Financials’ fortitude: EJF Capital eyes rotation trade as banks and insurers weather Covid storm

Hammad Khan & Peter Stage, EJF Capital

Founded in 2005, EJF Capital focuses on investment opportunities in financial services, targeting all levels of the capital structure on both a long-only and long/short basis. Specifically, the firm’s strategy seeks out ideas stemming from regulatory and structural changes impacting the banking sector, insurance companies and specialty finance.

Headquartered just outside of Washington DC, the firm was founded by Manny Friedman and Neal Wilson in 2005. In 2013, it established a European base in London, led by Hammad Khan (pictured, above left) and Peter Stage (pictured, above right), EJF’s senior managing directors in Europe. Lucas Netter, a director also focused on portfolio management, joined in 2014.

Eight years since launching its European operation, EJF is particularly bullish on the current investment opportunities in the region, with Khan and Stage forecasting a rotation into financials, which they believe will successfully weather the shocks brought about by the ongoing coronavirus pandemic.

“We look to invest in sectors and themes that allow EJF to be price makers rather than takers,” Khan tells Hedgeweek. “Often this means arranging and sourcing deals and playing the investment banking role. This allows EJF to underwrite risk appropriately and drive the pricing in our favour.”

In his role, Khan is responsible for identifying investment opportunities in European fixed income with a focus on banking, specialty finance and asset-backed securities. 

Before joining EJF, he was a credit analyst at Oak Circle Capital in New York where he analysed opportunities within the US RMBS and CMBS sectors. Prior to that, he worked at Ivy Square and Ceres Capital Partners in New York where he analysed investment opportunities in the credit markets, modelled complex structured deals and aided with trading and operations.

Stage is responsible for identifying investment opportunities across the European fixed income, equity and private markets with a focus on banking and specialty finance.  A member of the firm’s executive committee and co-CIO of EJF Investments, he was previously head of credit research at F&C Asset Management, focused on the banking sector. Earlier he was head of credit at Gordian Knot.

EJF today has some USD5.7 billion of assets under management globally, focused on financial services sectors, with an additional USD3.3 billion of securitised AUM. Altogether, the firm has 75 employees, including 28 investment professionals, with a four-strong team in London.

Can you describe EJF’s investment strategy?

HK: “We look to invest in opportunities created by regulatory and structural changes impacting the financial services sector. This includes banks, insurance companies and specialty finance. We invest across the capital structure, from the more liquid credit space, to private equity and credit, and we look closely at the risk/reward profile of potential investments. 

EJF started to allocate significant capital to Europe in 2013, ahead of the Basel 3 Accord coming into effect, and before the introduction of regulatory structures such as the Single Resolution Mechanism.”

PS: “We noticed a significant impact from these regulations in the banking sector in particular. We believe these regulations transformed a significant portion of the sector into a highly regulated and uniformed industry since the financial crisis. Our view was that the larger banks were treated more like utilities, and there were growth opportunities for smaller banks.

EJF looked to capitalise on such secular trends then and still does now, and we continue to see very attractive opportunities in the sector. Our overall strategy has largely been long-biased; however, from time to time we do put short positions on institutions which we can see are struggling to survive in the regulatory environment or against the strong competition.”

How do you position your strategy in terms of risk? Where do you see opportunities right now?

HK: “We remain bullish on the banking sector, which is seeing record levels of capital and liquidity. We’re opportunistic and entrepreneurial when investing; we do not have hard limits or allocations towards specific geographies or sub-sectors. EJF has been active in Europe for eight years now - we also manage vehicles with higher European concentration, as we continue to see growing opportunities here in Europe. 

A key driver to where we invest is credit fundamentals. We opt for a bottom-up approach while applying a top-down vision on the strategy and broader themes.

We believe the financial sector came into the current crisis from a position of strength, in comparison to where it was during the last financial crisis. Therefore, we think investing in AT1s and RT1s in the subordinated debt of such institutions can provide an attractive yield for investors. These largely fixed rate instruments provide a natural hedge to negative interest rates. In particular, we prefer to invest in the debt of middle and smaller sized issuers, as they benefit from further yield pick-up.

