J. Christopher Mizer, a 25-year alternative investment industry veteran, is President and CEO of Vivaris Capital, LLC and VICAN Fund.
Financial innovation has been a mainstay of economies for hundreds of years. Loans during ancient times, the creation of the stock market and the trading of various assets represent examples of how finance has been a driving force in generating returns on capital and managing financial risk throughout history. Its evolution plays a key role in investors’ never-ending quest to preserve and grow their wealth.
Traditionally, most banks, governments and corporations turned to the financial markets to finance their activities, and many of the investment products were simple. Investments had an issuer and a purchaser, and generally, the ownership wouldn’t change. The purchaser would hold onto the investment until maturity and collect interest or a share of profits in exchange for the investment.
As time progressed, many issuers and purchasers found themselves in situations where factors such as liquidity, performance and duration impacted their views on investment risk and return. They needed additional protection and tools to enhance their investment or business. This focus on managing risk and opportunity through financial engineering eventually categorized the various investment products under structured finance.
By the 1980s, in response to economic changes brought on by interest rates, oil shocks, an economic downturn and volatility in the capital markets, financial engineering evolved to meet investor demand for strategies that would allow them to mitigate various risks. By the 1990s, credit derivatives fueled the growth of a wide range of new structured products, including credit default swaps, asset swaps and total return swaps.
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Financial markets are currently highly complex with numerous investment products available, many of which were simply unimaginable in recent history. Structured finance is now one of today’s investment strategies of choice for some investors.
Structured finance is best defined as “techniques employed whenever the requirements of the originator or owner of an asset, be they concerned with funding, liquidity, risk transfer, or other need, cannot be met by an existing, off-the-shelf product or instrument. Hence, to meet this requirement, existing products and techniques must be engineered into a tailor-made product or process. Thus, structured finance is a flexible financial engineering tool.”
As background, it’s important to understand that there are many issuers and purchasers in today’s marketplace that transact on a wide range of structured financial products. While in past years, products yielding reasonable returns and secured investment were only available to large institutions and very high net worth individuals, today’s structured products are available to a broader investor base, presenting heightened opportunities to profit.
As a multitrillion-dollar sector of the financial industry, structured finance strategies continue to grow and proliferate in various financial capitals around the world. There are dozens of types of structured financial products available to meet the various needs of issuers and purchasers who recognize its value.
Structured finance is a solution to the business and investment requirements of a multitude of groups and continues to support capital flow in multiple markets. It presents a way to finance asset classes that previously could only be financed via traditional borrowing methods or not at all. New structures now offer issuers flexibility in terms of maturity structure, security and asset type, thus allowing them to earn enhanced returns and customize diversification in accordance with their risk appetite.
The new genre of structured products contributes to a more complete capital market that offers a trade-off by providing optimal diversification at a minimum transaction cost. For example, issuers obtain better credit ratings and more leverage compared to unsecured senior debt. This results in reduced borrowing costs, liquidity for illiquid assets and the transfer of risk to financial institutions as a means of exploiting regulatory capital arbitrage. In some cases, structured finance is even used to shelter corporations from potential operating liabilities.
When traditional financial sources are unable to meet specific requirements, structured finance allows for the management of risks and assets in an alternative structure. Through this structure, capital can be raised, returns can be amplified and financial goals can potentially be met. Structured finance does this in many ways. Through risk mitigation and transfer, structured finance supports increased asset value and cash flow for the note purchasers. The structured finance note’s ability to reorganize assets and transfer risk complements the capital raising process beyond the capabilities of traditional finance.
Today, structured finance offers numerous products to manage risk and opportunity for governments, corporations and individuals that generally fall into three major categories: derivatives; securing assets and income; and separating liabilities and obligations. Within each category, there are several subtypes of structured products that may include: securities backed by assets; commercial and residential mortgages; debt; bonds; future flow; loans; and principal secured notes. These structured investment products serve various purposes for issuers, and purchasers buy these products to unlock opportunity or manage risk.
There are two main purchasers of structured financial products. Many corporations and investment companies purchase financial products to protect and support their day-to-day business operations, while hedge funds and investment banks are involved in the speculative investment nature that some of these products hold.
Additionally, many institutions and high net worth investors purchase structured financial products as a differentiated, short/medium-term or long-term investment holding for their respective portfolios. Due to the complex nature of these types of investments, their access has been limited to the largest corporations in the world and to sophisticated financial institutions. Now, a new asset class is emerging that brings these opportunities to mainstream investors. These include retirement products, hybrid funds and structured middle-market notes. The future of structured financial products is expected to grow in scope and provides for the opportunity to earn enhanced returns on a risk-adjusted basis.
In summary, structured financial products are positioned to offer investors wide exposure to alternative types of investment options. Some are impressive in the way their returns can be enhanced. Some, however, are not appropriate for many types of investors and result in assuming an inappropriate risk.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.