Trade finance a vital global need creates an exceptional

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Title: Trade Finance: A Vital Global Need Creates an Exceptional Investment Opportunity
Author: Joel Parrish
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  • Trade Finance: A Vital Global Need Creates an Exceptional ...

Trade Finance: A Vital Global Need Creates an Exceptional ...

Trade Finance: A Vital Global
Need Creates an Exceptional
Investment Opportunity
March 25, 2019
Joel Parrish
10990 Wilshire Blvd., Suite 1150
Los Angeles, CA 90024
? 2019 Shinnecock Partners L.P. All Rights Reserved. 1
Raison D'etre
A seller (exporter) of goods wants the buyer (importer) to prepay for those goods, to eliminate
the risk of non-payment after delivery. The importer wants the goods to be shipped prior to
payment, to eliminate its risk that the goods will not be delivered.
There is a solution to these opposing needs. A trade-finance intermediary can remove both
parties' risk by, for example, extending credit to the importer and paying the exporter for the
goods prior to delivery.
Trade finance offers less-obvious advantages, as well. Cash flow is improved and businesses
can run more efficiently knowing that payment will be received on a specific date, or that goods
will be received without delay. "Pre-export financing" can provide cash to exporters using
buyers' orders as collateral, allowing them to make sales that they otherwise would not be able
to fulfill. "Factoring" enables exporters to sell accounts receivable at a discount for immediate
cash flow, preventing financial hardship or perhaps insolvency.
Babylonian clay tablets dating to 3000 B.C. represent the first known examples of promissory
notes and letters of credit; Babylonians are believed to have traded with civilizations as far
away as Egypt and present-day Turkey. The modern trade finance concept began in the
fifteenth century with banks opening new branches at international-trade junction points.
These banks initially facilitated the exchange of promissory notes between trading partners,
then began issuing letters of credit to guarantee payments. This led to the great expansion of
global trade that continues today.
Trade finance is critical to the global economy and a key driver of economic development. It
plays a crucial role in practically all sectors' supply chains, particularly agriculture and extractive
industries such as mining. The World Trade Organization (WTO) estimates that more than 80%
of global trade, representing over $10 trillion U.S. dollars, relies on some form of trade finance.
Large banks are the traditional providers of trade financing, but shifting regulatory
requirements have decreased their role. Since 2008, banks have been subjected to additional
capital and liquidity constraints. The reduction in available capital and the eroding profitability
of trade financing has caused many banks to reduce their exposure or even withdraw
completely from the sector. The "Basel III" international banking regulations, first implemented
in 2013, caused further reductions in bank-intermediated trade finance.
This exit of traditional lenders has created investment opportunities in the private markets for
alternative (non-bank) lenders. For investors, trade finance offers a short term (generally one-
to six-month) investment with attractive returns, uncorrelated performance, strong collateral
and historically low default rates.
? 2019 Shinnecock Partners L.P. All Rights Reserved. 1
"... trade finance is a reliable and low-risk asset class that should be looked
upon favorably by regulators, industry stakeholders and investors." - Daniel
Schmand, Chair of the ICC Banking Commission and Global Head of Trade
Finance at Deutsche Bank.
Types of Trade Finance
The umbrella term "trade finance" takes a variety of forms, which include:
? Insurance
o Trade credit insurance is purchased by exporters to insure against non-payment
by the importers of their products. Policies can cover specific transactions, but
usually cover entire groups of importers. Insurance protects against importer
insolvency/default as well as country-specific political risks.
? Letters of Credit
o The importer's bank provides a letter of credit to the exporter's bank that
guarantees payment upon confirmation that the shipment was made. The letter
of credit in effect substitutes the bank's credit for the purchaser's credit.
? Bank Guarantee
o The bank acts as guarantor of the transaction payment via a surety bond or
other means. Unlike a letter of credit, payment is only made if the bank's client
(importer or exporter) fails to meet its obligations under the contract.
