Get Working Capital at Competitive Rates - Accounts Receivable Financing at The Receivables Exchange

 
An International Perspective on the Credit Environment

“If we were to count our years by the revolutions we have witnessed, we might number them with the antediluvians. So rapid have been the changes: that the mind, tho fleet in its progress has been outstripped by them, and we are left like statues gazing at what we can neither fathom, or comprehend.”  Abigail Adams to Mercy Otis Warren March 9th 1807

The president’s wife reflected on 60 years of change in that letter, and capital markets are unlikely to have been counted among the revolutions witnessed.  As America’s political history begins a fresh phase with President-elect Obama, the revolution in capital markets that we have witnessed over the past 60 years has come to an unpleasant head. Further revolutions are likely to follow in direct consequence: political, social and technological among them. For the player or bystander in the recent capital markets maelstrom, the past two years must feel like an eon. The changes have indeed been rapid, and while the finest minds on Wall Street and in the City of London strive to stay ahead of the curve, few minds have proven fleet enough. Politicians, many of whom have focused on equity markets’ response to policy initiative, will shortly discover that it is the bond market that allows them to govern, and that without its consent they may not. Those that can neither fathom, nor comprehend the issues may get statues sooner than they had hoped.

Putting the Capital back into Capitalism:
We believe the capitalist system has at its heart two things; free exchange and trust. Both of these core principles appear to be somewhat lacking in the current economic environment. A de-leveraging process that began with distress in mortgage loans to lower income Americans has spread globally to infect the banking systems and economies of the United Kingdom, Iceland, Pakistan, Indonesia, Argentina, and Russia, to name a few. Credit is the lifeblood of a free-market based economy, its availability and price determines the economic fate of individuals, companies and countries. For companies to trade effectively with one another, credit is extended from seller to buyer of goods, but this credit does not come from thin air (unlike central banks’ extension of credit). It must be funded from working capital, which must in turn be funded from equity or debt. Equity markets are essentially “closed for the duration” in reference to new capital raising for mid-sized firms, and even very large firms are struggling. Where existing corporate debt instruments offer equity-style returns with a senior position in the capital structure, who would want to buy new equity?

One way of judging the impact of recent events on the global credit market is to see how much it costs companies to borrow money in theory and in practice. Companies can borrow money on a long term and short term basis as well as on a fixed or floating rate basis. The most sensitive of these measures is for firms who wish to borrow on a fixed interest rate basis for a long time. It would be enlightening, therefore, to see what the situation was “pre-Lehman” and at the current time.

In the summer of 2008, banks charged about 4.8% to lend fixed 15 year debt to each other. Known as the 15-year swap rate, this ratio is linked to the interbank lending market. In June, banks would add about 125 bps to this rate to arrive at 6.05% total rate to fund a long term cash flow generative project (like a solar farm) with a gearing level of about 80% debt to debt plus equity. Now, the swap rate is 4.20% and they add roughly 200 bps to get to a rate of 6.2%. The implication of these statistics is that thus far, the credit crunch has not materially affected the pricing of debt (6.05% vs. 6.20%) for some types of project finance. (This is not to say that numerous companies have not seen the cost of their debt rise substantially. Recent events have demonstrated the opposite, and this price escalation has been driven by the underlying credit deterioration of the company and the market in which it operates. Unfortunately, for the wider economy, those sectors such as construction and housing that have seen the most marked deterioration in outlook are also those with the highest proportion of debt in the capital structure – Soros’s reflexivity at work.)

However, this is not the whole story. What lending teams want to do and what they are capable of doing can be quite different. Whereas teams may want to lend at levels that are relatively unchanged from the mid-summer, they may not actually have the ability to get their hands on the money to lend. New projects with unknown management teams may face a grind to acquire the debt financing that they need. Relationships with banks that are still in business are therefore key. In addition to this base relationship, strategically aligning organizations that can provide access to debt capital markets or alternative funding sources, such as The Receivables Exchange, is an important consideration in business planning.

