For Asia's equity derivatives dealers, their New Year's Eve hangovers did not kick in fully until the first day of trading on January 4, when misguided circuit breaker rules that Chinese authorities introduced in January came into effect. Intended to slow a rout that had seen Chinese share values plummet in June 2015, the circuit breaker instead drove a rush to the exit by an overwhelmingly retail investor base.
After trading was halted twice in quick succession, Chinese regulators saw sense and ended the use of the circuit breaker. But the damage was already done: bourses around the region started the year badly; the Hang Seng was down 10% in January; and there were similar falls in all Asia markets bar Indonesia.
Poor performance and a lack of knock-in or -out events that recycle cash saw the volume of equity-linked structured products fall, Korea was down close to 70% year-on-year for the first quarter, and major declines were posted in the other North Asia markets.
China might have been the origin of problems for most equity derivatives houses this year, but it was a land of opportunity for UBS, which holds on to its title as a result of a strong corporate derivatives business. A $5 billion deal linked to China Postal's IPO was the headline grabber but, over the last 12 months, UBS has executed multiple transactions linked to unlisted shares of companies from China, India and Korea, with a notional value in excess of $2 billion. Deep relationships with private companies and their shareholder bases provide UBS clients with exclusive opportunities; in particular, wealth management and investment bank clients appreciate direct access.
Typically, an unlisted company gains a new pool of investors while UBS handles marketing, structuring and distribution, positioning the firm well for future IPOs. Likewise, UBS's wealth management arm gets access to the type of exclusive deals its clients have a very high demand for.
And it appears that this approach has won the bank some very high-profile investors. The Swiss firm doesn't identify end-clients, however in September the Li Ka Shing Foundation, the charitable arm of Asia's richest man, went public about a recent 11.5% stake it took in China Postal Services Bank, ahead of its recent Hong Kong IPO. The brief statement said that it took this interest via a structured note issued by an unnamed "financial institution". Despite the CPSB float involving 26 banks, both global, regional, and Chinese, UBS was the sole financial adviser.
According to Bryan Crawford, Hong Kong-based head of investor services at UBS Wealth Management and, in this context, a client of the investment bank, the direct investment offering is a vital part of meeting an acute demand from high-net-worth clients. He says the overwhelming feedback he receives from his wealth management clients is that they want access to direct deals. The problem is that, typically, the differing needs of investment and private banks make these hard to structure; the typical ticket size for a wealth management client is usually much smaller than an institutional investor's.
"There is explicit demand from our clients to deliver pre-IPO deals," Crawford says. "Clearly, we need to address client suitability, structure, and appropriate ticket size to distribute these institutionally sourced opportunities to clients of wealth management. Strong communication and a close working partnership between the investment bank and wealth management teams allows us to effectively address these issues."
Crawford describes the integrated structure between the investment bank and the wealth management arm as fundamental to the success of the pre-IPO funding product. He says a successful direct investment deal requires multiple structures in order to meet the requirements of all investors.
"Structurally, in many of our private deals we have used performance-linked notes, which allows the issuer to deal directly with UBS – UBS is the shareholder on their capital table – and, as a result of being able to aggregate many smaller tickets into this one structure, my wealth management clients benefit because they get to play in larger deals than they would otherwise."
For Nicolo Magni, co-head of strategic equity solutions group, Asia at the bank, the corporate derivatives business is the key differentiator between UBS and its competitors in Asia. He cites data from industry consultant Coalition which says the Swiss bank's revenues are double that of its nearest competitor and well ahead of the majority of those active in the market. While UBS earned revenues of "several hundreds of millions" from the corporate sector, three-quarters of its rivals are receiving less than $100 million.
While some deals are of the pre-IPO type, with listings taking place a few months later, Magni says typically firms aren't heading to market for two to three years and as such a private investment is a more accurate title.
UBS is not the only bank to provide investment banking services to corporates looking to IPO in the near future, nor is it even the only Swiss firm with a significant private bank attached, so how is it able to conduct these deals? It's a question the market is also wrestling with; one senior executive from a US bank expressed puzzlement to Risk.net about one recent high-profile transaction in particular, complaining that he "would never be able to get such a deal past my regulators".
And in the post-Volcker-rule world where proprietary trading is a big no-no, for banks how is UBS able to invest directly in corporates, alongside their wealth management clients? The answer, according to Magni, is with great difficulty. But difficult is different from impossible. He concedes it is counterintuitive for UBS to go direct, but says the answer is a function of acute regulatory understanding and excellent risk management.
He gives the example of an investment of this type last year, with a North Asian e-commerce firm. In this instance UBS got a reverse enquiry from a wealth management client who thought the firm was undervalued – the private bank has a specific piece of infrastructure set up purely to take such enquiries.
Magni says that due to the "bridge" between UBS's wealth management and investment bank arms he was able to establish that the Swiss firm had a mutual contact at the e-commerce firm via a global private equity company which is also a client. The private equity company told UBS that one of the e-commerce firm's other investors was looking to offload. Within a month the investor decided to sell and UBS was able to offer, via a special-purpose vehicle, equity-linked notes to its private bank clients.
"It was a beautiful trade: structured fully off-balance sheet, it strengthened relationships with both a key institutional client and the wealth management investors to whom it was distributed. It also paved the way for UBS to take a position in the IPO of the North Asian technology company."
Magni says the bank is able to trade in a private equity-like manner due to a specific aspect of the Volcker rule that allows direct investment in companies by banks as long as it is for a maximum of three months.
"If you have the right level of confidence it is possible to invest for the short term and quickly repackage and distribute risk off-balance sheet which provides access to private equity-type structures. We had a high level of confidence because we had previously executed deals with the same or similar companies. Nonetheless, deals need to be approached on a case-by-case basis as different jurisdictions require bespoke structuring and knowledge of the local market both from a distribution and competitive landscape standpoint."
And UBS has to be sure each and every time it structures one of these deals that it can get it right. Make one mistake and its track record – and, crucially, regulatory approval – disappears. This would leave UBS with a big problem: a huge capital call, an increase in risk-weighted assets and the bank would probably have to sell the deal at a discount to get it off its books.
And it is due to these short time limits that Magni says the real competition is not – at the moment – other banks, but instead hedge funds, sovereign wealth funds and other long-only investors.
"These competitors in this space are investing their own capital and don't need to find pockets of demand to syndicate the risk. In light of this, we need to match them in terms of agility and speed to ensure that we do not lose the deals. However, in some cases our investment is more strategic and may involve group strategy. For example, we recently made a significant investment in China which has established what we believe will be a long-term partnership."
Magni is also bullish about the geographic diversity of UBS's corporate derivatives business, with more than 25% of the unit's revenues coming from South-east Asia. This is a marked contrast to a typical Asia-Pacific equity derivatives book, which is usually skewed heavily towards Japan, Korea and Taiwan. Also, the direct investment approach results in a more diversified book of business that its competitors who Magni says are typically more than 90% in traditional margin loans.
But from the perspective of a UBS client for this product – its wealth management arm – offering this type of direct access deal enables the firm to provide meaningful differentiation from its private banking competitors. And while it provides a cheaper way for ultra-high-net-worths to access private equity performance, the real advantage is the role these investments play in succession planning, says Crawford from the firm's wealth management arm.
"As Asia transitions to the next generations of wealth, these deals are a way to get the younger generation involved directly," says Crawford. "It's a lot more interesting than talking to a private bank about discretionary mandates. We frequently see patriarchs putting the son in charge of the direct investment, and it is clear this is by far the most important part of the portfolio."
The week on Risk.net, February 10-16, 2018Receive this by email