Specialist Manager: Nordic investors increasingly access private debt through risk sharing transactions with banks
The issuance of so-called risk sharing transactions has steadily increased over the last few years, culminating at USD 8-10bn of new investments in 2018, according to estimates by Whitecroft Capital Management. According to the London-based asset manager dedicated to this asset class, risk sharing transactions with banks are becoming increasingly popular for Nordic investors seeking to diversify their private debt exposure.
Major commercial and universal banks are expected to provide commercial loans, working capital lines, and trade finance advances as part of their service relationship with customers.
The regulation known as Basel III calculates regulatory prudential capital requirements using 'through the cycle' parameters which assume that an economic downturn will occur during the life of all credit exposures held by banks. Additionally, a buffer for further unexpected events is required.
Regulators have been demanding steadily higher minimum capital ratios, adding further conservatism to the capital requirement. So, whilst banks are under strong pressure from their relationship customers to keep providing loans and trade finance, on a return on capital basis it is increasingly inefficient for banks to hold the resultant exposures on their balance sheets.
Motivated to reduce capital
This regulatory development has motivated banks to find ways to reduce the capital requirements, and risk sharing provides one possible solution, explains Whitecroft Capital Management Partner and Portfolio Manager Michael Sandigursky.
"While most large banks have pretty much exited all their non-core businesses in recent years, the regulators still require significant capital as a cushion for their core businesses prompting banks to manage capital more proactively," he explains.
"Risk sharing transactions work by identifying a portfolio of performing loans and trade finance facilities originated by the bank, which is a representative sample of a total bank portfolio, and then transforming it into an investable format, typically in the form of a credit linked note, which could be purchased by the investors," Sandigursky says.
The reference assets remain on the bank's balance sheet and continue to be serviced by it according to its standard policies and procedures. The bank is required to retain a significant proportion of each exposure to ensure better alignment of interest with the investors, Sandigursky explains.
Different risk profile than bank equities
Bank loans to corporates are always associated with a certain risk.
The risk varies depending on many factors related to borrower credit rating, type of a loan facility and security collateral available in case of a default, and the borrower is unable to honor its financial commitment.
All large banks have invested significant resources in establishing origination processes, designing credit rating models and implementing credit risk controls.
Credit models are constantly being updated, back tested and re-calibrated to ensure consistent underwriting over time.
By investing in risk sharing transactions, investors get access to this sophisticated infrastructure without a cost required to replicate and manage it, the portfolio manager explains.
"Investors are exposed to the entire bank if they buy listed shares. It is very straight forward, but one gets blended return of all businesses of that bank. Shares prices can be hit by a multitude of factors," he says. "In contrast, risk sharing transactions specifically target exposure to a selected core business of a bank and benefit from its individual financial performance."
In the past two years, interest in risk sharing transactions has gradually increased after years of flying under the radar, according to Whitecroft Partner and former head of Markets, for the Nordic region & Netherlands at Citigroup, Anders Larsen.
As more banks have established risk sharing programs, the number of investors has gradually increased as well, according to Larsen.
He estimates that more than 20 major institutional investors in the Nordics have exposure to this asset class either directly or through a specialist externally managed fund.
Larsen expects this number to grow "The risk sharing transactions have performed very well and have an attractive risk-adjusted return of around 7-12 percent depending on the underlying portfolio and the bank," Larsen explains.
"Despite the growth in issuance, risk sharing remains a fairly specialist market where risk premium isn't traded away like in some liquid markets. Most transactions are completed in private markets with very limited number of specialist fund managers aggregating the demand from a number of institutional accounts," he concludes.