Unhedged Commentary

Wednesday, March 16, 2016

Unhedged Commentary: Giving European Credit its Due

   Stuart Fiertz

With continued market volatility in early 2016, the collapse in oil prices, shocking acts of terrorism and waves of migrants seeking refuge from war, at Cheyne we believe Europe deserves more credit - literally. The anticipation of a flood of credit opportunities in the euro zone has existed for several years but proved fleeting. However, we think the time is ripe for compelling and scalable opportunities in alternative credit within Europe because of the combination of well-meaning but poorly designed regulatory reforms and the fact that efforts to address the looming need to shrink the banking system have only just begun.

To profit from the recent dislocation and increase allocations to Europe, investors will need to accept that we have reached the level of political and economic distress necessary to trigger effective policy responses. We think we have: European Central Bank president Mario Draghi has dusted off the quantitative easing playbook, U.K. Prime Minister David Cameron appears to be getting closer to securing sufficient concessions from the European Union to neutralize the risk of Brexit, and the EU is building fences on its external borders to stem the flow of migrants.

The global financial crisis highlighted that the European banking system was far too large relative to the size of the European economy. This means that European banks remain overly reliant on wholesale funding and are too big to either be left to fail or bailed out again. Regulators have recognized this and responded with measures to force banks to shrink their balance sheets, including increased capital requirements and explicit leverage limits.

Alternative credit has the opportunity to offset the withdrawal of liquidity that will result from shrinking European bank balance sheets. Consider that the total assets of U.S. banks are some $14 trillion, whereas the assets of European banks total $41 trillion although the underlying economies are approximately the same size.

The transition toward alternative credit is now being supported by the EU, which has gone from vilifying nonbank sources of credit to actively promoting them. Furthermore, the European distressed-­corporate-credit cycle is shifting toward opportunity. Postcrisis, many investors thought there was going to be a fire sale of European corporate loans. This flood of sales didn't occur, as European banks proved more willing to sell real estate assets than corporate loans. One of the motivations was political pressure to safeguard jobs and avoid putting companies into the hands of private equity, which would look to rationalize operations. Another factor was the surprising growth in the European high-yield market, which allowed the orderly refinancing of most of the largest and most leveraged companies.

It is also evident that European banks were not in a position to absorb the hit to their capital that would have been necessary to mark the corporate loans down to their clearing level. While still undercapitalized, European banks are today in a much improved position to sell down their corporate exposure, which will now begin to increase the supply of distressed corporate opportunities.

In the wake of the crisis, the impact that unemployment rates had on forcing real estate borrowers into receivership was muted. Banks were therefore in a much better position to sharply reduce their risk appetite for real estate loans as the crisis unfolded.

The most attractive opportunities can be found where the new regulatory capital regimes are most punitive and where the local regulator has a particularly negative bias. Bank loans to fund new construction, for example, are more readily available than loans for refurbishment. The opportunity to make this type of loan is underlined by the fact that the availability of credit in European real estate has been severely constrained since as far back as 2007, leaving a generous supply of assets in need of capital expenditures. What's more, there are an estimated €745 billion ($826 billion) of loans that will need to be refinanced over the next three years. It is estimated that European banks still need to work out some €333 billion of noncore real estate loans.

The total of nonperforming corporate loans that are likely to be sold by European banks now dwarfs the remaining noncore real estate on bank balance sheets. It is an indication of how far attitudes toward alternative credit have changed that the Italian government recently chose to securitize €350 billion of nonperforming corporate loans rather than sell them outright. a

Stuart Fiertz is president of London-­based Cheyne Capital Management (UK) and chair of the Alternative Credit Council of AIMA. This article is based on his findings from a recently published white paper.

Friday, January 08, 2016

Unhedged Commentary: Trust Is the Hidden Alpha in Hedge Fund Sales Coverage

By Dean Curnutt

   Dean Curnutt, Macro Risk Advisors

When it comes to asset management firms, studies have shown that how well their investments perform contributes only marginally to how much money they raise. In a previous Unhedged Commentary piece, it was reported that the correlation between investment flows and performance was between just 0.4 and 0.24 percent. What matters instead is a combination of client education, manager trust and an effective investor relations effort. Perhaps the old adage that money chases returns needs an update.

