Hedge funds fill gap left by lack of bank-based trade financing

As avenues of traditional trade finance have dried up as a consequence of the banking crisis, hedge funds have seen an opportunity. Jamie Wynn-Williams reports

Until relatively recently the financing of commodity trades has gone through the traditional banking route or trade finance houses. With the onset of the banking crisis and the lack of liquidity in the system, hedge funds have spotted an opportunity.

One company to take advantage of the gap in the market is Heriot Commodities. In June 2007 co-founders Gianfranco Cicogna and Stuart McArthur launched the Heriot African Trade Finance Fund. Cicogna and McArthur had been colleagues for many years and both came from a banking background. McArthur worked in structured finance and Cicogna in corporate finance.

The two identified trade finance as an opportunity in Africa. Having worked together on a number of transactions in the region, they believed there was an opening for a fund focused on African trade finance. In addition to the more obvious South African market, they also believed sub-Saharan Africa, their current focus, was significantly under-banked. The banks in the region are generally small, undercapitalised and often unable to provide needed corporate services, like trade finance.

"We didn't think initially that we'd have much business in South Africa because historically South Africa has been well banked. But with hindsight we found a number of niche markets that were operating in the country very profitably. So that was the genesis: our years of experience, years of contacts - pulling that together to build it into a business opportunity in the form of a fund. It was also interesting as it was uncorrelated to any other market," says Cicogna

The Heriot African Trade Finance Fund is not, according to Cicogna, your average trade finance fund in terms of how they approach transactions. In developing markets there are much smaller margins, a higher turnover of business operating on Libor plus a number of basis points and companies looking for volume to turn it around. Cicogna and McArthur thought the model for Africa needed to be significantly different and able to add real value simply by making sure the transactions actually happened. So the fund becomes closely involved with the clients it finances.

"We are very much considered a partner to the people we do business with rather than just a funder. At the end of the day if you are just a funder, all that anybody is going to look at is what are they are getting their money for. If the next fund comes along and offers it at a slightly lower rate, there will be no qualms about swapping," says Cicogna.

The amount of due diligence and work that goes into developing a relationship with a client can be significantly more expensive in Africa than elsewhere in the world, "because it is not something you can do from the comfort of your armchair and computer. You have to go out and see people," says Cicogna.

The fund believed it was important once a relationship with a client was developed to keep that relationship as a long-term asset. So the fund has focused on developing a logistics and operational infrastructure behind what they do in order to support the people they work with.

The fund, for example, helps its clients structure deals. In many cases the fund does much of the logistics for trades. "We are very much a partner so we don't charge them a traditional interest rate of Libor plus X. With whatever deal is made we will share the margin with the company, which at the end of the day is instantly more profitable than your traditional trade finance lender," comments Cicogna.

"In the current environment it is quite difficult from a corporate perspective to launch our new fund, with everyone being very wary about what they are doing and sitting on their hands," says Cicogna.

Taking business from banking

From a business perspective the credit crunch means the fund is now seeing transactions that were done through the banking system six months ago coming to the fund for finance. The fund is producing venture capital-type returns.

Most trade finance hedge funds operate from Switzerland where there is a history of financing this type of activity. Maxreal Projects is the advisor to a trade finance fund based in Switzerland, the Clepsydra Short-Term Trade Finance Fund. Thomas Kochnitzky, manager, product sourcing and placement for Maxreal Projects, is one of the four founders/managers of the company. All have experience in the trade finance industry with banks financing physical trade flows and trading companies.

They met in 2004, left their respective employers and decided to set up Maxreal Projects. The core business of Maxreal, says Kochnitzky, is structuring projects, essentially structured finance. Experience had taught them that trading was not a viable business model on its own.

"We have tried to integrate value and build stakes and accumulate assets. Some of our managers have been taking stakes in export ports on the Black Sea and the Baltics. Some others are building assets such as ports, elevators for mines, etc. That is what Maxreal is doing as a core business," adds Kochnitzky.

The other part of the business is trade finance advisory with the company advising banks and clients. At the moment Maxreal is advising a foreign bank to establish a trade finance desk in Switzerland. It has also been advising a number of trading companies to extend credit lines as well as creating credit lines with banks with which it has not previously worked.

The idea for setting up the fund came from these activities. They decided to set up a hedge fund to fund physical commodity deals. The Clepsydra Short-Term Trade Finance Fund is to be followed by a second, the Clepsydra Medium-Term Trade Finance Fund, expected to be launched in late 2008 or early 2009.

The company believed there was a positive trend towards growth in volumes of commodities traded physically and in rising prices. "During all of our careers we have been through many a financial crisis. Through all these crises we understood that commodities had been a safe haven, meaning that the trade finance divisions of banks were making a lot of money during those testing times," says Kochnitzky.

The trading companies Maxreal work with are established trade finance banks including BNP Paribas, ING, Credit Agricole and local cantonal banks in Lausanne and Geneva. These banks have expertise in this sector.

