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down the leverage mountain. Here Chenavari sees hedge funds as complementing, rather than replacing, banks. “We are working in partnership with the banks,” says Fery, and most of the time the banks and Chenavari share risk exposure to loan books as a measure of alignment.

Chenavari’s strategies are very niche in scope. The €1 billion Chenavari seeks to raise for the new regulatory capital fund is less than 1% of the UK’s bank lending to smaller and medium-sized companies in the UK of around £180 billion, which is just one of the target markets. “Our investment activities focus on asset- classes that banks now view as non-core, such as real estate or consumer lending,” says Fery. It would be a great exaggeration to think that alternative investors will replace banks. Yes, tens and possibly hundreds of billions have been raised for deleveraging direct lending funds, but that is still tiny – maybe less than 1% – compared with the €25 trillion of lending in the EU economy. Indeed, regulatory capital deals are often designed precisely to let banks hold onto portfolios and to continue making new loans, effectively focusing on monetizing relationships with the clients they lend to. When Chenavari in effect sells credit insurance on a slice of loan book risk, the Basel III new rules can mean that a much larger amount of bank capital is freed up. Nobody disputes that banks must still fulfill the essential utility function of maturity transformation – taking in short-term deposits or wholesale funding and lending for longer periods. This is not an activity Chenavari is willing to engage in – indeed, the liquidity terms of its funds are aligned with their investments to avoid liquidity mismatches.

The term “shadow banking” does not fit the way in which Chenavari interacts with regulators. Indeed, before each transaction, regulators are asked to validate regulatory capital deals considered by banks with funds like Chenavari – otherwise banks would run the risk of not benefiting from actual capital reduction. Fery finds that regulators are generally embracing the influx of alternative capital into this space, and he argues that Chenavari’s deals help to promote “financial stability, as it transfers risk from banks that are still up to 20 times leveraged, to funds that are generally unlevered”. In fact Fery does not see how unlevered (or sometimes term-levered) funds, with no liquidity mismatch between their financing and/or investors and their borrowers, could become a source of systemic risk. Should defaults exceed even Chenavari’s apparently conservative stress test levels, sophisticated investors will simply have to stomach the losses. In contrast, of course, the interconnectedness of the highly levered banking system means that a run on bank deposits (or freezing up of wholesale and interbank markets) would threaten contagion effects that will often require the state to step in as lender of last resort.

Regulatory thinking, however, is shifting from bail- outs to bail-ins. If Dodd Frank started the trend, the Financial Stability Board report was endorsed by the G20, and the EU Bank Recovery and Resolution Directive will prioritize bail-ins before bail-outs. Already Cyprus may be an early example of a bail-in, and 2014 has seen Austrian, Bulgarian and Portuguese bank failures this year described as being at least partial “bail-ins”. Some countries outside the US and EU, such as Canada, are also passing bail-in laws.

Risk retention and bail-ins are, along with bonus deferrals, claw-backs and co-investment requirements, designed to align interests amongst banks, hedge funds, their staff, investors, and the taxpayer. So “skin in the game” is the name of the game, and hedge funds that are regulated, exclusively for professional investors, and outside the scope of government compensation, deposit insurance, or consumer protection schemes, seem to be in tune with the zeitgeist of regulation.

A leading deal sourcer and structurer In regulatory capital, Chenavari proactively creates its deal flow because few of its deals are available from market makers or brokers, (at least before Chenavari has created the structures, which can then be syndicated or securitized publicly at a later stage). Some deals that are publicly traded might not meet Chenavari’s return requirements – the Credit Suisse Clock transaction only pays 9% above Swiss interbank rates, on tradable notes, which would translate into a net of Chenavari fees return of no more than 6% or 7% to investors.

In contrast Chenavari’s case studies show actual double-digit yields involving German SMES, UK mortgages or Spanish receivables, for instance. Chenavari needs a weighted average gross return in excess of 15% to deliver over 12% net to investors – and to achieve this, they will often tailor deals rather than buying off-the-peg ones conceived by somebody else. Deals that have to be held for several years should carry an illiquidity premium, and arguably Chenavari investors also benefit from an implied arranging fee factored into the yield on private deals.

When it comes to sourcing, Fery highlights that Chenavari is leading the pack. “In 2014, our teams succesfully traded two of the three main consumer finance deals closed in Europe this year, and almost 50% of the significant leasing transactions,” he states. Chenavari appears as one of the busiest players in regulatory capital, with a focus on niche opportunities: as Fery says, “We are told that we closed the largest number of bilateral trades with European banks in 2013. Not sure about that, but we are certainly pleased with our quality deal flow”. This seems logical to Fery, as the Chenavari team has spent their entire careers in European banking and finance.

Valuation and liquidity

The private equity structure means reported performance volatility can be lower than for funds trading liquid assets. Absent impairments, many loans are valued at par value plus accrued interest, which partly insulates reported performance from the ebb and flow of market risk appetite, and has historically contributed to very low fund volatility. Most of these deals are in effect self-liquidating, which means Chenavari does not need to find buyers. As well Chenavari has re-liquefied assets by acquiring portfolios, securitizing them, and then attracting the attention of market makers. However, there is no guarantee that returns will be a smooth straight line – in its first year in 2011, the Toro II fund reported a small loss, and recently the listed vehicle reported mark to market, i.e., unrealized, losses on £45 million of “mezzanine exposure to short-dated loans made by a Portuguese bank to a diversified pool of over 8,200 underlying Portuguese SME borrowers.”

Operational capabilities Chenavari’s regulatory capital repertoire ranges from “risk sharing” deals buying slices of loans, to buying whole loans, in areas that are now non-core for banks, such as leasing, mortgages and consumer finance – and the fund has also invested in operating portfolios of loans. Among operating deals publicly reported as funded by Chenavari were the acquisition last year of a leasing subsidiary of Dexia; and also the purchase earlier this year of a former BNP Paribas unit involved in credit card finance in Belgium. Fery explains that “although specialty finance units tend to be profitable, banks are generally re-assessing their involvement in these activities, considering that the cost of capital for non-rated exposure is prohibitive under Basel III.”

Consumer finance is an attractive investment opportunity, Fery says. But that does not mean Chenavari are chasing after the triple-digit annualized interest rates levied by some doorstep and payday lenders. To the contrary, Chenavari accurately foresaw that such high rates could carry regulatory risk, and indeed UK and US regulators have clamped down on some lenders. Instead, Chenavari prefers to focus on countries that have not just a usury rate ceiling, but specifically the lowest such cap – for example, Benelux.


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