By Hamlin Lovell, Contributing Editor, NordicInvestor
Whitecroft argue that bank risk sharing (also known as SRT) could deliver returns as good or even better than high yield or leveraged loans, but with a portfolio of mainly investment grade assets. This is largely due to the capital premium banks are willing to pay in exchange for regulatory capital relief. As a specialist SRT manager, Whitecroft offers a pure play on bank risk sharing, whereas other funds in the space could also mix in alternative credit strategies like asset-backed lending, specialty finance, and other structured credit.
Bank risk sharing is not a new concept; It has been part of the Basel regulatory framework for over 20 years. Whitecroft Capital Management co-founders, Michael Sandigursky and Anders Larsen, were there from the start. “Back in 2006-2007, risk sharing was a highly niche product, with only two or three banks executing a deal every year or two. While working on the sell side at Citigroup, we came across these transactions and structured our first deal based on Citi’s $100 billion emerging market loan portfolio. That successful program has now reached its 20+ iteration,” says Sandigursky, who subsequently spent six years managing the strategy and investing in over 30 deals for Mike Platt’s BlueCrest, before launching Whitecroft in 2017.
Fast forward seventeen years, the market has evolved into a well-established asset class. The Global Financial Crisis and the following implementation of Basel III significantly raised regulatory capital demands, prompting banks to manage capital as a scarce resource. “Today, at least 70 banks have executed these deals, ranging from large global institutions to medium-sized and regional banks. Last year, we saw several German Landesbanks, US regionals and a challenger bank in the UK join the fray,” says Larsen. Indeed, 2023 was a record-breaking year, with over 100 deals issued by around 40 banks worldwide. Thanks to strong relationships built over the years, Whitecroft remains at the forefront of deal flow, focusing primarily on the largest global banks.
Bank capital management and return on equity optimisation
Banks seek to buy first or second loss protection to gain regulatory capital relief, which in turn allows them to increase their lending capacity and recycle capital more effectively. They aim to keep a comfortable buffer above minimum capital requirements, reducing the risk of breaching regulatory thresholds and avoiding the need to raise equity. In today’s competitive landscape, banks must not only focus on the amount of regulatory capital but also on the returns they can produce on such capital. “Risk sharing helps to optimise these returns, enabling banks to pay dividends to shareholders while keeping loans on their balance sheets and preserving strategic relationships with borrowers, amid competition from direct lenders,” explains Sandigursky.
From a bank’s perspective, Whitecroft argue that risk sharing is often more practical and appealing than selling individual loans or pursuing true sale securitisation. “Typically, SRT does not require client consents, making the process far simpler, especially for bilateral loans, trade finance, and other loans spread across various jurisdictions. This approach avoids many of the legal, tax, and accounting challenges that arise when dealing with multiple booking entities. Additionally, risk sharing is more cost-effective, as the bank continues to fund most of the loans, which is generally cheaper than capital markets funding,” points out Larsen.
Focus on capital premium
Risk sharing offers private credit investors an opportunity to gain exposure to well rated term loan and revolving credit facilities that represent the core of traditional corporate banking for the largest global banks. These loans remain on the balance sheet of the banks and are otherwise not available to invest in. “The difference between these core loans and other bank loans, for example leveraged loans, is that core loans are originated by banks for themselves and not for sale. They only come into play as part of SRT if banks need capital relief”, says Larsen
Risk sharing is a unique product that offers investors a combination of credit risk and what Whitecroft calls “regulatory capital premia”. “This is essentially a cost of capital – banks are incentivised to pay over and above the credit risk to gain access to regulatory capital”, he adds.
Fair risk sharing through partnership
As the name suggests, the core ethos of risk sharing is built on a long-term partnership between banks and capital providers. Investors supply long-term capital and co-invest in the bank’s core business, making these transactions strategic for both parties and fostering a closer relationship.
Nevertheless, banks may attempt to share higher-risk exposures, raising concerns about adverse selection, which investors could be vulnerable to. “The bank’s motivation behind the transaction and what we call ‘fair risk sharing’ are crucial to our investment approach. We do not treat these deals as off-the-shelf products; instead, we cultivate long-term relationships with the originating banks. Assessing risks involves understanding complex, business-sensitive internal model data and documentation nuances. It takes years of experience to distinguish what works and what does not,” says Sandigursky.
While investors in risk sharing may have enjoyed stable and strong performance historically, there are numerous underlying risks that must be carefully considered and managed to ensure long-term success, especially in a less favorable credit environment. Some new managers, eager to establish themselves in the sector, appear to make overly optimistic assumptions and overlook critical details. “Many of these managers are focused on demonstrating that they are ‘moving in and moving in big.’ They are buying into the market without asking any questions, prioritising speed of deployment to showcase results to their investors,” explains Sandigursky.
Most deals tend to perform well in the first 12 months, but problems often surface later. With increasing risk differentiation between deals, investors will see much greater variation in managers’ performance in the coming years. Effective deal selection is crucial to keeping credit risk at a manageable level. There is no such thing as a “standard” SRT—each portfolio, replenishment criteria, and structural complexity must be carefully negotiated with the banks.
