Up until the last quarter of 2008, trade finance funds were one of the hottest new kids on the block. Surging commodity prices created a need for more financing than banks alone could provide and regulations, like Basel II, helped a troop of new funds scoop up risk that banks didn’t want clogging up their balance sheets. Much has changed, writes Helen Castell.
Trade finance has weathered the credit crisis better than many other forms of finance, but the funds that invested in them have faced challenges of their own. A rush of redemptions has proved a headache for managers, while troublesome markets like Ukraine have raised the threat of debt extensions or even default.
While funds are undoubtedly plugging at least part of a gaping trade finance gap, investors have questioned whether the returns compensate them adequately for keeping their cash locked up so long.
However, with some commodity prices starting to rise and most trade finance funds producing at least decent returns, managers could be already through the worst.
Differing nature of funds
There is a huge variety of trade finance funds in what is a relatively small space from an investor perspective, and this can be confusing to them, says Christian Stauffer, managing director at EuroFin Asia in Singapore.
“If you have a fund that does forfaiting for example, and a fund that does primary lending on commodities, both may be categorised as trade finance funds. But the underlying transactions that they’re looking at are so different that it can be hard to explain to investors,” he says.
In contrast with many trade funds, which tend to do business directly with corporates, the BlueCrest Mercantile Fund works only with banks. This means that its assets can be marked to market more easily than those of other funds, which often account on an accrual basis, argues James Parsons, portfolio manager at BlueCrest Capital Management in London.
BlueCrest also takes long and short wholesale trade finance risk from banks and then sells capital market instruments, such as credit default swaps, to hedge that. This strategy allows the fund to take on more risk, Parsons says. Many other trade funds are long only, relying on diversification as a hedge against defaults and losses.
Some trade funds have region-specific remits. Crecera Finance, for example, lends purely to exporters in Argentina, Peru, Uruguay and Brazil, and does not include local receivables. EuroFin Asia has, unsurprisingly, an Asia focus.
Nara Capital is a fund manager, most of whose funds originate in direct lending, including some exposure to trade finance transactions, says partner and co-founder Dominique Grandchamp in Geneva.
In contrast to a number of ‘hybrid’ versions, “we’re probably the only true trade finance fund”, argues Fritz vom Scheidt, managing director at Bermuda-based Tricon Trade Management. There may be other funds that have a “large trade finance component”, but “it is spelled out in our prospectus” that Tricon can only invest in trade finance and cash.
With liquidity tight, credit dried up and origination all but halted, “there are some billions of dollars of underfunded business in trade finance”, vom Scheidt adds.
The ‘pure’ trade finance fund space however is still tiny, with the biggest three or four funds combined boasting less than a billion dollars of assets under management, says EuroFin Asia’s Stauffer.
It is premature therefore to talk of trade finance funds grabbing business from banks, Stauffer adds. “Is that a possibility going forward?” he asks. “I think so.” Progress however will probably be slow.
Lower volumes and higher demand
Although general liquidity has plunged dramatically, there has been an almost equal fall-off in the volumes and prices of underlying trade flows, meaning there are fewer transactions for either banks or funds to finance.
Because of this, BlueCrest is taking on less risk via single, large trade transactions, says Parsons. Where it is seeing growth however is in its provision of capital relief to banks, by taking the first or second loss in a portfolio of trade exposure.
At the same time as the credit crisis has tightened banks’ capital ratios, Basel II has hiked the capital requirements for banks holding trade finance risk on their balance sheet, and many are turning increasingly to trade funds to plug this gap.
“There’s much higher awareness of the Basel II problem for trade finance,” says Parsons. “Since we’re a solution for that, because we provide a first-loss risk transfer that provides regulatory capital relief, we’re seeing more demand.”
Many of the European banks that jumped on the trade finance bandwagon fairly aggressively over the past few years are now packing up their bags, and this means financing from trade funds can be an absolute lifeline, says Robert Klein, president in San Francisco of Crecera.
Most Latin American companies have been unable to persuade banks to renew existing facilities, and only the largest firms have been able to access working capital during the crucial inter-crop season.
