Helping local government pension funds meet cashflow needs with stable and diversified income streams.
Executive summary
As LGPS funds mature and face uncertainty around any surplus that has built up, the need for stable income with good yield becomes ever more important. In this article we look at how Working Capital Finance (WCF) can deliver predictable cashflows, whilst providing stable returns with low default risk and adding diversification of income streams to LGPS funds’ portfolios.
Our WCF strategy has continued to provide a consistent stable return since 2019. The strategy targets a return of three-month risk free rate +250bps net1, and has experienced very low volatility with no defaults, even in times of market stress [1].
Our WCF assets are a form of short-dated corporate credit to mostly multi-billion-pound companies to help them achieve greater efficiency in their supply chain, which in turn improves relationships, reduces overall costs, and improves profits.
Given their short duration and self-liquidating nature, WCF assets have very stable NAV. With average tenors below 120 days, they have a natural level of liquidity, and investors can access their investments via a monthly open-ended share class.
The asset class’s resilience to downside risks is threefold:
1. Short-dated: nature of payables and receivables to service the needs of large global corporations provides a natural level of liquidity even in times of market turmoil.
2. Floating rate: as the assets are priced off of 3M SONIA, there is no duration risk i.e. the cash plus 250bp return will track interest rates rises and falls.
3. Low default rates: WCF performs structurally ahead of its senior unsecured position in the capital structure, benefiting from company creditors’ incentive to maintain a business as a going concern, even in stressed situations.
Low-risk profile of WCF assets is backed by data from Berne Union [2], which points to an average claims ratio of 13bps for short-term export credit between 2020-2023, a period that includes the economic dislocation of the global pandemic [3].
Trade Finance is a growing market, currently valued at USD 9.3 trillion and projected to see a CAGR of 3% over the next decade [4]. A 2023 J.P. Morgan analysis suggests that WCF specifically is expected to be a focus area for treasurers and CFOs, as companies seek cost-effective funding sources to optimise capital structure and support growth in a high interest rates environment [5].
Two major factors have allowed for the entry of non-bank lenders like Pemberton into the WCF space, which has traditionally been dominated by international trade banks. Firstly, banks have retreated from sub-investment grade lending following the Global Financial Crisis (GFC), causing a major funding gap. Secondly, reconciliation technology, which had been a barrier to entry, has undergone major innovation, driven largely by private and government investments into digital trade finance technology and other forms of fintech, aiming to secure global trade.
Pemberton has developed a robust proprietary IT infrastructure capable of effectively handling large amounts of WCF transactions.
Pemberton’s investment philosophy is one of bottom up-fundamental credit analysis. The WCF strategy focuses on providing funding to large and medium-sized companies. The emphasis is on sourcing high-quality short-term lending opportunities supported by receivables, payables and inventory. Pemberton Asset Management is a leading European alternative credit manager, investing in non-investment grade debt on behalf of institutional investors globally. Assets under management total €20.0 (2024) [6], with €29.0bn invested since Pemberton’s inception in 2013. Legal & General Group Plc (L&G) is a 40% equity shareholder, with the remainder owned by senior management.
Why we believe WCF could meet the needs of some Local Government Pension Funds
Several LGPS Funds have invested in the asset class, citing attractive investment characteristics such as:
- Attractive yields: the asset class offers an attractive return premium relative to its level of risk
- Floating rate returns: WCF offers investors positive exposure to rising short term rates
- Diversification: the asset class delivers an income from short-term corporate credit exposure unlike other credit risks available to investors
- Low default risk: the short tenor of the assets, uncommitted facilities, and structural “super senior” performance in a default underpin very low historic default data
- Low volatility: the lack of market exposure, duration risk, and low default rates deliver a low-volatility return stream
- Zero duration risk: no price exposure to changes in market interest rates and credit spreads
- Self-liquidating: facilities are repaid as part-and-parcel of a borrower’s trading operations
Pemberton believes the WCF strategy provides a range of attractive opportunities for Local Government Pension Funds
- An attractive complement or alternative to fixed-income investments in government and corporate bonds;
- A liquid cash plus complement to money market funds (MMFs) and bank deposits; and
- As part of a cashflow management toolkit to manage illiquid commitments.
Table 1: Stability and performance of WCF versus credit indices
Source: Pemberton Asset Management, as of 30th June 2024. Past performance is not a reliable indicator of future results. Performance is measured in USD and takes account of variable utilisation rates over time. All returns are based on gross performance. Actual returns will be subject to management fees and fund costs.1 Volatility of returns are calculated as annualised standard deviation of monthly returns over the previous twelve months for the WCF strategy, and as annualised standard deviation of weekly net returns over the previous twelve months for the Bloomberg indices. Fluctuations in volatility are based on the range of returns during the given time period, with WCF demonstrating consistent returns when accounting for changes in LIBOR.
