Russia and CIS Loans Roundtable 2008: Part 2
IFR: Retail bid disappeared last year partly on the back of the pricing being too low, but if pricing has increased, why haven’t they stepped back in?
Hasan Mustafa: There were a couple of pre-export finance deals that were done at the end of 2007, which saw retail investors come back, but I think what Christian is saying is that retail is blocked up essentially for these bridge facilities. Even though they have higher pricing and higher yield, they just do not see why they need to take a six-month, nine-month, 12-month view. There are opportunistic buyers who will take it, but you cannot go on and invite 40 or 50 retail investors and hope that 20 will come. They would rather do a term financing or pick up something in the secondary market, where term paper floating around at 97 or 98.
IFR: How important is the secondary market now?
Hasan Mustafa: I can talk about, from my experience, 2007 being the biggest year as far as secondary trading is concerned for us, and I think our volumes quadrupled. It was not only what we were selling from our portfolio, but it was a lot of trades were done buying and then selling on to somebody else. That still continues to be the case, but there are still a lot of investors looking for opportunities to buy assets in Russia, in CIS and Middle East and Turkey.
James Nisbet: If you look at what banks are offering in the secondary markets, you know, probably a year and a half ago 90 per cent was leveraged loans, whereas now probably as much as 50 per cent is emerging market loans. I think the key for the secondary side is obviously getting a balance between demand and supply. Obviously there is a lot of supply in the market now and I think the secondary market is still finding its price parameters because emerging market loans are not linked into derivatives such as loan CDS like the leveraged market. Secondary pricing on the emerging market side is very much based on what price people are prepared to sell at, and that is very much diversified at the moment, depending on how pressurised people are to sell, whether it is obviously on a trading book or whether it is just sitting on your balance sheet. If it is on a trading book and you have three months to sell it at any price, then you are going to have to discount it. So we are seeing at the moment some banks, particularly investment banks, having to offer out paper at quite discounted levels. Other banks who are not so pressurised are maybe offering things out in the 99s but they are not getting any traction so there is still price discovery going on. Over time, as balance sheets become more clogged up and country limits need to be released, people will be more forced to sell assets in secondary and therefore they will have to price them at realistic levels where they will trade.
There is demand there and there is the retail demand but there is relative value pressure. Because if you are a retail investor, you might say, well, I can buy the bond at this price, or maybe sell protection at this price, the loan is priced here, therefore actually I need to buy the loan at 97 rather than 99 to match the economics I would get on buying the bond. If you can do that, then you will find retail appetite in secondary, and probably even in primary as well. But I think there is a lot of scope to develop the secondary market now and it just needs people to be more realistic. We are not talking about huge discounts like we see on a leveraged market, but if banks need to relieve their balance sheets and lighten up assets because of the lack of derivatives at the moment, they need to be realistic.
Hasan Mustafa: I think if the bond markets do not come back within the next three months, starting from April, May and June, then secondary prices will widen further. So far the pressure always appears to be from the investment banks to sell as much as they can, as quickly as they can, at whatever price they get it. The universal or commercial banks tend to take a slightly more relaxed view. But there is bound to be pressure that needs to come, because at the end of the day, as we just discussed, the volumes will not drop.
These companies in Russia and CIS will continue doing business, acquiring assets in the region, outside the region, and who will they go to? They will come to us. If there are no other markets available to offload the risk, then there will come a tipping point where something has to give.
William Sharpe: There is definitely a disconnect between primary pricing and secondary pricing. I mean, a year ago, a year and a half ago, we would look at secondary loan market pricing for corporate and bank paper. We would also look at spreads in the eurobond market, but clearly there is a disconnected aim. Maybe they will align themselves. If markets function perfectly then they should, but for the moment I think it is back to basics. A year to 18 months ago, we were basically pricing liquidity in the market, from the point of view of participants.
Today I think there are two factors. We are back to pricing risk, so you can see where certain structures, like pre-export financings, they are a less perceived risk so they do better in the market in terms of liquidity compared to unsecured transactions. The other point is that banks’ own funding costs have gone up. So to a degree we are still pricing liquidity, but banks’ own liquidity. I think this is one factor which has constrained transactions five years and longer because we all know where European and American banks’ five-year CDSs are trading well over 100 basis points, so it is very difficult to lend at the rates that Russian borrowers have come to expect even with a healthy premium, given that situation.
James Nisbet: It is a very key issue again with the retail market. You have to look at the scale of the cost of funding. The retail smaller banks in the market who, two years ago were your natural lenders in the pyramid of the primary market, they are all sitting there with a much higher cost of funding than the big banks. So this is again why you are seeing the bigger banks stepping up to take more exposure, because on the jumbo deals where the pricing is quite cheap still, the big banks are pretty much the only ones that can even do it, irrespective of relationship or relative value, simply because the cost of funding is prohibiting the smaller retail investors. They are saying “my cost of funding is 100 basis points, therefore I need a return of maybe 200”. So they will look to the secondary market, they will look to the smaller higher-priced deals in the market. When looking at the retail investor base, you have to ask, on an almost individual case-by-case basis, what is the cost of funding for this bank? Speak to them, asking “what is your return criteria now?” It could change week on week. That is the problem. This is not something we are used to in the market - not since the Asian crisis when the Japanese premium was prevalent. Now there are a new set of issues that arranging banks are having to consider when actually structuring a deal and looking at retail appetite.
