An Introduction to Certificated Products and AMCs - Part 1

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The 80’s are coming to a close.

You’re a banking manager.

You look out the window of your “penthouse-office-suite” (which is actually a corner office with a small window on floor 15 of 54), staring at the horizon.

Everything the light touches is yours… the light beaming down from your buzzing halogen globes in your office, perhaps.

This is the late 80’s / early 90’s - bank profits are down. Seriously down.

Several banks in the US have failed.

Europe was not immune either.

Perhaps Japan is the only beacon of hope (we all know how this ended).

The Basel 1 Framework is in full effect and capital holding requirements sit at around 8%.

Average cost of capital sits between 7.5% - 15%.

You have got to find a way to raise cheap capital or you will be thrown out of your little empire in the next round of layoffs.

You need to find a solution that acts as a cheaper alternative to traditional deposits.

In Germany, Switzerland and the UK, a financial innovation is being used to achieve just this goal.

They’re calling them Certificated Products.

Major banks are coming up with their own investment ideas, packaging them into a financial product anyone can buy, and selling them to retail investors.

This package, the Certificate, is a debt note - money raised from investors is debt on the bank’s balance sheet. But it is not a deposit, and therefore doesn’t cost the bank as much to hold.

Remember, deposits carry costs such as Reserves, Insurance Costs, Infrastructure Costs, and others.

But the debt is unique.

While the debt obligation is unconditional, meaning the debt has to be repaid when the Certificate comes to end of term, the amount that has to be repaid is not fixed.

A Certificate’s payout is formula driven, and does not have to protect the capital originally invested.

What this means is that investors buying these Certificates will either make a profit or a loss depending on how well the investment strategy of the Certificate is managed.

And what’s more, the 8% capital holding of Basel 1 relates to assets, not liabilities.

The Beginning is the End…

And so the silver-bullet was formed! Adoption took off globally and everyone was hooked.

Only… not quite.

Adoption of Certificated products took off at a slow, but steady pace during the 90’s, and peaked with “Retail Mania” in the early-to-mid 2000’s, but by 2008 the market for Certificated products was hit hard.

The hit exposed major structural flaws behind these products: Certificates were basically unsecured debt obligations on a banks balance sheet, and their underlying investments were, unsurprisingly, concentrated in the stock of the bank issuing the Certificate, there was little real diversification. Banks not only used Certificates to raise cheap capital, but also as a means to charge high fees to investors.

Trust in these products was eroded almost completely.

It was clear real reforms needed to be made.

But the spark created never died.

Reforms were introduced, and greater transparency introduced.

Since the GFC the market for Certificated Products has become more sophisticated, and today Certificated Products are being used by both investors and managers for countless capital raising opportunities.

…and The End is the Beginning.

Banks still issue Certificated Products, and they still do so from their own balance sheet’s, but since the problems in 2008, several sophisticated players in the market started to structure and issue Certificated Products using a segregated assets structure.

A Special Purpose Vehicle (SPV) will be incorporated in a tax optimized jurisdiction, and this SPV will act as the issuer of the Certificated Product.

The SPV would either be a standalone legal entity, or a legal entity that would legally compartmentalized its balance sheet for each new Certificated Product.

This structure comes with several benefits, key of which being that the Certificated Product does not take on balance-sheet risk of any issuer. In other words, a Certificated Product issued by a bank, would be at risk to the bank failing, or the bank changing its risk categories and forcing a shutdown of the product.

The assets and liabilities of the SPV are segregated away from the investment sponsor / manager.

In many cases, when a product is issued by a bank, the investment sponsor / manager is forced to use the issuing bank’s trading desk to execute all trades for the investment strategy of the Certificated Product; this further enhances the bank’s revenue, but does not always translate into a better deal for you.

This segregated assets structure allows business owners, capital requirer’s, or capital allocators, to package investment opportunities into distinct financial products. This is probably one of the most important aspects of this type of structure, and it’s something I’ve alluded to in my previous posts.

When raising capital, there are two strategies:

(i) you can either solicit the capital directly from different providers, and enter into numerous rounds of negotiation around the structure and economics, or

(ii) you can convert your capital raise into a financial product that appeals to capital allocators, such as family offices, wealth managers and institutional investors.

The second option means avoiding lengthy rounds of negotiations, and creates a product that can be purchased or sold by the investor.

It is clearly the more efficient option.

Finally, there are many cases where Certificated Products are used in lieu of a traditional fund structure, due to their ease of setup and cost efficient structure. Granted they do lack the full sophistication of a fund, but many investment sponsors / managers may not be in the position to take on the heavy cost and time burden that is required to setup a fund; Certificated Product needs far less seed capital for the economics to make sense.

While Certificated Products have been around for 30+ years, there are still many jurisdictions that don’t know what they are, in other words, the exposure to this type of financial product has been very limited. However, this shouldn’t have to remain the case and for many jurisdictions, these products can provide significant benefits.

Certificated Products come in several “flavors” each to solve for a specific capital raising need.

In Part 2 of this series, we will work through the different types of Certificated Products, and their pro’s and con’s.