While their contribution to trade finance remains tiny compared with that of traditional banks, trade finance funds are an increasingly critical provider of liquidity, especially for the smaller producers and traders that are essential to global supply chains but which big banks no longer have appetite for.
Helen Castell, Senior Reporter
28 September 2017
The past two years have seen new fund managers enter the trade finance space, and many incumbents have also launched new funds or swelled existing vehicles to a size that is starting to attract the attention of bigger investors. Although obstacles remain – not least the issue of how to standardise trade finance assets to the degree that institutional investors demand – fund managers are confident that their seat at the trade finance table is now secure.
At a time when demand for trade finance remains high but traditional banks are in risk-off mode, many mid-tier commodity traders and processors are struggling to access liquidity. “Funds like ourselves and other players in the alternative finance space are coming to the fore to fill that gap,” says Jean Craven, director at Barak Fund Management.
Demand for mezzanine-type structured transactions that act as bridge finance while borrowers wait for equity or other injections is growing particularly fast, he says.
With a couple of managers now having passed the “glass ceiling mark” of $1 billion under management, commodity trade finance funds are finally building “cadence and momentum,” says Kristofer Tremaine, chief investment officer at Kimura Capital, which started lending last year.
Kimura’s book comprises mostly working capital and collateral funding but Tremaine says it is able to participate in any trade finance debt structure. “To quote Bruce Lee, the asset manager in commodity trade finance needs to be like water,” he says. “You need to be able to fit in any size of container but have the ability to cut through rock.”
EFA’s LH Asian Fund and EFA Dynamic Trade Finance fund combined have assets under management of around $800 million “with quite a robust pipeline of capital coming in until the end of the year,” says its head of strategic development, Gerry Afentakis.
Trade finance’s relative lack of correlation with the performance of the wider economy means returns “continue to be relatively consistent,” he notes.
Smaller managers are also expanding fast. Scipion Capital, for example, has more than doubled its assets under management since the end of 2015 to just shy of $150 million, according to chief investment officer Nicolas Clavel.
Most trade finance funds have carved a niche based on their expertise, so specialise in specific geographies, commodities or structures, albeit with room for manoeuvre, he notes. While Scipion focuses on unleveraged returns and Africa in general, Clavel sees an increasing number of opportunities in East and southern Africa and in mining and energy.
As commodity trade finance funds gain in experience, some are looking to test their boundaries and extend their offering into longer-dated finance and different lending structures or vehicles.
While IIG focuses mostly on Latin America, it has broadened its geographic remit with the launch this spring of the IIG Global Trade Finance Fund, followed in May by the IIG Structured Trade Finance Fund. The open-ended funds have a target size of $300 million to $400 million, respectively.
The funds see IIG partner for the first time with smaller commodity traders that may not have the same access to credit as the so-called ABCDs but which still generate high turnover. It lends to them on a profit-sharing basis, making it essential that IIG fully understands their trading flows and has the power to control risks and monies along them, says managing partner David Hu.
Although traders are perceived to be higher risk than commodity producers, their knowhow and access to certain markets gives them a competitive advantage that IIG wanted exposure to as it diversifies, says Hu. He expects the funds to generate double-digit transactional returns, offering investors mid-high single-digit returns.
Scipion this year extended its offering beyond short-term trade finance into providing two- or three-year tenor loans, typically to fund the purchase of mining or agricultural machinery that allows the borrower to increase its production.
Being able to do this can help it win short-term trade finance business from the same client, Clavel says. And because the borrower’s short-term trade flows go towards repaying the machinery loan, the structure is effectively self-liquidating.
This type of loan does not go into Scipion’s main fund though and appeals to a different type of investor – usually private equity or other funds.
Kimura this month kicked off the initial offer period for what will be its first closed-ended commodity trade finance fund. It aims to raise an initial $500 million and to start lending by April 2018, offering pre-export or supply chain loans with a tenor of up to five years.
Closed-ended funds are attractive to some investors, while offering generally bigger-ticket pre-export loans will allow Kimura to raise assets more aggressively, Tremaine says.
