Given most of our strategies at CT require a relatively small capital endowment, it is important that we continually try to find the best uses of surplus funds. Spare cash ranges anywhere from 50% to 90% of AUM at any given time, depending on risk appetite and quantity and quality of ideas within the strategy portfolio.
Clearly small deltas in return on this large portion of assets can have a sizeable impact on the full year P&L delivered to investors. A low risk trade that can generate 50-100bps, and be churned once every couple of months, could add as much as 5% per year on the full balance.
One new avenue we have begun pursuing is a nuanced version of Factoring (invoice financing).
In a traditional factoring arrangement, the lender will bear the credit risk not of the borrower, but of the the borrower’s debtor.
There is a subtle beauty in this type of contract – the company that is most in need of cash today, will be willing to pay a higher rate of interest to secure financing. Normally, this feeds through to a higher likelihood of default and therefore zero abnormal (risk adjusted) returns to be earned by the investor. But under factoring, we can use an outstanding invoice as collateral for our loan to the struggling firm – an invoice that is (perhaps) due to be paid, in time, by a very credit worthy company.
So we ‘novate’ the credit risk AWAY from the risky seller-of-goods-yet-to-be-paid-for TO the potentially high quality buyer-of-goods-yet-to-be-paid-for.
Even though the borrower has a high quality asset (an invoice to a high quality borrower), he may be willing to take a substantial discount (i.e. ~1%) to the invoice in order to get receive cash immediately. Clearly the extent of the discount is dependent not only on the creditworthiness of the invoice, but also on the desperation / time sensitivity of the borrower. It is the addition of the second point that can enable the investor to earn abnormal returns. You are being paid for being flexible and nimble with your capital.
The final, and nuanced, step – that we believe ensures that traditional factoring can be turned into a robust strategy (that can deliver a small but noticeable alpha to the portfolio) – is to insure the invoice against default from the invoicee.
This is the only ‘conventional’ outcome that can cause a loss of capital to the lender. It the possibility of this outcome that causes a normal market return to be available to anyone willing to bear credit risk.
We have no interest in this traditional source of return, so hedging it seems natural.
We are then accessing purely the ‘second’ source of return I mentioned above – and one that we believe can generate excess return in the long-run.