There are also some interesting dynamics going on in the Sovereign credit market. We have already talked about long term swap rates as the rate at which banks are willing to lend to each other. A more important rate is the rate at which governments issue their debt. Generally, governments are better rated than the banking sector, and therefore the 30-year long term interest rate on government bonds is lower (by about 20-30 bps) than the equivalent 30-year swap rate. In the U.S., 30-year swap rates are now lower than 30-year U.S. government bonds and the same is true of rates in the U.K. This indicates that either the market believes that the U.S. and U.K. governments are worse credits than their banks over a 30-year time period, or there is something very odd happening with long-term rates. It is, of course, the latter that is happening, driven by pension funds that have their assets tied up in equities. As equities have fallen, their deficits have risen and they are forced to invest in more bond-like assets to match their long term (bond-like) liabilities. Because their assets are bound, they are forced to go through the swap market (where they can avoid the use of their precious cash) to match their fund more closely to their liabilities. This creates a liquidity premium on swaps as they are not “bought” with cash. This process results in long term swap rates being lower than those of government (and higher rated) bonds.

It is worth mentioning at this point that for many years, Japanese swap rates traded at the same level as Japanese government bonds. This, however, did not indicate that Japanese banks were equivalent credits to the government. Rather, these parallel numbers demonstrated that the cohort of banks used to calculate this rate was equivalent to the Japanese government. This cohort included many international banks that, throughout the 1990s, were indeed a similar credit to the Japanese government.

Where the banking system is broken, the government has become the banking system, but in either case the ready availability of credit at any price to companies is problematic. The government cannot lend efficiently to companies for any length of time, and in some cases, governments have no money to lend. We believe the trading of credit between companies and investors without the intermediation of banks is likely to be a critical component to an economic recovery. The effective execution of such trade will require an exchange. This form of financial institution  tends to have the following key attributes: simplicity, liquidity, transparency – all of which sound rather attractive, especially in the current moment. If technology can help re-establish trust by clearly identifying the counterparties, the price and the risk, then credit can be traded again. It is this set of essential needs and the general features of an exchange model that have inspired The Receivables Exchange. The format is simple with the counterparties specified as companies needing capital and investors hoping to advance it. The trading is transparent, implementing the most advanced technologies and facilitating trade agreements where both parties are sustained and positioned for growth. Most important, the end result is liquidity. Taking into consideration the status of the credit market and the immediate needs at hand, The Receivables Exchange marks a huge step in the direction of revitalization. If private credit becomes available again, then we are likely to find a way out of this mess. If not,  you and I had better start building statues.

About James Clark and Alex Veys
James Clark and Alex Veys are co-founders of Capital SCF, a London-based strategy and corporate finance house. Capital SCF helps technology-driven organizations to identify, review and optimize capital allocation.  Both founders entered into this venture with a rich repertoire of experience in the financial services and software sectors. James was the Head of European Software & Services Equity Research at Credit Suisse, and Alex played an influential role at Fidelity Investments, London, where he  served as a Portfolio Manager and as Fixed Income Quantitative Analyst. The end result? Two individuals with a wealth of knowledge regarding the financial market and  with much to say concerning its current state, especially in reference to the cost of credit.

The achievements of the authors of this article are quite expansive and noteworthy. During his time at Credit Suisse, James Clark ranked 1st in his sector in the 2006 Financial Times Starmine Awards, he and his team also ranked first in the 2007 Extel Survey; 2nd in the 2008 Institutional Investor poll for European Software; and his team was ranked in the top three by Institutional Investor in the European Software category every year from 2000 until his resignation in 2008.

Alex Veys worked at Fidelity Investments from 1997 to 2007 where he ran gilt, corporate, aggregate, international and European bond funds to the value of USD $5 billion. As Fixed Income Quantitative Analyst, he built the quantitative analytic team and introduced state of the art risk systems and techniques. He also authored a short book on derivative instruments.  While helping co-found Capital SCF, Alex completed his MSCc in Sustainable Energy Futures at Imperial College, London. Clark and Veys represent two great financial minds who continue to drive innovation and change through their company, Capital SCF, and their analysis, interpreted through the lens of knowledge and experience.