Chenavari, one of The Hedge Fund Journal’s ‘Europe 50’ managers, is one of the most astute and eclectic credit managers in Europe. As of 30 November, it manages assets of USD 5.2 billion, including a seasoned multi-strategy credit hedge fund that has a proven ability to navigate the peaks and troughs of the market. Its vehicles include a liquid alternative credit UCITS strategy, on the Lyxor platform, that was among the top performers in 2017, and has continued to profit amid weaker credit markets in 2018. It also has two London Stock Exchange listed funds and CLOs. Expertise spans distressed debt, risk retention and risk transfer transactions involving regulatory capital. As one of the first credit hedge funds that expanded in the private credit space in 2011, the manager also runs USD 2.2 billion in a growing spectrum of illiquid credit strategies that encompass a wide range of European private credit investments: consumer finance, specialty finance, direct lending, real estate lending, and trade finance.
We have used our team and firm networks to scan the whole opportunity set, to identify a segment in the market where we can use short-term finance to plug liquidity gaps faced by larger companies.
Laurent Quelin, Senior Portfolio Manager
In this article, we focus on trade finance, one of the private lending strategies that Chenavari has been running since 2015 as a separately managed account, reaching capital of circa $320 million. The return profile from this strategy is similar to some of Chenavari’s other strategies, in that yields are related to floating interest rates. But expected gross returns, somewhere between LIBOR +4% and LIBOR + 10%, are somewhat lower than other private credit strategies for several reasons, while the liquidity offered to investors is higher due to the short-term nature of assets financed. In addition, because of this liquidity profile, some fixed income investors may find the trade finance strategy attractive as an alternative to capital markets investments due to a lower volatility.
Annual default rates on trade finance have historically been below 1%. According to the International Chamber of Commerce (ICC) Trade Register Report, they averaged from 0.1% to 0.8% between 2008 and 2016 depending on the type of trade financing. This is broadly comparable to investment grade corporate credit rated ‘A’ or above over the same period. The key difference is that whereas investment grade defaults were concentrated into 2008 and 2009, trade finance defaults were spread over the period. Moreover, recovery rates in trade finance have historically been high, between 40% and 80%. This is broadly in line with the range seen for senior secured loans, but also notably with less variation through economic cycles; the timeframe for making recoveries is also typically a matter of months. There is some variation among types of trade finance such as import guarantees, export guarantees, performance guarantees, and loans. But importantly, default and recovery rates have been quite de-correlated with the economic cycle. Combining low default rates and high recovery rates leads to expected losses of a few basis points.
By way of comparison, lending to smaller and medium-sized companies in Europe has historically experienced much higher default rates and less predictable recovery rates. This has particularly been the case in Southern European countries such as Spain and Portugal.
Chenavari’s trade finance strategy is unlevered. This increasingly meets investors’ requests for low/non-leveraged structures and leads to a lower return target than a levered format. Although Chenavari’s separately managed account trade finance strategy has the ability to access credit, the fund is not borrowing at present. Additionally, it invests in whole loans originated and structured in-house, whereas other Chenavari strategies obtain implicit leverage by owning the equity, junior or mezzanine tranches of various credit structures. These can be structured or securitised by Chenavari themselves or others. Some other trade finance funds do access the asset class via structured obligations, but Chenavari is not doing so for the time being. “We expect to reach the return target without leverage,” says Senior Portfolio Manager, Laurent Quelin.
Moreover, Chenavari’s trade finance deals seldom include the equity kickers that can be a feature of its other private lending strategies.
Although target returns are below Chenavari’s other private lending strategies, they are certainly much higher than “plain vanilla” trade finance. In the latter, most of the deal-flow, paying a low single digit annualised spread over cash, does not meet Chenavari’s return hurdles. Deals involving export credit guarantee agencies, development banks, multilateral government agencies, or traditional transactional trade finance are examples of those that do not yield enough.
Trade finance also has less need to offer an illiquidity premium, being significantly more liquid than some other private lending strategies. “Trade finance is a type of secured financing, which bridges the cash cycle from the time customers pay suppliers to delivery, and for the time it takes for suppliers to receive cash from customers. This is generally a period of up to 180 days,” says Quelin.
Chenavari has filtered the space to identify its sweet spot. “We have used our team and firm networks to scan the whole opportunity set, to identify a segment in the market where we can use short-term finance to plug liquidity gaps faced by larger companies,” says Quelin.
“Trade finance can apply to any kind of goods, manufactured or not, such as clothing or electronics. We like commodities because we believe they are the safest collateral, being quite literally commoditised, standardised and therefore easy for a borrower to remarket if a customer does not take delivery. Similarly, they are easy to re-source from different suppliers if a supplier does not provide delivery. In contrast, cargoes of customised and manufactured goods are more difficult to re-market or re-source, which increases the risk,” he declares.
Bank deleveraging in Europe is a multi-year megatrend that contributes to the opportunity set for many Chenavari strategies. Chenavari believe that the largest commodity traders have ample access to bank financing, but the neglected market niche lies in firms with $1-10 billion of turnover, who are often leaders in a particular commodity or geography but do not trade across all commodity markets.
Banks’ appetite for lending to Chenavari’s target borrowers has declined, partly as trade finance banks have limited capacity for lending to second and third tier commodity traders. The market gap has become more acute in relation to certain segments of trade finance, in part due to new regulations. Specifically, “a disproportionate impact comes from the Basel requirements. Historically, banks could use internal models to arrive at risk-weighted assets around 35-40% of the standardised approach for trade finance. Going forward, a floor of 72.5% of the standardised approach will apply, which increases costs of capital for banks and companies,” says Quelin.