Indeed, Crecera was launched during the 2003 Argentine crisis and one of its biggest selling points then was that it could help provide a more stable funding source to exporters as banks pulled credit lines. This is as relevant today as it was then, Klein argues.
Returns for trade finance funds typically range from 40 basis points to 1.1% per month, says Nara Capital’s Grandchamp. But because of the ‘cash drag’ inherent in funds – monthly subscription periods mean that cash is often sitting idle for several weeks – it is not fair to compare this with a straight portfolio of trade deals, he says.
LH – Asian Trade Finance Fund, managed by EuroFin Investments, grew 6% last year, compared with 8% in 2007, mostly due to its purposefully conservative approach combined with almost-zero returns on cash at year-end 2008, says Stauffer.
Crecera was up just over 8% last year, down from 11% the previous year. The fact that it focuses on agricultural sectors, where commodities have not suffered the same price and sales declines as others, has protected the fund somewhat, as has a depreciation in the US dollar, which has benefited many LatAm exporters whose revenues are in dollars and costs in local currencies.
Tricon’s return has been “very constant and stable”, says vom Scheidt. On a risk-adjusted basis, the fund is beating both the emerging market bond index and the LTP trade finance index, he notes, without providing figures.
The liquidity crisis can of course benefit the performance of trade funds, says Crecera’s Klein. “The interest rates that we can charge are much higher than they were 12 months ago. The collateral packages we can obtain are stronger. And loans are shorter term as well – we were typically doing one-year loans previously, and now we’re able to do 60 to 120-day loans.”
“Where we used to live in a world of Libor plus 100 to 300 basis points, we now live in a world of Libor plus 300 to 600 basis points,” adds Tricon’s vom Scheidt. “We can get the same yields as last year, by taking half of the risk of last year.”
Trade finance: a refuge?
Trade finance funds are also “largely uncorrelated” to wider market movements, Tricon’s vom Scheidt argues. “Investors are finding that that is a refuge. They’re also finding that a trade finance fund hasn’t lost money.”
Owing to the relative resilience of trade finance transactions through the past 12 months, “if we could, we would probably have a portfolio which would be very strongly allocated to trade finance, if not only to trade finance”, says Grandchamp.
“Most of the funds we know that are engaged in trade finance didn’t really have a major issue as a result of the crisis,” he adds. “It’s more immune to credit risk and to bankruptcies than other strategies.”
Compared with corporate deals, where “very often there is a residual exposure to the borrower”, trade finance is standardised, liquid and can be sold quickly, “especially if you are ready to apply a discount”. Nara Capital’s Grandchamp says. “And if your collateral is oil or grain, it is much more liquid than say machinery or equipment.”
The problem with trade finance transactions, however, is that deal maturities tend to be long and yields are not high enough to compensate for such illiquidity.
“Because the trade finance markets are semi-efficient, very often it’s a Libor-based pricing,” which has been falling in recent months. Many hedge funds have set floors for their funding – which borrowers currently have no choice but to accept – ut this only partly mitigates the problem, especially when the maturity of transactions is taken into account, Grandchamp argues.
“Say you enter into a trade finance transaction for 1.5 years. At 12% in dollars per year, it’s not that much at the end of the day,” he adds. Investors may prefer instead to buy investment-grade corporate bond with a yield to maturity of 6% or 7%.
“Granted that’s a little bit low, but I can just press the button and sell it every day.”
“It is very hard, especially in our space, to have investors committing capital into locked structures at the moment,” says Grandchamp. “And therefore it is very difficult to sell these transactions.”
Shorter-term factoring and purchase order financing deals are therefore at the more popular end of trade finance for funds right now. Such transactions are “very short-term, well paid and they turn over very fast”, although they are also prone to default and the market is very fragmented, he notes.
One of the biggest constraints to the growth of trade finance funds is that investors still find trade finance “relatively complicated for the kind of return it may offer”, says Stauffer.
“Our biggest challenge is to find the balance between investor expectations and what a market like trade finance can offer,” he says.
