European banks lean on hedge funds as recap gathers momentum
LONDON, Dec 4 (IFR) - European banks have turned to hedge funds to help them raise deeply subordinated hybrid capital in 2013, but the high risk nature of the asset class and potentially higher rates could pose problems further down the line.
Hedge funds used to suffer cuts in allocations on subordinated debt deals in favour of real money accounts. But throughout 2013, European banks have been reliant on these investors that, in some cases, have bought almost half of new issues. Banks have raised almost US$40bn equivalent in euros and dollars so far this year according to Thomson Reuters.
"The bank subordinated debt market has been very hedge fund heavy for some time. The volatility created by the crisis chased away a lot of the traditional long-only investors," said Nick Linnane, senior portfolio manager at hedge fund firm Cube Capital, which runs $1.3bn in assets.
"This is exactly what hedge funds do. We do our homework and go into an area where other people are yet to go."
New regulations, designed to ensure turning to tax payers is the last resort in future bank bailouts, mean new-style capital issues expose investors to a higher probability of losses.
Hedge funds have stepped into this void with clear benefits for European banks, but not without dangers. Because they are leveraged, if there is a market blip, there is a risk they might - or be forced to - exit at the same time.
Barry Donlon, head of capital solutions and liability management at UBS, said it is unclear whether the role of hedge funds in providing deeply subordinated capital to European banks could be easily replaced.
"Because they have flexibility in their investment mandates and greater risk appetite, they are generally better positioned to buy Tier 1 than many of the more traditional fixed income investors," he said.
One example is the Nationwide Core Capital Deferred Shares deal, where hedge funds bought 30% of the GBP500m perpetual at the end of November
According to Andy Townsend, the UK mutual's treasurer, hedge funds did not anchor the deal, but they were very helpful in finessing Nationwide's thinking. "They provided thought leadership," he said.
While the nascent Additional Tier 1 market has proven the main hunting ground for hedge funds, they have also bought some of Europe's weaker banks' subordinated issuance.
Some 27% of Banco Espirito Santo's EUR750m 7.125% Tier 2 in November was placed with hedge funds, an even larger allocation, just under 37%, of Bawag's 8.25% EUR300bn Tier 2 in October, and around 40% of the EUR500m AT1 sold by Banco Popular Espanol in September.
Relatively high yields on offer in the bank capital market have been a big pull.
"There is the demand for this kind of paper because volatility is very low and rates are very low," said Antoine Cornut, Founding Partner at Camares Capital, a credit hedge fund.
The search for yield is apparent throughout the debt markets right now, but Cornut is worried about what happens when rates back up.
There are various warning signs the market has gone too far too soon. According to one manager of a large financials-focused hedge fund, excess liquidity in the market is pushing yields down too far.
"You are starting to see the loose behaviour from investors and aggressive behaviour from issuers that you see at the top of bull markets."
John Raymond and Simon Adamson, analysts at CreditSights, also sounded a note of caution, saying that the AT1 asset class as a whole was not compensating investors enough for the equity-like risks they are taking both on principal and on coupon payments.
"There is therefore a structural repricing risk, especially if supply takes off in a serious way and/or interest rates rise," they wrote.
The Bank of England warned last month that a shock to long-term interest rates could be amplified in financial markets and lead to disorderly losses, adding that one of the possible channels for amplification could come from forced asset sales.
"In particular, the investment strategies used by some hedge funds can create highly cyclical liquidity demands," the bank said in its November Financial Stability Report. (Reporting by Helene Durand, Tommy Wilkes, Additional reporting by Christopher Whittall, Editing by Alex Chambers, Julian Baker)
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