Why Working Capital Finance matters

From a high level, it is estimated that roughly one-third of global trade flows are supported by some form of trade finance. Historically, banks have dominated this market. But bank reform initiatives like Dodd Frank and Volcker, Basel III and now Basel IV have compressed banks’ balance sheets, driving a funding gap estimated at over USD 1.5 to 2 trillion¹. Similarly, to what we've seen in other asset classes, we believe this creates an opportunity for non-bank capital to step in and capture that structural alpha. Funding gap means that there is an opportunity for institutional investors to potentially capture structural alpha. Trade finance assets have historically benefited from lower default rates and higher recovery rates with approximately twice that of unsecured bonds. Historically, the yield pickup for each unit of duration and liquidity has been much better than corresponding debt in the credit markets.

We invest long and short across credit globally, from investment grade through distressed. In 2019, we were presented an opportunity to participate in a trade finance transaction of a company we knew and had actually owned some of their loans. The yield pickup versus the loans piqued our interest, and we spent the next three months speaking with banks, servicers, consultants, and law firms about the asset class. The work reinforced our interest in the strategy as this short duration self-liquidating asset created an attractive investment profile. The shorter duration improved historical loss content AND yield enhancement to observable spreads to obligor’s corporate debt also resonated with our investors. We've now been managing this strategy for over four years and continue to build out our exposure and grow our franchise.

To enter an investment, two things must line up:

1. the team needs to be comfortable with the credit worthiness of the obligor and
2. we also need to have confidence that the structure provides adequate protections and controls. The process begins by working with origination platforms. All platforms must pass our due diligence, which involves our legal, operational, risk and compliance control functions, along with the investment teams. In addition, we do a legal review with both internal and external counsel on all of our programs. The onboarding process takes about one month. The team identifies potential risks and establish necessary risk mitigates in the structure. For underlying positions, we typically begin by analyzing the relative value of the opportunity versus the public debt and peer set. If we believe the transaction offers a compelling yield pickup, we then move to do a full fundamental underwriting of the company. At the core of our underwriting process, we're assessing the company's ability to pay. Our goal is to identify key risks to the business and assess the probability and impact of credit positive and negative events. The working capital team leverages buyside, legal, industry experts and other O`Connor resources, to round out our view.

O’Connor has extensive experience underwriting and investing in credits across the rating spectrum, which we've been doing as part of our Multi Strat for over 20 years. We believe that our key differentiator is our ability to fundamentally underwrite the credit risk. We're actively investing in the credit markets daily, which allows us to see where risk is pricing across the credit spectrum. This relative value framework gives us the ability to determine the seller's cost of capital and price each transaction independently, seeking to optimize the yield per unit of risk for our investors. It also allows us to monitor risk in real time. If our view changes on the credit, the sector, or the macro, we stop funding. Given the short duration of our working capital assets, the tenor of the assets provided one of the strategy’s most important risk management tools. If we think there is drift in our thesis, we can typically cut risk quickly, taking only one quarter of earnings risk in aggregate. Lastly, we use an open architecture approach where we source from numerous originators spanning banks, platforms, ERPs and brokers. This creates a larger funnel and gives us the ability to be more selective on what we choose to fund and provides a real time view of where the trade finance market is pricing risk.

Volatility tends to be a positive for us. In addition to the secular headwinds constraining banks’ balance sheets in times of volatility, they tend to pull back even further, creating more opportunities for nonbank funders like us. Also, management teams typically seek to shore up their balance sheet and increase cash levels during volatility or weak market environments. That typically drives additional sourcing opportunities. Increased volatility normally means wider spreads, which means we may have more pricing power on behalf of our investors. In times of volatility, we may be able to provide counterparties with much needed liquidity due to our flexible capital and the ability to get up and down the diligence curve quickly.

Like all asset classes, the Working Capital Finance strategy is not without its risks. The primary risk we try to isolate in the strategy is payment default. We look to alleviate this risk through robust fundamental underwriting, utilizing the expertise and experience of our credit team. O’Connor is in the market everyday, trading bonds long and short across sectors. as well as monitoring company and sector earnings and news. Most of our programs have bonds or loans and often have public equity with observable pricing and reference yields, which provide real time information on our portfolio. The secondary risk specific to accounts receivable financing is fraud. We try to mitigate this risk through structural protections like control accounts and processes like invoice verification and assignment to identify malicious acts ahead of funding.

¹ ICC trade register report 2022.