Trade finance funds looking to attract capital from big-ticket institutional investors must provide more clarity about their strategies and where they sit within the broad world of private credit, according to panellists at a recent event hosted by Kimura Capital.
Helen Castell, Senior Reporter
05 December 2017
The key challenge in attracting large, sustainable investments to trade finance funds is one of definition, said Daniel Page, head of asset management advisory at KPMG Ireland. While there is “real appetite” for trade finance assets among the investors Page speaks with globally, a lack of clarity about the structure of trade finance funds, issues like post-transaction risk control and recovery, and how to perform due diligence holds many back.
As with any emerging asset class, it will take time for the asset allocation community to get comfortable with trade finance’s risk profile, he said. “That’s the journey the asset class is on.” However, “I think we will certainly see that tide turn very significantly at some point.
Trade finance has “indisputably investment-grade characteristics,” said Patrick Stutz, chief investment officer at Bayshore Capital. “We think it’s very, very attractive.”
Unlike some other segments of the private credit market, trade finance has a performance history that can be tracked through the last recession, he noted. And the figures are good. One early market entrant for example did not experience a single down month throughout the 2008 financial crisis.
That said, will trade finance face a redemption shock in the future? Over a cycle, “almost certainly,” said Page, although the cause may be macroeconomic in nature rather than specific to trade.
The industry as a whole has not experienced any major redemptions since inception. This raises the question of how well prepared it would be if this changed – and how funds can reassure investors that their interests would be met, agreed Kristofer Tremaine, founder and CIO at Kimura Capital.
“Is the current structure of a trade finance book able to give true investor liquidity through one of these cycles?” he asked. “If you’re offering your investors 90- or 100-day liquidity, are you able to grant them a true exit on the basis of the terms you are offering?”
Fund managers should be careful not to create a fund that is considerably more liquid than the assets inside it, Stutz cautioned. Not only does this create an “inherent liquidity mismatch”, but it makes the fund more vulnerable to runs in a crisis, when investors often dump even well-performing assets if they are liquid.
To avoid becoming a casualty of any future crisis, funds should therefore seek to draw in a mix of long- and short-term capital, he advised.
Having in place a so-called gate provision – which limits the amount of withdrawals allowed from a fund during a redemption period – is a big deterrent for some investors. It is however a good way of protecting remaining investors from any that run for the doors, he added.
“A gate, deployed in the right way, is better for everybody,” agreed Page.
The question of liquidity is once again one of definition, he added. What should matter to investors is how they expect the fund manager to perform.
“Has the manager constructed their constitutional documents, their risk framework? Is their portfolio really expressing what they say they’re going to do, to deliver the liquidity that they have promised you as an investor?”
Dealing with defaults
Trade finance fund managers face risk in both directions, noted financial crime, legal and compliance consultant Alexander Brennan.
Conducting due diligence and know your customer (KYC) checks on investors in some Asian markets can be difficult because of a lack of available information. On transactions too, while bill of ladings and certificates of origin provide comfort, “you don’t see that from a fund level,” he noted. “So you have to mitigate that risk from the fund level down, which is tricky because of your inherent reliance on those conducting the actual trade finance deals.”
While default rates in trade finance funds are low compared with SME or mid-market lending – less than 1% versus around 4% there is also a need for more clarity on how funds deal with defaults, and even how defaults are defined, noted Tremaine.
“Defaulted loans, as infrequent as they are, can be incredibly time consuming and problematic for the manager,” he said.
And while SME mid-market loans are defined as being in default after 30 days, there has been no drive to establish a standard in trade finance. “There’s no real ruling on what constitutes a default scenario in trade finance in terms of how far over the payment terms are they.”
Creating an industry body to govern the industry and devise a formal framework for defaults has been discussed for years, but little progress has been made, noted Brennan. Everyone therefore has different interpretations of default, depending on the risk and the value of a loan. Recovery is a bigger issue and the amount of time spent on that must be factored into underlying risk from the start, he argued.
The bespoke nature of trade finance extends to defaults, so how they are handled should be governed by why they occurred, what has happened to the asset and whether it can be reclaimed, argued Alan Gordon, partner at Kimura Capital.
For example, if an asset has been stolen or vanished, “it becomes an insurance job.” If a client has gone bust and the asset has been sold on, it may be reclaimable. The industry should therefore categorise defaults into ten or so different scenarios and devise a standard way of dealing with each, he argued.
The smaller the number of parties involved in a default, the easier it is to resolve, added Stutz. Compared with bonds, where 40 people may be at the table, in private debt there are often just two. In strategies Bayshore has invested in, defaults can sometimes be positive from a recovery perspective, for example allowing the lender to negotiate more equity in a business. “It’s about being smart in structuring and then turning defaults to your advantage,” he said.