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The Basle II Capital Accord is being welcomed with open arms by Octagon Asset Management. It runs two alternative funds that specialize in asset-based lending, and CEO Mead Welles is confident that his firm will benefit from the higher credit costs that banks will likely charge borrowers they perceive to be particularly risky. The liquidity gap that Octagon fills between commercial banks and investment banks for borrowers – predominantly in the agriculture, food and shipping industries in emerging-market countries – is likely to widen.
Welles worked for Cargill’s emerging-markets investment and trading arm before deciding to set up Octagon in 1998. “There was and remains a tendency for traditional lenders to avoid making loans to companies located in developing countries due to the perception that it involves much more risk,” he says. “And many of the companies that needed credit fell below the radar screen of the big players in the asset-based lending market. There are also constraints on cross-border lending for most banks that limit how much exposure they can have to developing countries. Where there is less liquidity, there is less efficiency, and that is where there is opportunity.”
The Octave-1 Fund, Octagon’s first fund, specializes in inventory finance, trade finance and asset-backed securities of primarily small and medium-size emerging-market companies. In the inventory finance space, Octagon invests in loans and repurchase agreements secured by readily marketable goods such as commodities, textiles, or building materials.
In trade finance, Octagon originates, structures and distributes trade receivables, or buys and sells trade receivables in the secondary market. As part of its trade financing strategies, it became one of the first entities to take advantage of the US Department of Agriculture’s export rebate programme. This subsidizes US cotton exporters by offering a rebate on cotton shipped to non-US countries. Octagon buys the rebate at a discount from the exporter, collecting the full rebate from USDA about 45 days later.
Welles’s ability to quickly recognize opportunities in the market led to the launch of Octagon’s second fund. As part of Octave-1, Octagon was providing lending facilities to film companies, using as collateral a combination of a company’s film library and the sales contracts with the broadcasting companies for the rights to air the films. Similar to the liquidity gap found in emerging markets, these transactions fill the void that exists because the deals are too small for the big investment banks to spend their time on, and too highly structured for commercial banks, which are accustomed to more conventional loan structures. In September 2004, Octagon spun off the strategy into the Octave Entertainment Fund, which specializes in the securitization of cashflows from film libraries, television series and music catalogues. Since its inception, the Octave Entertainment Fund has returned close to 10% net on an annualized compounded basis to investors without leverage, and opportunities in the sector continue to expand, says Welles.