Several years ago I did a survey asking hedge fund clients what made a salesperson’s coverage good or bad. Many responses cited market knowledge or product expertise as important. But there was a striking focus on consistency and trustworthiness as characteristics of the valuable salesperson. At its core, the success of a buy-side–sell-side coverage relationship hinges on that unspoken yet all too important presence of trust.

As trading technology improves, the costs of execution continue to decline. For example, the average commission rate in the listed options space for voice brokers has fallen by 11 percent over the past five years, according to financial market research and advisory firm Tabb Group. On the fixed-income side, the advent of TRACE (Trade Reporting and Compliance Engine) by Finra as well as the migration to swap execution facilities increases price transparency and serves to reduce the spread that dealers can extract through client flow. This greater transparency has caused the after-tax return on equity to fall for flow businesses from 20 percent to 7 percent following the financial crisis of 2008, according to global consulting firm McKinsey & Co.

With these profitability headwinds in mind, where can brokers improve their flow businesses? With markets increasingly complex, providing higher-quality research seems an obvious place to allocate resources. While differentiated research matters, the mass forwarding of original work is an unfortunate reality in the investment business, greatly reducing the returns on content.

A less obvious but higher return investment in strengthening a flow business is in building more trust with clients. In the words of motivational speaker Zig Ziglar: “If people like you, they will listen to you. But if they trust you, they will do business with you.” If investing is all about finding performance edge, trust can be looked at as providing alpha of the very best kind: It has high payoff, requires no capital, is completely uncorrelated to the market, lasts indefinitely and has significant barriers to entry. As with other kinds of alpha, however, trust is difficult to earn.

From a client coverage standpoint, building trust first requires a salesperson to accept the reality that a client’s inner circle of advisers is typically established over years. In this way, the broker-dealer firm’s incentive system must also embrace the long game of trust building so as to provide the salesperson with considerable runway for this process.

My survey work suggests that when clients cite “trust” in why they deal with a particular salesperson or firm, they perceive a strong sense of business alignment in the coverage relationship. Absent is any view of hidden agenda in which the broker-dealer’s objectives may be counter to the investment results sought by the client. In light of the LIBOR and foreign exchange market manipulation scandals, it is easy to see the skepticism that many clients feel about their counterparty dealings. As a result, a sell-side firm must make transparency a top priority when transacting with clients.

A second component of trust is a sense of familiarity and rapport. “Am I being listened to?” is an unconscious question a client repeatedly asks when evaluating the relationship. In the hedge fund universe, clients tend to be bucketed into easily consumable categories such as long-short, macro, credit, etc. However, no two clients are the same, and the effective salesperson must excel at asking the right questions and listening intently to the road map the client provides on how optimal coverage can be achieved. The thoughtful salesperson knows what is important to the client, effectively screening the delivery of information based on a careful assessment of its relevance.

Lastly, clients equate trust with broad business advocacy. When the alpha of the coverage relationship is at its apex, the client views the salesperson not just in light of superior market intelligence and transaction execution, but as a partner in business development. In the ultracompetitive world of investment management, funds are not just hunting for the next great trade idea. Rather, they aim for constant platform improvement, searching for better technology solutions, looking at expansion into new strategies and always seeking the strongest professionals to join their teams. The salesperson who has truly earned the client’s trust becomes a meaningful element in this ongoing business development process.

In an environment where margins are experiencing secular decline, it is easy to be bearish on the sales and trading business. Commission rates are compressing as electronic trading increases and it is difficult to be compensated for research. While these headwinds are real, clients are clamoring for sales coverage that delivers not just expert market insight but that is fully aligned on business objectives. By making the achievement of client trust a primary focus, a desk can powerfully differentiate its efforts from the competition.

Dean Curnutt is CEO of Macro Risk Advisors, an equity derivatives strategy and execution firm that specializes in translating proprietary market intelligence into actionable trade ideas for institutional clients. The New York-­based firm is a registered broker/dealer with the FINRA.

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