Trade finance: a liquid alternaitve to private credit
1 October 2018
Private credit is compelling.
Over the past couple of years, many investors have turned to private credit as an alternative source of returns. Banks have been moving their businesses away from lending to mid-size borrowers due to more onerous regulatory requirements. The investment case for institutional investors to step in and take the banks’ place was, and remains, strong.
However, some investors are put off private credit by its lack of liquidity. Investments are often locked up for years at a time, which can be particularly problematic for pension schemes that want to de-risk over a relatively short time frame.
Trade finance could provide an alternative without the illiquidity
Similar to private credit, investors in trade finance are again benefiting from banks moving out of the space due to stricter regulation. However, such investments are much more liquid, with investors often able to redeem monies on a monthly basis.
What is trade finance?
Trade finance involves providing short-term private debt financing to buyers and sellers of commodity and industrial goods. Borrowers use this type of financing to bridge the trade cycle funding gap between:
- buyers who want to make payment only once the goods have been received; and
- sellers who want upfront payment before shipping goods to manage working capital.
Why would you invest?
Trade finance could fit in the growth section of a portfolio, given it:
- aims to achieve set return targets, irrespective of wider market conditions. The funds generally target around cash + 4-6% pa;
- is uncorrelated to traditional asset classes, such as equities or bonds. The movements of the equity or longer-dated bond markets are expected to have little impact on returns; and
- has historically low default rates.Trade transaction cycles are relatively short-term, and companies are typically stable. In addition, many arrangements have security over an asset if the borrower were to default.
Banks haven’t just reduced their long-term loans to private companies but their short-term loans too; this creates opportunities for other investors.
What are the key risks?
The key risks are that the buyer or seller does not honour their obligations. Depending on the exact structure of the loan, this could be either:
- the buyer defaults on the payment; or
- the seller defaults on the delivery of goods. In both cases, the investor may not receive the repayment of their loan. However, these risks are often mitigated as:
- portfolios are well diversified, with many underlying loans;
- transactions are protected by collateral and/or insured; and
- managers carry out rigorous due diligence on their investments.
Overall, trade finance could provide a good investment solution for investors
The investment case is compelling, with expected returns of around 4-6%, creating an opportunity for investors to take advantage of an area being vacated by banks. Furthermore, the absolute return target, low correlation to traditional asset classes, and liquidity makes trade finance a really interesting area.