Mark Cernicky, product development manager at Aviva Investors North America, says the current credit crisis has created an historic opportunity for an old style investment banking business model to earn sustainable returns by lending to disenfranchised companies

As we enter 2009, let's look ahead and stop asking who or what should take the blame for the current economic mess: sub-prime, credit derivatives, "quants" or even Alan Greenspan's low interest rate policy which inflated housing prices.

As a result of the application of leverage to poor credit underwriting, investors today have an historic opportunity to earn attractive and sustainable risk-adjusted returns through active credit underwriting. Moreover, despite the pain of 2008, there are plenty of investors that are a little excited for 2009. They know that if they can capitalise on the opportunities created from this crisis, they could become the next George Soros or Julian Robertson.

But the point is not who will do that; rather, it's the opportunity itself. Low leverage, long-only strategies focused on lending to disenfranchised borrowers represent an historic opportunity for the right asset manager.

Moving beyond the tactical to long-only strategies
We should look beyond the tactical to the strategic: from arbitrage-driven strategies to long-only strategies. This is not to suggest that there are not opportunities in "absolute return" or "alpha" strategies.

For example, long-short credit strategies and tactical asset allocation strategies can take advantage of current dislocations in the market and may represent an attractive way to add return with little portfolio ballast. However, the opportunity in long-only strategies is much more historic because only certain managers will be able to capitalise on the opportunity and therefore earn sustainable long-term returns.

In addition, these technical pressures have not been discriminating. Well-run companies trade like bad companies; secured assets trade at lower prices than unsecured assets.

Realised volatility is extreme; however, unidirectional volatility can be challenging, even for long-short strategies. In addition, de-leveraging continues.

As a result, when market technicals dominate credit fundamentals, the catalyst for arbitrage, mean-reversion may not be present. This makes it harder to harvest gains from typical arbitrage strategies or even basis trades.

Most arbitrage strategies also require leverage to hit their return targets, making them susceptible to margin close-outs. Long, directional strategies that don't use leverage should be able to withstand the excessive market technicals.

Furthermore, strategies that do not require tactical trading opportunities to generate returns are more likely to be sustainable. A long-only strategy focused on providing loans to well-run companies without access to capital markets - disenfranchised companies - represents an historic investment opportunity.

Declining conventional financing alternatives for good borrowers
Commercial banks will not be in a position to lend as they did in the past. Capital is too precious, despite government infusions. Banks de-leverage and continue to lose capital as companies draw down on their reserves.

Bank consolidation also will continue to distract from lending opportunities. As a result, banks are likely to keep their capital for their biggest clients and for lending to home buyers. They are less likely, for example, to make it available to the US$400m industrial company that makes parts for fast-food restaurant fry machines under a long-term contract.

This creates a class of disenfranchised borrowers that is likely to persist for some time. Because of the secular decline in the conventional financing alternatives for good borrowers, a strategy focused on lending to disenfranchised companies has an opportunity to earn attractive and sustainable risk-adjusted returns for its investors.

This sustainability is burnished by several barriers to entry. Capitalising on the opportunity requires a talent that not everyone has: active credit underwriting, which has become an endangered species.

1. Active credit underwriting is required
Remember bank underwriters? Not the passive credit underwriting in which you pick up a 10-K, read some rating agency research reports and then write an opinion.

Active underwriting requires real due diligence. It requires analysts who conduct plant tours, meet with management, speak with customers and suppliers and understand how to write covenants - basically, what bank underwriters used to do.

The lack of active credit underwriting and investors' reliance on the passive underwriting of others had much to do with the credit crisis. Many investors thought they could rely on someone else to do the credit work, whether this was through rating agencies, investment banks or even hedge funds.

As long as liquidity was ample and the economy rolled along, passive credit underwriting appeared to work. Unfortunately, liquidity dried up and the economy contracted, exposing the danger of leveraging poor credit underwriting. Going forward, navigating the crisis requires active credit underwriting.

2. Partner with an asset manager with permanency
Because loans made to the disenfranchised companies are illiquid, an asset manager will have to obtain permanent or committed financing in order to capitalise on this lending opportunity. To provide permanent financing for these attractive risk-adjusted returns, investors will be looking for an asset manager with certain characteristics: some permanency, strong capital, a long-term track record of underwriting credit and a deep organisation with separate risk and operations groups.

In addition, the asset manager will need to have access to a pipeline of prospective borrowers and these borrowers will be looking for a partner - someone with permanency, similar to investors.

3. Lending today creates business tomorrow
There is a powerful second-order effect from lending to the disenfranchised borrower. It can stimulate sustained long-term fees, which translate into long-term performance for investors. The concept is that lending today creates business tomorrow.

If you help a client in times of distress, you become that client's partner. As a partner, you are more likely to be asked to help them in the good times as well; for example, in obtaining future merger activity or other advisory business. As a result, investors have an ability to extract a long-term annuity from the borrowers that they partner with, much as the old investment banks did.

Those investment banks and merchant banks did actual underwriting for their investors. For instance, prior to selling the debt of a US railroad to European investors, the house of Morgan would meet with the railroad's customers and management to make sure that investors could reasonably expect to get their money back. Those relationships, which were cultivated by J.P. Morgan through the bank's lending, often led to additional work from the US railroads and provided the footings for one of the most powerful US investment banks at the turn of the 20th century.

Move over George Soros, here comes J.P. Morgan
Long-only lending represents an historic opportunity to earn sustainable returns without leverage. The secular decline in bank lending creates a long-term opportunity to lend to disenfranchised borrowers. However, it requires the right asset manager to capitalise on the opportunity.

That asset manager will need to have the right combination of characteristics: permanency, active credit underwriting and a willingness to be a partner - not a loan shark. That's very similar to the way in which the old investment banks operated. Perhaps the next George Soros will look like J.P. Morgan.

Disclaimer
Opinions expressed herein were drafted as of the date of this article, and are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

Any statement concerning financial market trends is based on current or past market conditions which can fluctuate over time. Information contained herein has been obtained from sources believed to be reliable, but the accuracy of such information is not guaranteed by the author or Aviva Investors^SM North America, Inc.