House of the Year in Credit Derivatives: Credit Suisse
As traditional corporate finance providers retreat in Asia, Credit Suisse has spotted an opportunity: to use its platform to provide companies with access to alternative finance which is then pre-packaged through a range of capital market instruments for distribution to institutional clients and private banks. It has turned out to be a very successful and profitable business over the past year.
The bank has done a number of deals this way in 2020. The idea, they say, is simple: bridge the gap between the supply of private credit and demand from traditional capital market investors.
“Generally, banks will make a syndicated loan and sell it to other commercial banks, or if it’s a high-yield loan, they can sell it to private credit funds – but in all cases, the loan would be sold outright,” says Terence Chia. , boss of APAC debt market syndicate at Credit Suisse. “Here, our solution is more creative and opens up a whole new pool of liquidity.”
A loan transaction with a corporate borrower shows just how creative it is. Credit Suisse guaranteed the loan as the client’s principal. The bank then packaged and sold the risk across numerous sales divisions within the bank to its network of institutional and private clients.
This collaboration between the investment management and the markets management allows the bank to underwrite large private loans, while offering exposure to private credit with an attractive risk premium for investors unable to invest purely and simply. in private loans.
The instruments used to sell the risk vary according to the appetite of the end investors. It could, for example, be sold as a simple credit-linked note, issued through the bank’s special purpose vehicle platform. For investor clients who want more leverage and a higher rate of return, a total return swap or a credit default swap can be used.
Regardless of the instrument, Chia says, private credit exposure offers a risk-adjusted rate of return that compares very favorably to what’s available in government debt markets — especially in the market environment. where spreads and yields are compressing.
There are different layers of protection for investors in private loan agreements that are not present in public or private bond agreements, he points out.
Investors are first protected by loan covenants and early termination triggers to cover events such as credit rating downgrades. Since Credit Suisse keeps a portion of the corporate loan on its own books, the covenants are actively monitored by the bank throughout the lifecycle of the transaction.
“When we undertake such a transaction, we closely monitor [the performance of the borrower]explains Chia.
Private bank investors also benefit from Credit Suisse’s due diligence on the borrower, as well as a group of sophisticated investors who anchor the deal alongside Credit Suisse. The bank says it uses a sophisticated model to price the loan to value (LTV) and funding gap for each transaction based on counterparty quality, asset quality and early termination trigger levels.
These protections for end investors were understandably put to the test as the spread of the Covid-19 pandemic earlier this year wreaked havoc on financial markets, crushed corporate finances and sparked a surge in defaults by borrowers around the world.
During this very difficult period, the bank’s credit solutions business did not experience any loss or forced liquidation of the underlying collateral. This helped to limit the impact of deteriorating credit conditions and to avoid a negative cycle of price movements caused by the distress sale of assets.
Even if the worst-case scenario occurs and a transaction appears to be at risk of violating an early termination trigger, daily monitoring of transaction parameters enables the bank to act quickly. A restructuring plan can then be negotiated with the customer prior to the termination event.
“It helps us avoid a shortage of cash in a very bad environment,” says Jacqui Zhang, head of APAC structuring credit solutions in Hong Kong. “What we want to avoid the most is that a client has to look for liquidity when there is no liquidity available in the market.”
With falling yields in more traditional credit markets occurring at a time of widespread deterioration in credit quality among businesses, demand for investments with such comprehensive controls and credit mitigation measures has, understandably, been strong.
The financing solutions that the bank can offer investors on loans are also an important pull factor. Credit Suisse’s sales and trading desks provide loan asset financing – with or without recourse – to its institutional and private investors.
Similar transactions completed by the bank over the past year have been oversubscribed, with private banking accounting for much of the demand.
“We have done many such transactions with great success,” says Min Park, head of market solutions sales at Credit Suisse in Hong Kong. “These are very good alpha trades.”
Such has been the success of this business for Credit Suisse that other investment banks have inevitably sought to replicate this model of private loan origination and distribution in recent months.
Credit Suisse’s unique “One Bank” model, in which investment banking, private banking, global markets and financing divisions work together to innovate, create and distribute, means few – if any – competitors of the bank are currently able to match the bank in terms of scale in these types of transactions, says Zhang.
“It’s because to do jobs like these, you have to have all the stakeholders in the organization working together,” says Chia. “Some of the deals we’ve done have been quite large.”
A senior hedge fund client of the bank agrees that it’s the One Bank philosophy that gives Credit Suisse the edge when it comes to lending solutions like this. This, according to the director, is one of the main reasons why the bank’s structured credit finance business is one of the best in the market.
Other banks, he confirms, have started to offer similar services, but they lack the coordination to provide financing on loan assets as efficiently as Credit Suisse.
“By far, Credit Suisse is the most efficient,” he says. “From their bankers to their structuring, their financing team, to the risk managers, they are all very coordinated to provide a single solution. It’s still a very cohesive conversation.
One bank, one winner
The benefits of multiple banking units and businesses working together, as can be seen in several other credit solutions the bank has structured over the past year.
A convertible bond financing hedging solution, for example, involved collaboration between the bank’s Asia-Pacific prime brokerage and credit solutions businesses and its we securities lending office. The launch of CDS Index Skew Notes is another example, with the solution involving collaboration and teamwork between the bank’s structured flow and non-flow businesses.
Convertible bond hedge financing was executed on behalf of private banking clients who were seeking financing on a convertible bond and had hedged the bond’s long equity position. To create the short stock position, the client had to be able to borrow stocks in size. To maintain it, the client had to pay a certain amount of margin on the transaction.
Normally, given the illiquidity of the security, Credit Suisse should have been cautious with the LTVs he charged on the transaction. However, the short equity position the client needed for his hedge offered a way to reduce the cost. The solution was to bring together the different components sitting in different banking units.
The Credit Suisse branch in New York procured the stock in the size required by the client. Using these borrowed shares, the client then created a short position in their main account at Credit Suisse Prime, which then traded with the Structured Credit team.
Because the convertible bond price volatility was effectively hedged by this equity short, Credit Suisse was able to provide an optimized loan-to-value ratio on a total return swap (TRS) for funding. With the bank watching both the TRS and short equity positions as a whole, the investor was able to benefit from delta hedging against the short equity position, offsetting the TRS exposure.
If the bank simply offered financing on the convertible bond, the transaction could be subject to a discount of up to 50% with another 10% discount applied by prime service for the short action.
“The overall risk of such a transaction is very low,” says Soumitra Bhattacharya, head of APAC structured credit trading at Credit Suisse in Hong Kong. “But the question is, can you give the client the right financing solution that actually makes sense for a hedged position?”
But the right financial infrastructure also had to be in place. For compensation to work, the TRS and short positions in stocks had to be legally net.
“The client can hedge close to 100% of the risk, but the question is, can you give them the funding that actually makes sense from a hedge position?” said Bhattacharya.
This has been made possible through the framework agreement that customers accept when joining the core services platform. The master agreement already includes other obligations of the customer towards the bank, so that in a repurchase transaction within the framework of an overall master repurchase agreement or TRS under an Isda master agreement, separate positions may be documented as legally net.
“We were able to do [this transaction] because – even taking into account that the long and short sides belong to two different businesses, Credit Suisse can – at the level of “One Bank” – consider it as a hedged position,” says Bhattacharya.