This was originally supposed to be posted before we altered our strategy to focus on investment in systematic crypto strategies. In the coming weeks, I will be putting out a piece outlining how I think the digital asset markets are similar to the emerging markets and I believe that this will be helpful in providing additional context to those who read all the posts here.
During our time as a Stanford’s Endowment and Fintan, our strategy focus was on investing in areas that had suffered financial upheaval. It was through our investments in distressed, emerging market companies that we learned that long-term corporate loans didn’t always offer the best risk/reward way to participate in the cash flows of recapitalized businesses. We discovered that it would be better to finance businesses by discounting invoices from their customers rather than loaning to them directly; your period of risk was outstanding for significantly less time (30-180 days), and you were generally being paid by a higher quality credit entity at a premium, as opposed to the invoice payer’s cost of capital while investing in an asset that in most regions is bankruptcy-remote. To avoid currency risk, we structured these transactions so that the payer is in a hard currency jurisdiction such as the US, UK, Japan, or Europe. In 2008, we applied our knowledge of factoring (invoice discounting) in a market that had suffered its financial crisis a year before the rest of the world, Brazil. This also became an opportunity for us to highlight and refine our secondary research focus; regulatory change. Brazil had experienced a change in its bankruptcy laws 3 years before, which made their law similar to US bankruptcy law. This made the path to collections of defaulted assets more straightforward than it had been in the past.
Since the investment was in a foreign jurisdiction, strategizing for local regulation and tax was of utmost importance in order for us to realize the full return potential of the investment. To invest in a tax-efficient manner, credit investments in Brazil needed to be done through funds similar to ABS securities, which we implemented. Through tactical structuring, we were able to match the duration of the assets in the underlying investments to the liabilities, as well as have the originator/servicer of the factoring transactions provide a reserve fund to absorb losses in the portfolio. As a result of our swift timing and skillful application of expertise, it was our best-performing investment that year. Over the next 2 years, real rates and spreads began to come down in Brazil. That, along with management changes at our local partner led us to the decision to exit this investment after having maximized our success in that market.
While we have no recent active investments there, we have continued to follow developments in Brazil as a useful exercise in forecasting. Developments we think are of note and will have regional and global implications include: invoice enrollment through government-sponsored registries, and the recent launch of a new payments infrastructure, PIX. These fit within the purview of our third research theme of looking for the adoption of technological innovation. Even if return thresholds for factoring in Brazil aren’t currently attractive for a foreign investor, lessons can be learned and then later applied in other jurisdictions that are adopting similar regulations and technologies. For example, the relevance of Brazil’s technological innovations to the US market can be seen through our anticipating and then seeing the Feds’ new announcement of FEDNow and more. Companies operating in Brazil and Mexico, where SPEI is similar to PIX, have an operational and technical advantage over their US peers by operating such systems. Their presence in other markets could lead to integrations that facilitate cross-border finance in a way we’ve never seen before.
As a result of our above success in the South America market, when we launched in 2014 we focused on technological innovation as our central issue as we recognized that exponential digital growth and transformation was driving radical change in financing. In the US, Lending Club was seen as an innovation in customer acquisition and underwriting for consumer lending. But in Latin America, technological change was driven not by a desire to increase lending, but by governmental desire to increase tax revenue. This shifted our focus to factoring and small business lending, as those businesses were about to undergo dramatic change due to technological automation and regulatory transformation. Specifically, we invested in Gulungo, a technology-driven SME platform in Colombia. Publicly available digital invoice registries and political adjustments that had begun to allow electronic signatures opened the doors for a traditionally manual credit underwriting and contract execution process to move from a paper process to a digital one, reducing operational overhead and making it possible to charge more affordable rates to the end borrower. The synergy created by combining digitized invoice registration with open banking meant that processing costs would go down and net interest margins would increase, making it the perfect investment opportunity while also opening the door to anticipating similar changes elsewhere. Thus, it was familiar territory when API integration and web scrapping in the US began to lead to increased democratization and efficient analysis of bank information for individual and small business borrowers, leading to an explosion of revenue-based financing in the US we were then well prepared to capitalize on.
As always, most groups focused on scale vs return. However, we were investing our own money so we took our lessons from Latin America and focused on domestic small balance revenue-based financing, which was still a largely ignored space. TI took advantage of this lack of attention by analyzing data from Aquila, an emerging financing platform that was using blockchain technology to observe these changes in the US market. Under the hood, we saw an opportunity to create a successful underwriting strategy for these revenue-based advances. Notably, we saw that small-balanced borrowers weren’t experts in managing their cashflow, therefore traditional lending strategies of allowing successful payers to extend the duration of their future advances in order to lower their regular payments weren’t sufficient, and led to payment defaults and other problems. If advance durations remained short, payers were less likely to experience cashflow issues and were more likely to achieve long-term success. As a result, we were able to recognize the lack of budgeting skills in our business pool that a traditional underwriting process that requires business plans would flag, but a tech-based process would not, combining analogue skill with digital innovation. The data told us we got more defaults by extending the duration and our experience and insight helped us determine why.
Participating in this platform offered us a glimpse into what the future could be like in other parts of Latin America and Europe with the adoption of PSD2 and open banking regulation. Thus, we continue to use our institutional knowledge gained in US lending to look for opportunities near the front of the curve in Latin America, where similar regulatory changes and technological adoptions will lead to catalytic shifts in the structure of the lending markets or vice versa. Eventually this research led us to the digital asset markets and where we are investing today.
Summary of Our Three Areas of Research
Financial Upheaval – Investing After a Default
Credit cycles are cyclical and are often asynchronous across sectors and geographies. By focusing our research efforts on areas experiencing financial distress, Terra Incognita can maintain a consistent set of opportunities from which it can choose. We understand the transition from downturn to recovery can be highly variable, and therefore don’t look to “pick the bottom” but look at distress as a time to initiate research to determine what are the best opportunities when the region/sector enters the recovery phase; our most successful focus being distressed debt. However, instead of investing in distressed companies or people, we focus on providing additional capital to those companies that managed a downturn well and are poised to expand while their competitors are bogged down in financial restructuring.
In keeping with monitoring markets going through financial distress, we have also found it essential to concentrate on regulatory change, as both areas are often interrelated and can affect one another drastically. Therefore, we carefully monitor any legislative or governing change while applying our vast frameworks of experience to anticipate how those developments will transform the market; and which areas are most worthwhile in terms of focusing our attention. Similarly, we also observe how changes in regulation affect particular markets, and then we look for similar changes in regulation in adjacent industries or geographies and apply those principals again.
Technological change and adoption
Our research into technological change and adoption tends to run parallel to our research into regulatory change. Usually, innovation comes first, but widespread adoption requires regulatory revisions and therefore we cannot solely rely on them to clue us into the progress being made. Rather; we look for disruptive tech and innovation that is looking to replace or improve current systems in finance-facing industries, as well as technological companies that are looking to scale up. Our above-outlined expertise in financially uncertain markets and translating regulatory change across vertical markets leaves us well poised to use this knowledge to anticipate what areas will foster technological growth in the near future.
LEGAL INFORMATION AND DISCLOSURES
This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Terra Incognita has no duty or obligation to update the information contained herein. Further, Terra Incognita makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Terra incognita Capital, LLC (“Terra Incognita”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
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