* Illiquid positions in private credit: risky, perhaps; profitable, definitely
By Christopher Whittall
LONDON, Sept 30 (IFR) - It’s not all doom and gloom at Deutsche Bank. In fact, one corner of the bank is thriving amid the turmoil and job cuts and is even outshining the performance of similar units at rival banks.
That business is Deutsche’s colossal credit-trading unit.
Credit has become a crucial money-making machine in recent years for Germany’s largest bank, accounting for roughly half of the €5.4bn in revenues its currency- and bond-trading operations pulled in last year, analysts estimate.
Unlike most of its rivals, though, Deutsche has built a business focused mainly on trading and financing the least liquid and most complex areas of the credit markets.
Some rivals say that is a risky gambit. But it is one that has put Deutsche at the forefront of the latest boom in debt finance: private credit.
“The private credit space is growing much faster than the public markets. At Deutsche Bank we have been at the forefront of that, making sure this is at the centre of our strategy,” Chetankumar Shah, global head of credit trading at Deutsche, told IFR in an interview.
So far, the strategy has paid off. The bank has steadily taken market share in credit trading in recent years, leapfrogging US behemoths Bank of America Merrill Lynch, Citigroup and Goldman Sachs into the top tier alongside JP Morgan in terms of revenues, according to analytics firm Coalition.
To get there, it has not been afraid to head into areas that others fear to tread, while largely shunning the more traditional “flow” business of buying and selling corporate bonds on behalf of clients.
In the process, Deutsche has developed what may be the biggest distressed-debt unit on Wall Street and it has carved out a similarly large niche in lending against hard-to-value assets. It is also deeply involved in the burgeoning - and murky - market for bad loans in China [See Box story below].
Rivals say that focusing so intently on the less well-trodden and, they argue, riskier parts of credit markets could leave Deutsche vulnerable when the cycle turns.
But, so far at least, Deutsche has avoided the kind of heavy losses seen at some rivals when credit markets have slumped in recent years. That’s because, executives say, they aren’t taking excessive risks.
“Private credit risk is a different type of risk from the flow businesses. The flow business is subject to mark-to-market fluctuations. The structured credit businesses are more driven from fundamental credit evaluation and can be less volatile if managed well,” Shah said.
Deutsche has long been known for its prowess in structured credit, spawning such industry figures as Gregg Lippmann, who figured prominently in Michael Lewis’ book “The Big Short”, and Rajeev Misra, who now heads SoftBank’s Vision Fund.
For years senior management touted Deutsche’s pedigree as a “flow monster”, referring to the huge volumes it shifted in more standardised products. But chief executive Christian Sewing effectively drew a line under that era when he announced a retreat from equities and a significant chunk of the bank’s once-mighty rates trading business earlier this year.
The credit unit, however, remains largely intact. Indeed, Sewing identified structured credit as a crucial business last year and said it merited investment.
The world of structured credit has transformed since the financial crisis. The emphasis has shifted from designing funky-sounding products crammed full of credit derivatives, towards financing and investing in hard-to-value assets - or lending to funds that do so.
That is because private credit markets have mushroomed. Private debt funds had US$764bn in assets at the end of 2018, according to data firm Preqin, a more than threefold increase over the past decade.
In its financing unit, Deutsche provides leverage to funds that buy pools of soured loans or that lend to mid-sized companies. It also provides financing for commercial real estate, transport (such as aircraft leasing), infrastructure and energy projects. In distressed debt, Deutsche channels money more directly towards struggling borrowers.
There has been no shortage of material to work with, particularly in Europe where post-crisis regulations encouraged regional banks to curb their lending operations and offload portfolios of bad loans.
“Structured credit post-crisis is more on the financing side,” said Shah. “It caters to financing needs of segments of the real economy, and therefore the opportunity set is vast.”
Other banks don’t tend to talk about their distressed debt desks in public. Deutsche’s senior management, on the other hand, referred to it in 10 of the past 17 quarterly earnings calls, according to transcripts, showing the division’s significance.
Gavin Colquhoun, head of European credit, has risen up the ranks as distressed debt has grown in prominence at Deutsche. He joined from Merrill Lynch in 2002, where, he says, nine out of 10 of his graduation class moved over to Deutsche (including former credit supremos Boaz Weinstein and Colin Fan). Colquhoun joined the distressed business in 2004, became European distressed head in 2009, before taking over European credit flow trading as well in 2016.
He said Deutsche allowed people to be “creative”, citing recent examples in special situations such as fronting a trade finance backed loan to the crisis-hit commodity trader Noble last year, or driving the restructuring of Spanish chocolate company Natra.
“Just because it’s illiquid doesn’t mean it’s bad risk,” said Colquhoun.
