Fields says. Last year Rosemount led a syndication for the firm and then another in April. Both transactions took various forms of security locally, with repayment made offshore via the receivables.

Rosemount is also providing financing through syndicated and bilateral loans in Brazil, Peru, Russia, Ukraine, Azerbaijan and Georgia, amongst others, he adds. Rosemount may also buy paper in the secondary markets as part of its investment strategy, although its preference is to directly originate deals. “We will do deals in the secondary market if we think they will give a good return, we both sell and buy transactions from the market, we are not a one way fund,” Fields says.

The LH Asian Trade Finance Fund, for its part, is mostly invested in base metals, steel, wood products, coal and very selective soft commodities, Dotta explains. For instance, he says, the fund recently provided a Singapore-based rubber merchant a US$5mn revolving trade credit facility. It will disburse the loan directly to the suppliers upon reception of complete set of documents; within 45 days the loan self liquidated from proceeds of the sales. Until that point, the fund held title documents as control on its collateral.

In another example, the fund provided a one-year US$10mn facility to a Hong Kong-based metals trading company. Proceeds of that loan will be used to purchase lead ingots from a first class Chinese smelter and delivered under an offtake agreement with a Taiwan lead-alloy manufacturing group. Together with assignments of contracts, the facility is secured by contract frustration insurance.

The loans the fund makes are transactionally secured, meaning that the goods have been pre-sold by the trader or producer before being financed. “We make sure we have the first security interest on the goods, either through the bill of lading or through a third party warehouse service,” Dotta says.

Credit market woes

One common denominator among these funds is that they have successfully leveraged the opportunities that have arisen from the credit crunch of the last year. In some cases, that has meant buying investment grade paper at a discount on the secondary markets. In other scenarios, it has meant underwriting an investment grade loan at premium rates because the banking market has dried up for that company or sector. “This is really a terrific time to be doing what we are doing,” Octagon’s Welles says.

For instance, Rosemount recently closed a new US$25mn transaction for the Brazilian soya cooperative Carol, which is also a repeat deal for the fund. “This is the second syndicated loan for the cooperative that we have done,” Fields says. There have been some well publicised issues with other soya companies in the market, but that has not dissuaded the fund from investing again with Carol, he adds. “There are some good companies in the sector that have navigated choppy waters very skillfully.”

None of these funds views themselves, though, as competitors to trade finance banks. More than likely, the banks are not concerned about the emergence, and more recent rapid growth, of these funds either.

Crecera’s Klein says it is not a competitive threat to banks even when it is invested in the same company. “Our capital is viewed differently by the borrower, it sees us as a more flexible source of funds and because we are the owner-operator, we are much more transparent in the approval process.”

Echoing Klein, Dotta says his fund is not a competitor to the banking industry. “Our contribution is primarily related to the size of the transactions financed, the flexibility and the timing to fund an operation.”

Even, or rather especially, BlueCrest Mercantile, with its role of providing balance sheet relief and risk overlay to banks, has found the environment of the last year much to its liking.

Indeed, Parsons couldn’t have known it at the time but when BlueCrest Mercantile launched in November 2006, the market was poised to change – for the better from the fund’s perspective, at least. “True value then was difficult to find because spreads were low.”

With the liquidity crisis still gripping the markets: “there is much more demand to lay off risk and spreads are wider – or rather, spreads have normalised.” In the month of June, for example, the fund transacted some US$200mn-worth of deals.

The pricing BlueCrest offers for these deals, though, are not likely to reflect what can be found in the market, Parsons says. Because of its hedging strategies and other internal processes, “we can price from a completely different perspective.”

Which is the point after all, pricing that doesn’t move in tandem with the primary market is what banks want as they shuffle off unwanted risk. Like its fund counterparts, BlueCrest is filling a gap in the trade finance market.