EFA launched in July the EFA SME Trade Finance Fund, a supply chain finance (SCF) and receivables fund offering 30- to 180-day loans to Asia-based SMEs. It aims to deploy about $45 million this year, with transaction sizes ranging from $250,000 to $5 million.
The launch marks a departure from EFA’s historic focus on commodity trade finance funds and follows a recent expansion into asset-based finance.
The fund will target net annual returns of 7% to 8%, which is higher than those for EFA’s traditional trade finance funds, Afentakis notes.
The poor state of infrastructure in many countries has created fresh lending opportunities for trade finance funds, says Hu. For example, in a bid to avoid paying demurrage charges for vessels queuing to enter increasingly congested ports, some traders have started paying small barge owners to unload commodities from carriers and transport them to buyers.
IIG has been approached to provide transactional finance to one such barge owner but, while it admired the innovation, found the opportunity too high risk.
Demand is slowly returning from the energy sector as producers readjust to the low oil price environment, says Craven at Barak, which early this year contributed to a big-ticket syndication for Glencore. Barak has also seen a “big uptick” in demand from miners, particularly of base metals.
“Enormous” demand from borrowers is pushing pricing up, says Tremaine. In the two years between Kimura’s founders deciding to launch a commodity trade finance fund and starting to lend, returns on such vehicles expanded up to two percentage points in the industrial sectors. “That’s a good indication of the tightness of credit down the credit stack in terms of counterparty ratings,” he says.
One advantage that funds offer borrowers over banks is the speed with which they can lend. Kimura’s lead time between seeing a deal and disbursing funds for example is typically under two months.
The process could be even faster however were it not for the bespoke legal work often associated with lending to smaller counterparties, he adds.
Clavel at Scipion has a slightly different take on the market. While demand for trade finance is perennially strong in South Africa, the improving risk profile of many borrowers there mean funds now have to compete on price for solid opportunities, he notes.
He also sees “fewer deals around now than three years ago” as lower commodity prices reduce the ticket size of trade deals and mean that some simply do not take place as the cost of transporting heavy or bulky goods long distances is less easily absorbed.
Demand is however cyclical and macro factors, such as the tightening of monetary policy in individual countries, triggers shifts in where lending opportunities arise, Clavel notes. Commercial lending rate caps in Kenya, for example, have reduced local banks’ appetite for lending, creating opportunities for funds.
At the same time, as investors become more comfortable with trade finance as an asset class, the pool of money available to funds is growing.
Funds’ ability to gain a granular knowledge of underlying transactions gives investors comfort. And because most secure their lending against an asset on which they can create a daily mark-to-market value, investors have transparency in terms of exposure that banks lending into syndications for revolving credit facilities rarely enjoy, notes Kimura’s Tremaine.
Trade finance funds also typically perform very well, reflecting the “stability” of commodity trade finance as an asset, he adds. “It’s very unusual to find a manager posting even a negative month, other than right at the very start of the launch of the strategy.”
That said, some investors continue to shrink from exposures in emerging markets because of concerns about their legal position should a deal go sour, he notes.
“We’ve seen a lot of liquidity on the investor side,” especially in the past six months, says Craven. “I think it’s a sign that people are still chasing yield out there in this low-yield environment.”
The fact that Barak’s assets under management now exceed $500 million has also put it “on a different radar” to smaller funds that struggle to pull in institutional investor cash, he says.
In Q2 alone, Barak attracted investments from three sovereign wealth funds, all with “massive tickets,” Craven notes. “We’ve actually had to hold back on a bit of investment because we’re just flooded with liquidity,” which is “obviously a good problem to have.”
Institutional investors’ interest in trade finance has increased in recent years in synch with a wider trend of investing in private credit funds as tighter regulations force banks to retreat from lending, says Hu.
Many institutional investors however require a fund to have at least five years’ track record before they will invest, notes Tremaine. For this reason, Kimura’s investor base is still made up purely of high net worth individuals, family offices and fund of funds.
One way of getting around this is by developing an insurance-wrapped product – a solution that Kimura, along with many of its peers, is exploring, says Tremaine.