IFR: It sounds like retail investors have become a lot more sophisticated in how they approach the market rather than just taking pure primary. Why has there been this sea change?
Christian Eberl: They have learnt from mistakes in the past. Now they recognise that they could be important for the MLAs in order to slim down their exposures, and they can afford to sit on the fence, given just the big supply. Therefore they really can cherry pick. It looks like they could take over an upper hand to a certain extent. This is what is driving the appetite from the retail investor. So they are watching the development very closely and carefully and, as we have heard, relationship for them is not a big issue, so they can play around and it does not make a difference whether they, let us say, ship in five million, ten million in this transaction or in this transaction. As long as the overall credit matrix or sector remains intact for them, they are happy to go wherever the highest yield is.
Benjamin Binetter: I think at the end of the day, the bookrunners over the past two years have made quite an effort in expanding the universe of banks that could look at Russia as a country, and on every deal you tend to see a finite group of same investors being approached. The mere fact that you have so much paper coming out to the market at the same time means that those same investors have opportunities to choose between five deals, not including the secondary opportunities. At the end of the day, that same group of people are looking at five deals on the table and just cherry picking deals.
IFR: Are there any banks that are in a better position than others to win at the retail or secondary level? Are there any banks that are more liquid than others?
James Nisbet: The banks that have not had the issues that a lot of the larger banks have had with subprime and all the other things. The issue at the moment is that subprime is being blamed for everything. We all know, we all work for large banks or have worked for large banks and clearly the issue is not just subprime, it is a number of other factors. It is the banks, the small retail banks that maybe have clean balance sheets that have maybe a reasonable cost of funding at the moment, that are sitting in quite a good position.
So we know that the institutional investor market has pretty much evaporated for the time being. It has never really been part of the emerging market scene anyway, so thankfully we are not reliant on that. It has always been a very traditional bank market in terms of the investor base. Luckily it is a global investor base and we have we have all worked over the years in the market to develop that global investor base. So now we are going to be looking at new areas, or not necessarily new areas, but more focusing on areas like Asia were there is investor appetite.
If you look at secondary, a lot of the interest is coming from the Asian market. At the moment we are seeing appetite more obviously at the sort of borrowers who may be linked to state risk such as financial institutions or utility companies. But as the investor base becomes more interested and knowledgeable, then I think it will start to look further down. That just ties in with one of the issues about will we start to see new banks emerging as arrangers and lenders in this market, and I think to a certain extent we may do. Some of the smaller banks will start to, if they have the balance sheet available and they have the resources and the expertise, they will start to step up to take the place of some of the banks that maybe are more constrained. The challenge for book runners and arrangers will be to educate and develop these new investor bases. There is institutional money as well that can be put to play from the state funds, and we have seen a lot of the Middle Eastern funds even bailing out banks to a point.
There is a lot of liquidity there, but you have to think outside the box. You have to say, when we look at things like infrastructure deals and the more complex financings that are going to be coming up in Russia and CIS, they are not obviously going to be able to just be funded from the loan market, they have to be funded from equity and other areas.
So it is finding those areas and absorbing them, maybe in conjunction with the loan market and come up with new financing solutions so that the loan market can become an integral part of these financing solutions.
IFR: Do these new investors have different requirements, different criteria when they approach deals?
Hasan Mustafa: If you start at the top, you have the oil and gas companies, then you have metals and mining. As you go down the different investor sectors, the universe keeps shrinking. A case in point is some of the retail deals had a tough time getting done, and to do a US$100m deal or US$200m deal in a retail or non-core sector of Russia is possible, but to do a US$1bn, US$1.5bn, US$2bn deal is challenging, because the investor universe is so limited.
Benjamin Binetter: I think in the syndication strategies that are implemented today, the new types of investors, new Asian investors and the like, are tapped, but I do not believe that anyone is relying on that liquidity. We are still not relying on new investors for the deals to get sold because it is actually very difficult to establish exactly where their interest lies. Some are very focused on shorter-term deals, clearly the oil and gas and commodity sectors are key, but there needs to be a link somewhere. They get tapped, but with not much success.
William Sharpe: They definitely show up from time to time though, especially when there is an opportunity for visibility as an arranger, as a mandated arranger. If you had to try and classify their priorities, probably number one would be credit, number two would be pricing and number three would be visibility, pretty close behind. So it is obviously easiest for them to go with the big names, and these would be the oil and gas companies, or on the FI side, some of the more well known banks, either publicly held or the top private banks in Russia.