"Clepsydra is co-financing along side trade finance banks the trading company's physical flows of commodities being purchased mostly in the emerging markets and then exported into the developed countries. So we put up a portion of the margin that the clients of the bank cannot come up with. The average duration of a transaction is 14 days," adds Kochnitzky.

The fund launched in July 2007 with only $3 million, hoping it would find willing investors. Although there is interest in the strategy, with consistent returns, in the present climate Maxreal is finding it difficult to grow the fund.

What Max Tomei, CEO of Inoks Capital and manager of its Ancile Fund, liked about the trade finance strategy was that as well as always being commodity orientated, it is an activity where there are a lot of market inefficiencies. The fund, also based in Switzerland, was launched in August 2006.

"These are not only market-driven inefficiencies but also operational inefficiencies where hedge funds can really add a lot of value. First, because of the borrowers that the Ancile fund targets. Second, because of the geographies we work in. And third, because of the operations we have streamlined and made far more flexible. In this zone in particular we saw a huge amount of potential and today are managing over $100 million," says Tomei.

A conjunction of elements has to come together that occur probably once in a lifetime for a commodity financier, believes Tomei.

"People panic because their milk gets a little bit more expensive, but actually commodities have been undervalued for a number of years. There is still a business growing at a local level and a huge potential. We see growth rates of 5% a year as far as the emerging market exports of commodities. The second point is that the local banks are becoming stingy in giving out loans, not to mention credit lines, because they are having difficulties refinancing themselves. At an international level credit lines are being put on hold also," says Tomei.

'Floating in a grey zone'

The fund targets companies that have in the past financed themselves locally but cannot now tap into that source because they are considered "too small". This is what Tomei calls "floating in a grey zone". These companies are usually second tier, reasonably healthy medium-sized processors and exporters of commodities. This segment needs financing and is having difficulty finding it.

The advantage inherent in the strategy Tomei has been pointing out for years, is that there is no correlation to other markets. The fund does not use any leverage. "We want to return 80-90 basis points every month with no surprises and no correlations. Our collateral is commodities sitting all around the world in emerging markets. It is the world gross national product. So we are fundamentally uncorrelated to other strategies," comments Tomei.

The disadvantage of the strategy, believes Tomei, is that it relies on growth. If the export market for commodities does not grow, then credit lines will not be needed and the fund will not be competitive, he concludes.

Louis Zanolin of Nara Capital in Switzerland uses trade finance as a sub-strategy of his asset-backed lending fund (see article, page 24). Because trade finance is needed and already established, Zanolin decided to add some trade finance elements to his portfolio. He believes, like Max Tomei, that it is a stable, uncorrelated source of income for the fund.

"It is a very efficient market and the returns are not as great as other hedge fund strategies, but they are more robust and resilient towards any economic downturn," he says.

The credit crisis and almost zero trade financing bank activity have been providing more deal flow. As banks have reduced allocations to trade finance, Nara Capital has seen more opportunities. "Someone has to fill the gap from the traditional line of financing from the bank and the commodity trader," says Zanolin.

Also commodity importer superpowers like India, China and Brazil are emerging and that has changed the face of the strategy. "This has given us a rich world of supply and demand," Zanolin notes.

The biggest risks Nara Capital foresees is that markets are even more difficult and people start to default on transactions. Also if the volume of transactions reduces dramatically, this would be a major concern. However, Zanolin does not believe this will happen. He believes there is and always will be a demand for food, energy and basics.

Christian Stauffer, CEO of the LH Asia Trade Finance fund based in Singapore, has been involved in trade and structured trade finance for the last 16 years. Together with his partner, Craig Dimmick, he decided to set up an advisory business, Eurofin Asia. They decided the trade finance model was an excellent strategy for a hedge fund and launched a fund in 2006.

"We know and are still of the opinion that trade commodity finance strategies are certainly more resilient than other strategies during this difficult period of time," says Stauffer.

The strategy consists of lending to a borrower, avoiding secondary risk and counterparty risk. The fund has a direct relationship with the borrower to cover a specific trade finance transaction. This, Stauffer believes, is relatively simple.

In using primary trade finance, however, he thinks the fund is limited in the returns it can produce. "Unless a fund starts artificially gearing, or leveraging or going nuts on the amount of trade, you can't really significantly increase return. There is a limit. The limit is the logical amount that a normal company under normal circumstances will pay for their financing," says Stauffer.

He does not think the global economic crisis has substantially affected trade finance. Funds of this nature need to be more vigilant of the risk since it is not ring-fenced from the rest of the world.

At the moment Stauffer does not see substantially higher risks from any area other than pure systematic risk. "The crisis is such that many banks are going bust and there is no more exchange of money. Anything can suffer. I am of the opinion that trade finance will be the last to suffer," he says.

Trade finance still remains, and will probably remain, a market dominated by banks. Banks provide a vast majority (85%-90%) of the usual trade finance liquidity in the market.