? Forfaiting
o Forfaiting derives from the French word forfait, which means to relinquish a right
(in this case, the exporter's right to receive payment from the importer).
o A third party purchases receivables from the exporter at a discount and assumes
all risk of non-payment by the importer in exchange for the negotiated discount
rate. The exporter attempts to recover the full forfaiting cost (discount) from
the importer in exchange for the credit terms extended to the importer,
effectively allowing the exporter to receive up to 100% of the invoice value for
goods shipped.
? Factoring
o Exporter's account receivables are sold to a third party at a discount
o Differs from forfaiting in a number of ways:
Factoring finances 80% - 90% of the invoice value; forfaiting can be 100%.
Forfaiting is without recourse to the exporter; factoring can be recourse
or non-recourse.
Cost of factoring is borne by the exporter (seller); cost of forfaiting is
borne by the importer (buyer).
Factoring is short-term (less than 180 days); forfaiting is medium- to long-
? Lending Facility (the remainder of this article will primarily focus on this form)
? 2019 Shinnecock Partners L.P. All Rights Reserved. 2
o Pre-export financing: Exporter obtains a loan needed to produce goods, utilizing
orders from buyers as collateral.
o Prepayment financing: Importer receives a short-term loan from lender that is
repaid upon receipt of goods from exporter; exporter receives cash upon
shipment; the loan is secured by the goods themselves as collateral.
Risks and Challenges
Asset-backed global lending is subject to inherent uncertainties, but proper controls and
structuring can mitigate the risks involved.
Collateral depreciation is the risk that the underlying collateral (shipped goods) will decrease in
value during the transaction term. This risk is mitigated primarily by the short-term nature of
the loans (usually less than six months). Additionally, the "loan-to-value" (LTV) ratio (loan
amount divided by collateral value) is typically less than 100%, which allows for principal
depreciation - for example, an 80% LTV allows the collateral to depreciate by up to 20% before
principal impairment. The value of most commodity goods can also be hedged in the futures
markets at a reasonable cost, but the trade finance provider must still arrange for an off-taker
to purchase the goods.
As interest rates continue to rise from 40-year lows, interest rate risk can be eliminated through
a floating rate loan structure (although fixed rate loans only have modest risk due to their
short-term nature).
Currency risk arises when the importer and exporter are in different countries with different
currencies. For example, if a buyer in Country B agrees to pay for a shipment from Country A,
and the value of Country A's currency relative to Country B's currency falls prior to the payment
date, the exporter will receive less in its local currency than originally expected. (If Country A's
currency appreciates relative to Country B's, however, the exporter will receive more than
expected). The same risk applies to the trade financier - if loaning in U.S. dollars to a borrower
who repays in its local currency, the lender may receive less than projected when converted
back to dollars. The simplest way to avoid this risk is by denominating all transactions in the
lender's currency. This passes the burden of currency exchange, and any fluctuation risk, onto
the borrower. The disadvantage of this approach is that it could result in lost opportunities
from borrowers who don't want to assume this risk - and may instead give their business to a
competitor willing to finance transactions in the borrower's own currency. It may also increase
the risk of default if there is a significant currency devaluation of the borrower's currency
versus the lender's currency. Alternatively, currency risks can be hedged via futures, swaps or
forwards (however, at an additional cost).
Political risk stems from political factors that may prevent payment or delivery of goods. A
government may confiscate a shipment due to claims of non-licensing or some other reason, or
expropriate a shipment for its own use. Political upheaval may grossly devalue a currency or
cause limits to be imposed on sending money out of the country. Even a third, unrelated,
country through which cargo travels can introduce additional risks. Cultural misunderstandings
? 2019 Shinnecock Partners L.P. All Rights Reserved. 3
may occur in transactions negotiated between parties in different time zones, with different
languages and varying cultural practices and ethical values. No risk can be completely
eliminated, but lenders can address these issues through careful due diligence and by
employing best practices from their experience with prior transactions. Political risk insurance
is generally available and probably a must if the lender desires to work with certain high-risk
countries (typically this is paid for by the borrower). Currency conversion and devaluation risks
can be reduced as discussed above.