Understanding of trade finance as an investable asset class may be improving, but a lack of standardisation remains an obstacle for many institutional investors, fund managers say.
Trade finance was historically “a niche investment class that investors didn’t really understand, or it was so new that they didn’t feel immediately comfortable with it,” says Afentakis. Awareness has improved over the past three to five years however as funds invest in educating investors and as more players enter the market.
A wider “explosion of interest” in direct lending has also benefited funds like EFA, he says.
When IIG started in 2000, investors “had a very notional understanding of trade” and “didn’t really understand the nitty gritty details and the risks involved,” says Hu. As more sophisticated, institutional-type investors enter the market, this is slowly changing.
However, in contrast to markets like commercial real estate, student loans or credit card receivables, which benefit from standardised documentation and can be readily packaged and securitised, doing the same with trade finance is difficult and banks’ efforts in this direction have met with little success, he notes.
The lack of a “common denominator” with trade finance therefore makes it difficult to expand trade finance assets to a size that will attract big-name institutional investors with huge amounts of capital to deploy.
And even if trade finance assets could be easily standardised, the returns they generate would likely struggle to compete with those of bespoke trade finance structures where the nuances of a business and its risks are understood and factored in, Hu adds.
IIG successfully launched in late 2013 a $220 million collateralised loan obligation (CLO) based on trade finance assets but on being paid down it was not reissued – and to Hu’s knowledge no other non-bank has yet followed suit. Indeed, only a handful of banks have launched trade finance CLOs and the vast majority of these have not been refinanced or reissued.
Cooperation and competition
The small number of players active in the trade finance fund space means that most work alongside each other regularly, co-funding deals or selling participation to other players, and have a shared interest in promoting trade as an investable asset class.
“A rising tide lifts all ships” and managers are aware of this in their dealings with each other, says Tremaine. “It’s a refreshing space to be working in.”
EFA views other funds as peers rather than competitors and speaks to most on a regular basis, says Afentakis. “We’re happy for all of the strong trade finance funds in the marketplace because they raise the profile of the asset class, which ultimately benefits everybody.”
Many managers say they would like to develop a similarly collaborative relationship with commercial banks, despite them being competitors. The withdrawal of stalwarts like Standard Chartered and Barclays ABSA from the commodity trade finance space will increasingly create an opening for funds like Scipion, says Clavel. And as the administrative burden of anti-money-laundering and other regulatory requirements persuade more big correspondent banks to cut ties with local banks, this creates a potential new customer base for the fund.
Unlike many banks however, funds like Scipion focus on financing trade flows that are not secured on land or real estate. “So, in a certain way, it’s not competition – there is space for both,” he notes.
The shrinking of correspondent banking networks from US money centre banks has created an indirect opportunity for alternative lenders like IIG as local banks become less able to issue letters of credit and other trade finance instruments, says Hu.
The fund’s real competitive advantage against banks is however the value-added aspects of its structured transactions. “Companies feel that we’re not just financing a piece of their supply chain and exports – we’re trying to do as much as possible of the whole chain.”
Bigger players like Barak are increasingly working alongside banks on larger transactions, for example taking the first loss chunk of a deal. Funds are less regulated than banks, which are subject to more stringent return on capital requirements, Craven notes.
Banks must do more
Kimura would like to see more of this kind of cooperation, with banks and funds “circling the wagon” together. The existence of funds allows banks to maintain relationships with clients to which they are keen to offer foreign exchange or debt capital markets products but not trade finance, but too many banks continue to treat trade finance funds like a poor relation, says Tremaine.
“We want to see them beginning to take more initiative in engaging with us, because I am fearful of the shortfall of liquidity for the market generally,” he adds. “We all have a responsibility to ensure it is still there.”
As Basel IV threatens to trigger an even bigger pull-back by banks, the long-term health of the commodity market relies on funds being able to grow their share of the trade finance market to between 15% and 20%, from just 3-4% now, argues Tremaine.
Without more support from banks, or new entrants to the trade finance fund space, any surge in commodity prices over the next two or three years could trigger a serious liquidity crisis for smaller non-investment grade traders and producers, he warns.