Introducing WCF and Trade Finance
WCF is made up of three core products:
- Payables Finance: in which the lender extends payment terms to the buyer, while assuming the responsibility of timely payments to the sellers,
- Receivables Finance: in which the lender provides the seller with early payments against their invoices – assuming the buyer’s payment risk and the counterparty risk of the seller,
- Inventory Finance: in which the lender provides financing against a book of warehoused inventory or unsold goods.
The WCF market comprises the financing of working capital assets (receivables, payables and inventory) on company balance sheets worldwide. This includes but is not limited to financing related to cross-border trade, which is valued at an estimated US$18 trillion [7].
WCF assets are typically between 90-180 days in length and self-liquidating. As an operating expense they perform structurally senior to other forms of corporate debt, benefitting from the creditors incentive to maintain businesses as a going concern, even in stressed credit situations (see credit box below).
An investable asset class
Once exclusively offered by trade finance banks, regulatory changes since the GFC, such as Basel 3 and 4, have resulted in many banks becoming more restrictive in their trade related lending activities – with some ’derisking’ from the sector altogether.
Non-bank lenders have stepped into the breach, many offering short-term WCF via digitised platforms that connect borrowers with institutional funders.
Credit Risk – Low Loss Rates for WCF
Loss rates for WCF have historically been low. There are various reasons for this, including:
- WCF assets are often short dated, the bulk of Pemberton’s WCF strategy is invested in payables or receivables with maturities between 60 and 120 days. Default rates over short-time periods are historically low [8].
- WCF facilities are generally uncommitted in nature, as such a funder may cease funding further invoices at any point, without penalty.
- Short-term payment behaviour is a highly predictive factor of future corporate credit deterioration. With real time oversight of payments, providers of WCF funding are in a privileged position to assess the near-term default risk of a borrower. This allows funding to be stopped in good time.
- Outstanding working capital obligations are considered operating expenses. In most defaults, of medium or large companies, existing senior secured creditors maintain defaulted businesses as going concerns, so as to maximise recoveries. In a going-concern state, short-term obligations, such as payables and receivables, continue to be paid. Given the operating status of WCF liabilities they can perform super senior to other corporate liabilities.
- Further evidence of the lower-risk attributes of trade finance is provided by the Berne Union [9]. Its 2023 industry report highlights credit insurance claims of short-term trade-related insured debt relative to insured commitments. This data, for short-term trade credit insurance, covers the types of programmes funded by Pemberton’s WCF strategy – predominantly payables and receivables programmes for “BB” rated companies. Globally, the total annual cover in 2023 was $2.3 trillion, with total claims of $2.6 billion.
- Between 2020-2023 Berne Union data reported an average annual default rate of 13bps p.a. This period includes the displacement in global trade of the pandemic period, which contributed to higher-than-usual default rates [10].
- Longer term data from the International Chamber of Commerce shows default rates of 7 bps p.a. between 2008-2017 [11] and of 8.8 bps between 2017-2021 [12].
Table 2: Investors benefit from Investment-Grade Equivalent Risk
Source: S&P Global Ratings Credit Research & Insights and S&P Global Market Intelligence’s CreditPro.
*Pemberton estimate based on data from Berne Union, S&P and International Chamber of Commerce
Key benefits for LGPS pension funds
Source: Pemberton Capital Advisors LLP.
[1] There is no guarantee that target returns will be achieved. Such forecasts are not a reliable indicator of future performance.
[2] The International Union of Credit & Investment Insurers, The Berne Union, is an international association and community for the global export credit and investment insurance industry.
[3] Berne Union Export Credit & Investment Insurance Report 2023.
[4] Trade Finance Market Size Forecast 2023-2032 – Global Market Insights.
[5] Strategies for resiliency Working Capital Index 2023 – J.P. Morgan.
[6] Assets under management are defined as committed capital. For closed funds the FX rate used as at final close. For separate managed accounts and open funds FX rate used as at time of commitment (as of 30th June 2024).
[7] BCG Omnia Global Trade Model 2020
[8] International Chamber of Commerce Global Survey 2018
[9] The International Union of Credit & Investment Insurers, The Berne Union, is an international association and community for the global export credit and investment insurance industry
[10] Berne Union Export Credit & Investment Insurance Report 2023
[11] International Chamber of Commerce Trade register 2021
[12] International Chamber of Commerce Trade register 2023
[13] There is no guarantee that target returns will be achieved. Such forecasts are not a reliable indicator of future performance. Target returns are presented as a guideline for investors only. The target returns have been based on a variety of factors and assumptions, including, among others, investment strategy, volatility measures, risk tolerance and market conditions, and such assumptions are subject to various risks. Target returns are not intended to be, and are not, a prediction, projection or guarantee of future performance and should not be relied upon as an indication of future performance. For more detailed disclosures about the target returns please see the Important Information slide at the back of the presentation.