Another issue facing funds is managing their own liquidity, and this is even more the case in current conditions as investors queue up to make redemptions.
Although trade finance funds have not been hit as hard as equity or bond funds, increased redemptions mean all fund managers now have to manage their own liquidity further in advance. Tricon for example is now forecasting its own liquidity requirements two quarters in advance, compared with the usual two months.
During smooth market conditions, mutual funds can easily keep their portfolio almost 100% invested, but in volatile conditions, investors are required to meet margin calls and may have to draw out of a fund, vom Scheidt explains. “You’ve got to manage more liquidity to be able to meet redemptions as they come up.”
“As with funds of all strategy types, we have had some investor redemptions, but it’s not drastic for our fund, so we’ve been very thankful,” says Klein. “Investors have certainly differentiated us from other strategies that have not performed so well through the crisis.”
Crecera is in the process of trying to renew its debt facilities and expects to be successful with “some but not all” of its credit lines.
Managing risk would become harder for trade funds if underlying trade took a bigger downturn, says vom Scheidt. “The biggest challenge we face would be managing diversification in asset allocation if the supply of assets were cut in half again.”
With the crisis affecting some countries more than others, some assets are being restructured.
“We’re no different from any other trade finance bank in the world in that we have a small portion of our portfolio in Ukraine,” says Tricon’s vom Scheidt. Although “it’s hard to quantify”, Tricon “probably has less of its portfolio exposed to Ukraine trade finance than a normal EU bank would.”
Much of Tricon’s Ukraine trade finance does not mature until later this year, so will probably have its duration extended in line with the central bank’s recapitalisation programme rather than experience default, vom Scheidt says. Ukraine assets that had a remaining life to maturity of four to eight months will likely be rescheduled to a new average life of around two years, he adds, noting that around 10% of the fund’s portfolio could be affected.
That said, “you can change the maturity of a deal, you can try to find a work-out, but that doesn’t mean it’s not going to go bad”, notes Nara Capital’s Grandchamp. “Deciding to extend it doesn’t prevent you from having a default – it just postpones it.”
Investors should also look out for so-called side-pocketing when comparing the returns of trade finance funds, Grandchamp advises. Side-pocketing allows a fund to push an asset that they think is on the brink of a default outside the fund, meaning it does not have to be reflected in its performance.
“The next year is going to be a good one for trade finance funds such as ours,” predicts Crecera’s Klein. “Obviously each bank or fund has a couple of challenges in its portfolio, just on a company basis, but those are getting worked out.”
“If you’re a preferred creditor, which we are in all our loan facilities, you’re not getting any haircut – your payment period is just being extended, from one to three years,” he adds. “As long as you’re not bogged down with too many restructurings, and you can maintain your capital base, then there’s an excellent opportunity ahead for investors to take advantage of this and earn outsized returns.”
“For trade finance funds, whatever approach they’re taking, I think the future’s pretty bright,” adds BlueCrest’s Parsons.
“There is more investor interest in trade finance now,” he adds. “They’ve seen that the numbers look attractive. And for the funds themselves, spreads are much wider than they were. So the prospects are good.”
However, demand for trade finance will only increase if economic growth returns. “A collapse in world trade is the biggest threat to the trade finance sector. Because then the demand for the product isn’t there. And that could occur due to further economic downturn, or a rise in protectionism.”
Although higher returns will benefit trade funds, until liquidity returns “trade finance is going to struggle just as much as the other markets”, predicts Tricon’s vom Scheidt. “Green shoots or no green shoots, this is going to be a long, painful process.”
“I see a bleak future at the moment for trade finance funds,” says Nara Capital’s Grandchamp. Although current conditions are a “great environment” for underlying trade finance transactions, “everybody wants to get out of this strategy – the whole world wants cash”, he explains. And if the economy and commodity prices worsen, then even the collateral underlying trade deals will start to look shaky.
Within three or four years however, expect a turnaround, and the cycle to begin again. A new guard of ‘wannabe’ trade finance fund managers are already waiting in the wings, ready to open shop and take advantage of a lag between the real economy recovering and banks to start lending again, Grandchamp predicts.