Structured Credit & Loans: It’s a good cop-bad cop thing
Martin Steward speaks with David Creighton of Cordiant Capital on structuring emerging market loans alongside the world's major development banks
It has become such a ubiquitous cliché that it now feels drained of all useful meaning: emerging markets are now less risky than developed markets. But sometimes it happens to be true in surprising ways. That is how it feels to look at emerging market loans.
First, we might compare them with developed market loans. These tend to be ‘leveraged loans' - credit extended to entities that already have significant debt, often to fund private-equity buyouts. In emerging markets, by contrast, borrowers tend to be taking on their first significant debts to invest in capacity-boosting, value-adding capital stock or infrastructure. A lot of existing developed-market loans are today non-performing or distressed. The picture in emerging markets could not be more different.
"We've considered putting together a distressed emerging market loan fund," says David Creighton, CEO and founder in 1999 of emerging market loan specialist Cordiant Capital. "There just isn't enough available product."
A study in progress at Cordiant looks likely to show a lower default rate and better returns than US leveraged loans, with less volatility - Creighton says that yields bounce in a narrow band of 200-600 basis points over US Treasuries.
Those spreads also compete nicely with those on emerging market bonds. But whereas bonds usually repay principal in a ‘bullet' at maturity, leaving refinancing issuers at the mercy of volatile markets, loan principal is amortised. And if you think inflation is one of the key emerging market risks, would you rather be receiving fixed interest, or a LIBOR-plus floating rate?
As in any form of lending, with its limited upside, protecting the downside is crucial. Whereas emerging markets private equity enjoys expected returns of 20% or more that can paper over the cracks of the odd bankruptcy, state expropriation or other left-tail event, loan yields do not compensate for these risks. Diversification is relatively simple and effective - particularly compared with what can be achieved in the bonds world. But Cordiant Capital's particular route into loans helps to mitigate the perils further: wherever possible, the firm will partner with development agencies such as the European Bank for Reconstruction and Development (EBRD), the World Bank's International Finance Corporation (IFC), the African Development Bank or the Asian Development Bank.
"We are in these deals with the 800-pound gorilla who can fight governments that decide to act capriciously," says Creighton. "Because we are helping them to fulfill their mandates to encourage private sector involvement, in effect we get that support for free."
Cordiant has been nurturing these relations for years. Creighton himself dealt with the IFC and EBRD treasury desks when he worked for BMO Nesbitt Burns in London, and had a spell at the Bank of Montreal when it was regularly approached to be a partner in deals by the Asian Development Bank. Cordiant has hired several development bank alumni over the past decade, including, in 2002, its CIO Bertrand Millot, who spent eight years in the EBRD's infrastructure group. Nonetheless, until recently, the commercial banks would take the chunk of collateral left by the development agencies, leaving Cordiant Capital and a handful of non-institutional buyers with whatever they syndicated (Cordiant claims to be the only significant independent commercial asset manager involved in this asset class).
"When I first approached the IFC with Cordiant Capital, they said: ‘Sorry, you're not rated and we only deal with banks'," Creighton recalls. "Now, of course we're best friends. In 2008, we were their number-one partner. The dynamics are changing, very much in our favour."
The big players in this market were the likes of Dresdner, Deutsche and Santander, now facing more pressing problems at home. Some might still be in for a (much smaller) share of the deals, but now Cordiant is more likely to find itself the sole partner of the development agency, perhaps alongside a local bank with a longstanding relationship with the borrower.
Again comparing loans against bonds, as well as having the security of the collateral, getting into this exclusive club offers a great advantage in determining credit terms - which can control everything from how and when the funds are drawn down, to how they are deployed.
"Under the old hierarchy, by the time deals got to us they were fully structured - take-it-or-leave-it," says Creighton. "Now we are dealing with the people structuring these deals and expressing our opinions. The combination of very tight covenants and a close relationship with borrowers helps us to avoid problems, but if they do arise, we see them before they turn into something dramatic. With bonds everything seems OK until you don't get an interest payment."
Cordiant has the war stories to demonstrate the value of these relationships. Creighton recalls one East European financial services companywhose capital crashed when the local economy went into a tailspin.
"The lenders worked with the regulators who ringfenced it while we got the equity holders to hand over $35m of fresh capital," he says.
In that kind of situation Cordiant and the development bank enjoy a certain symbiosis. The latter's development mandate means that it takes a lot for it to throw in the towel on a deal, and the development bank's "hospital unit", as Creighton calls it, is crucial for avoiding outright defaults. But the development bank also wants to get the best restructuring for its money. "If they get pushback from the borrower, they can say: ‘Well, this is what those mean capitalists at Cordiant require and they have a veto over the whole structure'," says Creighton. "Its quite an effective good cop-bad cop thing."
Today, Cordiant Capital manages more than $1.1bn (€870bn) across five funds, the first of which was launched in 2001, raised $360m, and is now almost all paid back. The latest, the Infrastructure Crisis Facility Debt Pool (ICFDP), is allocating €500m from German development bank KfW via an IFC-sponsored platform.
As the name suggests, this is a pure infrastructure debt fund, but infrastructure is a key theme for the firm and has accounted for about 40% of each of its other portfolios (including a new vehicle that is approaching its first close). Creighton says that a big draw of infrastructure is the way it keys into local consumption growth.
"Look at Africa, where you have 200 million people moving towards a disposable income over the next five years," he says. "That's the engine for these projects - you're not providing extra capacity and competing over a couple of cents per kilowatt hour, you're providing electricity where there wasn't any before. Similarly, the ICFDP is financing a container port in south-east Asia, where a lot of manufacturing for Japanese companies is moving from China and there is a bottleneck because they are having to load up sampans to get goods onto ships offshore."
These are fast-growing markets. When Cordiant started in 2000, perhaps $5bn worth of good-quality loans were generated each year. Today that's more like $30-50bn, and the commercial banks are pulling out. Creighton tells of an investor who wants to put €500m to work and says that is eminently do-able. The difficulty is one of definition; this involves going into ‘risky' markets and doing low-risk lending with rock-solid partners.
"The question every institutional investor asks is: ‘Where do I put this? What do I compare this to?'" says Creighton. "We have the most luck with investors who get the concept and just put it into their ‘Other' bucket of various non-correlated returns. And ‘Other' is probably as good a label as any. People in emerging markets will continue to want electricity regardless of what's happening in the euro-zone or anywhere else."