So once they are pretty sure they can sell the credit story internally, then it becomes about, how much can I make as an MLA, as an arranger, compared to how much I could get in terms of yield if I picked up the asset in secondary? And sometimes those two forces are in opposition. So this is why perhaps success has been mixed to date, in tapping Middle Eastern, Asian investor bases.
IFR: Are there obstacles in getting new investors to participate in the market?
Benjamin Binetter: Borrowers in Russia are certainly acutely aware of the liquidity issues that the bank market has as a whole, and are very sensitive to banks offering the ability to sell deals in new markets. But again, I have not seen that being oversold to borrowers, in that you are not seeking to pin down your syndication strategy in the hope that you are going to raise US$100m, US$200m, US$300m from those markets alone. It is really opportunistic at the moment.
William Sharpe: The withholding tax issue is still significant as well, because what we have seen is that arranging banks have become less willing to play the role of fronting bank, for various reasons. So whereas before we were able to get around this issue of withholding tax between Russia and certain countries in Asia and the Middle East, today it is becoming more difficult. This is another obstacle to tapping that liquidity.
James Nisbet: A lot of countries need to work a lot harder on double taxation treaties, because certainly a number of deals we have done recently we have had to act as fronting bank. We closed a deal in the Ukraine recently where we were fronting bank and certainly the accounting rules now are starting to clamp down on this, because really from an accounting perspective whoever books the interest should be disclosed. So the whole fronting structure really is something that banks are trying to move away from, very clearly. But of course I think it is one of the major obstacles and has been to getting these Asian investors more interested in the market, because time and time again they come up against this. Sometimes in secondary they can buy through sub-participations, but again that is not an ideal scenario. Banks like to get the asset off their balance sheet in its entirety. So these more technical areas need to be addressed and I think it is going to take time for that to happen.
IFR: We have seen a revival of the pre-export structures this year. Initially this structure was put in place primarily to mitigate country risk, so as Russia’s credit quality increased the need for that structure would fall away. But Russia’s credit has not changed in fact it improves, with oil pumping out the ground at $100. So why the revival? Why is there the comfort in this structure?
Christian Eberl: I think in an environment where each credit department is scrutinising each transaction and each credit twice or three times, asking more questions, even if the borrower is well known, it is always good if you have a good structure behind, a proven structure which has worked in the past, even in very difficult times. That is the first thing. It makes life easier to get something approved and also to get big chunks of commitments approved. The second point is country limits. Despite, Russia having improved in terms of external rating, still banks need country limits for the transaction, and once we have an offshore payment stream, banks can have a certain relief on country limits. With just these big jumbo amounts and big takes the banks have to put on balance sheets, I think the banks are willing and able to go this route to a certain extent and increasing their country limits, but at a certain point in time each bank will reach a certain country ceiling. Therefore I think these are two major things in terms of why the secured lending is back. The other thing is the secured or pre-export finance structure still allows tenors of three years to five years with an amortisation schedule, and when structuring deals you want to get maximum liquidity and for all of us as MLAs, flexibility is required. Really we try to structure a loan in a way that we think we can tap each potential investor, each pocket of liquidity, and clearly a pre-export structure can broaden your potential investor base because all the commodity trade finance banks will look at it who might not be able to look, for example, to an unsecured transaction.
James Nisbet: Banks have also learnt a lot from what we have seen in Western Europe. We have seen a weakening of structures on the leveraged markets and clearly that has been part of the issue with the demise of that market. Even in Russia structures need to be tightened up. We have been through a period where unsecured lending has become much more prevalent in Russia and CIS, but now people are going back to basic credit analysis, which is exactly what the market should have been doing all along. So now it is unsurprising that the banks, all of us that are lending, we are scrutinising structures much more closely and saying, well, in the current environment where we have a potential recession coming up, nobody knows how this is going to impact Russia and the emerging markets, credit risk is in the forefront of people’s minds. They want to protect themselves, so you are seeing appetite for shorter-term risk. But the longer term three and five-year deals, as Christian was saying, people will do those, but they want to see a good structure in place that gives them comfort that if something goes wrong they can catch it early.
Hasan Mustafa: It is ironic as you have a country where you have the world’s largest gas company, you have the world’s largest aluminium company and you have the world’s largest nickel - everything is the world’s largest in terms of these core sectors. Despite all of that and the credit strengths of some of these businesses, people are still looking back and saying where Russia was seven or eight years ago and do not want to get burnt. I think the memory of 1998 still lingers on. So whatever we were seeing in the first half of 2007 where everybody was saying pre-export financing is out of fashion and we are going to move on to the unsecured side, I think there was, even before the correction, a realisation that yes, you could do unsecured, but a lot of banks, especially the European banks, do not want to do unsecured. They only have commodity financed businesses, and that is the only way for them to get into Russia.
Click here for Part Three of the Roundtable.