Trade Finance
Key takeaways
- Trade Finance is a sub-category of private debt.
- Transactions are privately negotiated loans to finance the processing and shipment of goods and commodities.
- Regulatory changes after 2008 caused banks to withdraw from commodity trade finance, which has served as the entry point for private lenders.
- Trade finance loans provide the lenders stable income streams backed by strong collateral, which leads in combination to an attractive yielding investment in a relatively liquid format.
Addressing the trade finance gap
“Trade Finance” finances the processing and shipment of goods and commodities from the supplier’s location (i.e. iron ore from Ukraine) to the location of the buyer (i.e. a foundry in Germany). These are typically cross-border transactions from one country or continent to another. Often, it is also described as “supply chain financing”. The financing is performed via privately negotiated loans, a “lending format” that banks have historically mainly performed. However, over the past years, trade financing has substantially expanded into the private alternative lending sector. The attractiveness of such financing is that the loans are short-term in nature and backed by liquid collateral. We classify this type of lending as a sub-category within the private debt investment universe.
Supply chain
The value chain is the lifeblood of most cross-border business transactions. It is about bridging the time lag between production, shipment, inspection and money collection. Most trade finance is short-term and self-liquidating within 60 to 180 days. Secured trade finance transactions experienced historically a very low average default rate and compare favourably against classic corporate bond investments. In practice, fraudulent action of a borrower or a counterparty and the sudden closing of a border as experienced in the Covid-19 pandemic are among others the key factors to monitor and analyze.
During crisis
Structural changes in banking after the financial crisis
After the financial crisis in 2008, regulatory changes and higher capital ratio requirements (i.e. Basel III) have caused banks to withdraw from commodity trade finance to small and medium-sized enterprises (SMEs). This has created a structural funding gap (shortage) and opportunities for non-bank (alternative) lenders to step in. Alternative lenders are more than happy to step in and to benefit from an asset class with stable and attractive yielding cash flows.
Pandemic - The effects on trade finance
The Covid-19 pandemic crisis has forced importers, exporters, logistics service providers and financiers to re-think how they conduct business and their processes regarding unforeseen disruptions. The pandemic has kick-started an irreversible trend within organisations to speed up digitalization to make trade finance and supply chains faster, safer and more cost-efficient. Finally, as banks continue to withdraw from trade finance for various reasons, funding needs have only increased. From an investor’s perspective, the borrower quality in trade finance will increase and the pricing for trade finance loans will increase.
In a world of low yields, trade finance exposure combines the following attributes optimally:
- Uncorrelated returns
- High income/cash flows
- Low risk as loans are collateralized
- Self-liquidating [short-term loans]
The asset class suits investors who seek stable uncorrelated mid to high single-digit returns. A successful investment in this sector requires deep knowledge and experience in the whole supply chain of trade finance. Strong and trustful counterparties are a must, and it is imperative to avoid concentration risk. Hence, an optimal portfolio asks for a sensible diversification across borrowers, commodities and regions.
Direct Lending
Secured Lending
Secured Lending describes loans, which are secured by a collateral. We classify this type of lending as a sub-category of the private debt investment universe. The strategy unifies the benefits and attractiveness of a niche and specialized market. The strategy gathers an illiquidity and complexity premium, while facing reduced risk of losing capital as the loan is backed by a collateral. We specifically like hard assets as collateral and identified the bridge loan market for real estate financing as particularly attractive.