“Recently, we have observed some managers paying less attention to documentation, a trend we have seen before in other investment products. As documentation becomes looser, someone inevitably pays the price,” warns Sandigursky. “It is essential to know what you are doing, which involves extensive negotiation and investigation with the bank before becoming comfortable with a transaction. If we encounter red flags and risks that are not properly mitigated, it is critical to walk away from the deal. Unfortunately, many managers today cannot afford to do that.”
Whitecroft’s approach to risk sharing
Whitecroft has developed its own conservative and stringent approach to risk sharing. They reject more deals than they accept, applying criteria that often differ significantly from those of competitors. “We’ve learned what works and what doesn’t, particularly in less benign credit markets,” says Sandigursky.
Whitecroft’s philosophy centers on monetising capital risk premia. While investors have plenty of options when it comes to credit managers, none can deliver capital premia in the way that risk sharing can. As a result, Whitecroft’s strategy focuses on maximising capital premia while minimising credit risk. “Ideally, we would prefer to eliminate credit risk entirely, but regulations require us to take on some,” jokes Sandigursky. “We manage a very conservative portfolio, primarily investment-grade, with high granularity and diversification across sectors and geographies. This is how we mitigate the idiosyncratic risks in our transactions.”
Whitecroft focuses on senior term loans and revolvers extended to large corporate borrowers, with some investments in trade finance. They steer clear of high-risk leveraged borrowers and sponsored commercial real estate. “We concentrate on classic, plain vanilla large companies, which typically have more liquidity and refinancing options, even in challenging markets. We avoid taking on additional structural risks that are not adequately compensated within risk sharing,” he adds.
SRT return are more attractive than direct lending
Whitecroft’s managers have a 12-year track record, having invested in over 70 transactions. Most risk-sharing deals are structured as fixed income securities that pay a quarterly coupon, typically a floating rate plus a fixed spread—for example, 3-month EURIBOR plus 10%. “Historically, spreads have ranged between 8-12%,” says Larsen. Post-pandemic, returns have risen due to both higher interest rates and wider spreads. Although spreads have tightened since their peak in 2023, recent deals have been completed with spreads of 8-10% over EURIBOR, resulting in 11-13% coupons.
The repayment of principal in risk-sharing investments is tied to the performance of the loan portfolio referenced in each transaction. If a borrower defaults and the bank incurs a loss, some of that loss will be passed on to investors, reducing the principal of the risk-sharing bond payable at maturity. “It is crucial to carefully model potential losses. We receive extensive historical data from the banks, which we then stress-test to gauge a range of outcomes. Pricing based on a best-case scenario alone is not sufficient,” notes Sandigursky. “While historically, risk-sharing transactions have outperformed banks’ own loss estimates due to the conservative nature of their ratings, this might be different when we enter the next recession.”
Whitecroft argues that SRTs offer exposure to higher credit quality borrowers and are generally less vulnerable to credit downturns. “We primarily invest in large corporate investment-grade loans, which are more stable compared to single-B rated leveraged loans or concentrated direct lending portfolios. These lower credit quality investments are likely to be impacted much sooner than SRTs,” explains Larsen. “Therefore, on a risk-adjusted basis, SRTs are significantly more attractive.”
Evergreen model is gaining popularity
Whitecroft’s fund, which is only marketed and available to professional investors, is a pure-play risk-sharing strategy and uses an evergreen model. This structure inherently provides greater diversification compared to a single closed-end fund. “This offers a significant advantage to investors, providing immediate portfolio diversification and high returns virtually from day one,” says Larsen.
The open-end structure also incentivises the manager to consistently maintain the fund’s performance. “We do not see ourselves as mere originators who complete a few deals and then move on to the next fund. Since all our resources are invested in this fund, we are committed to its ongoing management. This creates a strong alignment with our investors,” explains Sandigursky.
Another advantage of the open-ended structure, though it may be seen as a drawback by some investors, is liquidity. Whitecroft provides a degree of liquidity to its investors, avoiding the long lock-up periods typical of most private credit funds, which often span 10-12 years. “SRT generate regular, substantial cash flows and, unlike private equity or direct lending, are tradeable. We aim to pass this benefit on to our investors,” says Larsen.
Future of SRT
The market has experienced dramatic growth in recent years, and Whitecroft considers SRT to have evolved into a distinct asset class. Annual issuance is estimated to have reached $20-25 billion in 2023 and is projected to surpass $30 billion this year. Crucially, regulators in both Europe and North America are now well-acquainted with the SRT mechanism and are increasingly supportive of its development to bolster bank lending to the real economy.
Typically, investors in SRT funds include major institutional players such as pension funds, endowments, and foundations. However, fund of funds and family offices are also beginning to recognise the value of this asset class. “Risk sharing has grown too big to ignore. We believe that all institutional investors in private credit should consider this asset class as part of their strategic allocations. It offers attractive risk-adjusted returns, providing steady income and serving as an excellent diversifier for investors’ direct lending and CLO portfolios,” summarises Larsen.
However, risk sharing is a technical field that demands specialised skills. “In the past 12 months, we have seen many more new managers aspiring to enter the market. We observe these new players tend to be less discerning about risk, pricing and documentation. Only time will tell if the more cautious approach adopted by established players like Whitecroft proves to be the right strategy,” Sandigursky concludes.