We look to invest in sectors or companies which we can underwrite and then play a significant role in structuring and driving the investment. Two attractive sub-sectors for us are non-bank lenders and fintech, and we are seeing many strong sponsors looking for growth capital here.”

How do you analyse potential positions? What is your research and portfolio-building process, and how does EJF set itself apart from other similar strategies in your field?

PS: “Generally, we first analyse regulatory frameworks and their impact on the financial sector in a thematic way. We typically then apply our findings to specific issuers and individual securities based on a deep credit bottom-up analysis. Our investment team conducts surveillance regularly on the investments.

We believe one of EJF’s differentiating factors is our focus on smaller, lesser-known issuers. We provide subordinated regulatory capital to these issuers in the UK and Europe. We tend to see less competition in this space as many investors do not focus on the issuers who issue relatively small amounts of debt, and so we are able to provide attractive returns for our investors here.”

How did the fund perform in 2020? How did the coronavirus pandemic impact your portfolio and the markets you trade?

HK: “As with many asset classes, we have seen a large drop in asset prices in European financial debt instruments. Certain AT1s fell by up to 50 points and Tier 2 up to 15-20 points. This was driven in part by fears of the virus, and technical factors such as the amount of leverage which some investors applied to these assets.

Since the lows in March, we have seen significant asset recovery and strong primary market issuance across the capital structure. AT1s have now almost made up their losses and new issuance is occurring at pre-March levels, demonstrating the strength of the asset class.

We invested into the dislocation within the sector, as well as in companies that were impacted directly or indirectly by consolidation themes and speculations. We have also invested more recently in bank equities due to the positive newsflow regarding vaccines and the potential for bank dividends to resume this year.”

PS: “In our view, banks are likely to fare better than expected from potential Covid-19 credit losses. In the decade after the financial crisis, bank resolution moved from “bail-out” to “bail-in”, and a new era of bail-inable securities such as AT1s were ushered in. 

In this era, we have witnessed bank leverage reductions, material elevation of capitalisation levels and more stringent oversight. This means that banks are well-placed to weather any potential stresses generated by Covid-19. At the moment, liquidity is also very strong given regulatory initiatives and other factors.”

What are some of the key ideas/themes for your fund heading for 2021? Where do you see the main opportunities and challenges?

HK: “We see many factors coming to play that will benefit the sector in 2021. To us, the response of regulators and politicians to the pandemic alike messages that they want to maintain a robust financial sector and to ensure that there is a workable framework in place. Unlike during the financial crisis, we see banks are part of the pandemic solution. 

We believe the vast majority of banks and insurers will come out of this year largely unhurt, especially the smaller ones. We feel the real-life stress test will be a strong proof of our strategy’s strength, and we believe that many investors who have lacked conviction in the sector could start to revisit.

We predict that we will see a rotation into financials. They have been largely un-loved in 2020 due to fears of the impact of the pandemic. We believe financials will be the beneficiaries of a possible reflation and expansionary trade.

We have seen significant deal flow in Europe over the past six months, and we believe we will see some M&A activity in this geography in 2021, which could be welcomed by investors.”

Speaking of investors, how would you gauge sentiment and appetite right now? How have investor attitudes towards financials/credit strategies changed in the years since the financial crisis?

PS: “After the financial crisis, we started to see some appetite build for the sector. However, this was largely driven by sector specialists, while generalist or macro funds largely steered clear of the asset class. 

Investor interest began to grow as banks and insurance companies continued to strengthen from a credit perspective and the AT1 and RT1 asset classes emerged. Since the asset classes have evolved and matured, we have begun to see more institutional capital coming into the sector. This is positive as it brings greater stability to the classes.

We believe that investor appetite in the banks and insurance sectors will continue to build once the pandemic is over, as investors will see how well these sectors weathered this year. Indeed, while we recognise that profitability remains challenging for banks and insurance companies, some of this year’s valuations in our view were too depressed. 

Recently, we have also seen investors rotate into cyclicals and value sectors, which has benefited the financials as well.”

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