Counterparty and custody risk include loan default, fraud, theft, documentation errors or
omissions, quality control, warehouse liens and natural disasters. These risks are primarily
addressed through insurance, SPV structures (see below) and, of course, careful due diligence
by the lender.
There are a number of additional ways a trade finance lender can further reduce its risk.
The lender may screen opportunities based on the characteristics of the underlying collateral,
rejecting loans against goods that are not readily marketable, highly perishable, or critical to a
country's economic stability.
Deals should be structured with bankruptcy remoteness to protect against bankruptcy of the
financed party. Transactions can be made off-balance-sheet via a separate "special-purpose
vehicle" (SPV) in a tax-favorable jurisdiction. In addition to creating legal separation from the
parent/borrower, the SPV is structured to limit its right to file bankruptcy, requiring the consent
of a neutral third party. The SPV also agrees that it will not incur any additional debt - and
bankruptcy courts are generally inclined to dismiss cases that are essentially two-party disputes
(one borrower and one creditor).
Loan agreements can include covenants that, if triggered, accelerate principal repayment. Such
triggers can act as an early warning of financial difficulties at the borrower, such as a decline in
the debt service coverage ratio, a decline in EBITDA, or default on another obligation.
Investment Characteristics
For investors, trade finance is a compelling opportunity versus traditional investments and even
compared to other areas within the alternative (non-bank) lending space.
Short-Term: Loan terms of generally less than six months reduce exposure to interest rates and
other risks.
Collateralization: 70% to 100% advance rate = 100% to 143% collateralized by real goods.
High Return: Trade finance offers high yield in a low-yield environment. Investors can achieve
returns in the high-single and low-double digits, very favorable for short-term, collateralized
Low Default/Loss Rates: The 2017 International Chamber of Commerce (ICC) Trade Register
reports that default rates across various types of trade finance ranged from only 0.03% to
? 2019 Shinnecock Partners L.P. All Rights Reserved. 4
0.24% between 2008 to 2016. Even during the 2008 - 2009 financial crisis, the ICC indicates
that a mere 445 out of 2.8 million transactions defaulted. Default rates must be considered in
the context of each transaction type - higher-yielding trades come with higher risks.
Low Correlation: Trade finance performance is tied to individual collateralized loans and does
not directly relate to any type of marketable security. Its historically-steady return stream is a
valuable component to any portfolio.
Modest Competition: Despite growing demand and very favorable investment characteristics,
the trade finance sector is largely overlooked by traditional capital markets. Industry estimates
range from only 12 to 20 investable funds worldwide that are dedicated wholly or partially to
trade finance.
"It's one of the most predictable cash flow investments that an investor can
make today... a differentiated return stream that has virtually zero
correlation to the financial markets. It is a true alternative investment." -
Kristofer Tremaine, Founder & CEO, Kimura Capital
The world has truly become a global marketplace. 2017 trade growth of 4.7% was the highest
in six years, and preliminary estimates from the WTO suggest 2018 was similar. Developed
countries have experienced faster growth but in the past decade, developing economies' share
of international trade flows has grown from one-quarter to one-third.
Trade finance supports 80% - 90% of these transactions; the diminishing role of traditional
banks continues to fuel demand for non-bank solutions.
"The amount of demand for trade finance is extraordinary. If all the funds
out there raised a billion dollars each, it wouldn't even scratch the surface."
- Mead Welles, Portfolio Manager, Octagon Asset Management
Trade finance is not an undertaking for an individual investor as it requires domain knowledge
and experience in sourcing, due diligence, deal structuring and risk management. This is best
left to the experts via an allocation to a non-bank investment vehicle, which often concentrates
on a specific geography and, importantly, has a physical presence in that area.
The opportunity for investors is clear. Trade finance offers distinct advantages and protections
versus traditional investments. It is a non-correlated complement to most investment
portfolios via short-term, collateralized loans with well-defined, addressable risks and negligible
historical default rates.
? 2019 Shinnecock Partners L.P. All Rights Reserved. 5

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