Distressed is an umbrella term, encompassing trading the publicly-issued debt of companies that have run into trouble; “special situations”, or lending to companies going through tricky periods; and non-performing loans - portfolios of smaller loans, such as mortgages, that have gone bad.
Deutsche often competes for such deals with private investors, but Colquhoun said that the bank can be more flexible in its targeted business than a typical distressed fund.
“The lower cost of capital allows banks to participate in the lower levered, more secured portions of the capital structure,” he said.
Distressed exposures are typically held on a bank’s books for far longer periods than ordinary corporate bonds. By definition, they involve dealing with riskier borrowers with strained finances. And it can be a risky business: other banks that have suffered large losses in distressed trading in recent years include Credit Suisse and Goldman Sachs.
As regards risk management, Shah said the bank monitors underlying credit exposures on a regular basis with an “emphasis on credit, structural risks.”
There are even indications that Deutsche’s risk appetite has increased. When a rival bank tried to hire a Deutsche team focused on special situations around 18 months ago, Deutsche increased the amount of money the group could deploy by several times to over US$1bn, according to a person familiar with the matter, and said the team could retain virtually all of the risk rather than having to parcel most of it out to other lenders.
FINANCING Distressed frequently goes hand in hand with the other business that makes up the lion’s share of Deutsche’s credit revenues: financing. Here, Deutsche partners with private investors instead of competing with them. Patrick Connors, European head of the credit financing and solutions group, said Deutsche’s financing business has expanded as competition to buy assets has intensified and deal sizes have ballooned.
“We’re in a yield hungry world. The number of investors that are willing to look at unrated, unlisted financing facilities has grown by a lot,” he said.
Two large deals in Spain illustrate how the market is shifting. In 2014, Deutsche bought a portfolio of bad loans from Spanish bank BBVA with a book value of €1.7bn, outbidding distressed funds such as Savia Asset Management and Lindorff Group, according to local media reports. More recently, Deutsche and Morgan Stanley arranged a €7.3bn loan to a joint venture between Blackstone and Santander to manage the real estate assets of failed Spanish lender Banco Popular, which were valued at around €10bn.
Connors said that most of the financing trades have an average life of around two years and involve offering senior funding to an investor stumping up around 30%-35% of their own capital to buy the underlying assets. That provides Deutsche with a healthy buffer against any potential losses, Connors said, with the deals overall representing an attractive risk-return prospect. GO WITH THE FLOW Deutsche is now looking to turn around the more run of the mill area of any credit trading unit: buying and selling corporate bonds. After several years of losing money, Deutsche reported revenues were “materially higher” in flow credit trading in the first quarter of 2019 and indicated performance was strong in the second quarter. It has also made several senior hires.
“Clearly the credit cycle has had a long run. Keeping those headwinds in mind, the objective of the bank is to continue to focus on [the credit] business and grow selectively,” Shah said.
The bank nonetheless faces some obstacles, including a potential ECB investigation into whether it contravened regulations by allegedly trading its own Additional Tier 1 bonds between 2014 and 2017.
And some are sceptical that Deutsche’s credit business can maintain market share amid the broader restructuring at the investment bank.
“So many times we’ve heard before they’re investing in the business and going to turn a corner, but it’s never quite turned out that way,” said Jon Peace, head of European banks research at Credit Suisse. “We would expect them to give up market share [across fixed income] going forward.”
Certainly, the most pressing issue may well be preserving the business that Deutsche has already built at a time when more banks and investment funds are looking to expand their footprint in private credit markets.
“Maybe they have the right model,” said one head of credit trading at a rival bank. While Deutsche focuses on high-margin, structured transactions “the rest of us are competing for a few cents here and there.”
BOX STORY - BIG IN ASIA
Chetankumar Shah is based in Singapore, making him the only global credit head at a major international investment bank in Asia. It is, in part, a reflection of the importance of the region to Deutsche’s credit-trading division.
Deutsche set up a specialist bad loan unit earlier this year in India. But China is arguably its biggest market in the region.
China’s sprawling debt markets represents a huge opportunity for banks, though a risky one because of the political and legal uncertainties that are part and parcel of doing business in the country.
Deutsche has developed a formidable financing and distressed debt business in China thanks to its joint venture with China Huarong Asset Management, Hong-Kong-based fund Clearwater Capital Partners and other unidentified firms.
The unit, Huarong Rongde Asset Management, was established in 2006, according to the company’s website. Today, it has 14 subsidiaries, 33 branches across China and Rmb600bn in assets.
“The challenge is making sure we find the right balance given the credit cycle and geopolitical situation we’re in,” said Shah. “We believe we have a good understanding of the business landscape and the legislation and jurisdiction in those markets.” (Reporting by Christopher Whittall)