This also has a knock-on effect reducing banks’ regulatory capital programmes, as these are more complex for banks to put in place for trade finance assets than for other types of lending. Hence, even though the manager has already participated in trade finance focused regulatory capital bank-led programs, Chenavari favours lending directly to corporates with a trade finance collateral: the Chenavari trade finance fund launched in early 2018 is focused mostly on bilateral lending opportunities.
The preference for lending directly to corporates, rather than doing so via banks, is also due to the way Chenavari originates and assesses deals. “We do not in any way want to compete with banks on interest costs and prefer to underwrite deals relative to the profitability of the borrower’s business,” he says. “We are providing tactical working capital that can allow commodity traders to take advantage of opportunities they might miss out on if they awaited a decision from a bank”.
Chenavari can move faster than banks can, since they may take six to 12 months to open a new credit facility. “We are carrying out continuous due diligence and dialogue with potential borrowers and we can deploy capital fast, in 24 hours or two days for individual trades, once a facility has been agreed, which might take a month or two,” says Quelin. The objective is to develop long-term relationships so that capital stays actively deployed for long periods, without the “cash drag” that can reduce returns for those trade finance strategies that focus on non-standardised and intermittent deal flow.
Chenavari is highly selective when assessing investment opportunities – approximately 10% of transactions that are scrutinised are executed. The funnel involves four stages. Initially, the investment team will draft a shortlist of potential companies, excluding those not meeting their risk criteria. The team will undertake a deep dive analysis into the profile of a potential borrower prior to presenting an investment case to the Co-CIOs and CRO. The third stage, which often runs in parallel, is to negotiate a commercial term sheet and carry out extensive due diligence and documentation, including regulatory due diligence (KYC), which may identify “red flags” that are deal breakers. The final stage is to present the final transaction to the Investment Committee (IC), who have the veto on whether the transaction proceeds. The IC includes Chenavari Co-CIO and CEO, Loic Fery, the Senior Portfolio Manager, and the CRO, as well as other Chenavari investment team members on an ad-hoc basis.
Chenavari envisages a capacity of around USD 300 to 500 million for the dedicated trade finance fund launched in early 2018, although will have a larger allocation to the strategy firm-wide, as some deals could be spread across several vehicles.
Chenavari has over 100 staff including 35 investment professionals. Its trade finance team is led by seasoned bankers. Laurent Quelin joined in early 2015, having previously run a commodity-backed finance strategy at Credit Suisse, where he sourced and managed bilateral lending transactions. This business sat on the trading floor due to synergies with Credit Suisse’s commodity trading and hedging activities, but he noticed the bank’s appetite for mid-market corporate risk was declining and saw the chance to build out an offering on the buy side.
Head of Strategic Development, Benjamin Jacquard, also oversees the strategy. He joined Chenavari in 2018, having formerly been global head of credit at BNP Paribas, where he ran trading, structuring, securitisation and financing of all credit assets from bonds to ABS.
Trade finance appears to offer high yields relative to default risk and recovery rates, partly because it is subject to operational risks, which include fraud, that may be greater than those entailed in buying listed bonds or loans. This risk can take the form of fraudulent paper documents, such as forged bills of ladling, fake trade finance bills, and fake warehouse receipts. There have recently been a number of public cases, some of which involved banks in China.
To guard against these risks, Chenavari seeks to verify, check and corroborate the substance of trade or goods being shipped, by contacting suppliers, customers, and storage providers. Quelin also reiterates that, “we have full recourse to large and reputable companies, who would need to absorb fraud costs through their balance sheets, and which themselves go through extensive scrutiny of the investment team as part of the underwriting and on an ongoing basis during the life of a facility, which makes the strategy also more scalable”.
The vast majority of deals are structured under English Law, with a few under New York law or other jurisdictions. “We always structure deals so as to ensure that we have access to jurisdictions where we would be comfortable litigating,” says Quelin.
The fund also diversifies its company and country exposures. “We do not want to take on too much idiosyncratic risk. We want to be fully satisfied that if there are delays in transportation, or customers fail to take delivery, the borrower is still sound financially,” he adds.
Other risk mitigation features can include: covenants in deal documentation, assignment of invoices, receivables, receivables insurance, cash reserves, share pledges, guarantees, Lloyds insurance, other insurance, signatory rights, and confirmed letters of credit.
Amid fears of an escalating trade war, mainly between the US and China, Quelin observes that “there is generally sufficient notice of tariffs so that they do not impact the trade cycle. It is rare that tariffs put a cargo or company into distress, but this should anyway be mitigated by full recourse. It is more likely that tariffs shrink a business”.
Commodity trading has historically been associated with reputational or “headline” risks including alleged abuse of UN Oil-for-Food programmes, bribery and corruption, and breaches of sanctions sometimes involving erstwhile fugitives such as prolific commodity trader, Marc Rich. Things are changing fast however, as some of the leading commodity traders are signing up to codes of ethics such as the United Nations Guiding Principles on Business and Human Rights.
Some trade finance funds have historically excluded US investors in order to increase their potential range of country and company exposures. Chenavari has a New York office, can accept US investors, and observes sanctions including those from the US, EU, UK and Switzerland.
Beyond this, Chenavari has developed an ESG policy as part of its investment process, which is incorporated in the IC and is monitored by the Chief Risk Officer. Trade finance today may seem relatively exotic or esoteric, but in the 1980s, securitising mortgages into bonds seemed very novel. As investors search for new sources of diversification, more types of alternative credit strategies, including trade finance, are attracting greater interest.