What is a Structured Product?
Aug 28, 2018
       


What is a Structured Product?

Typically, investments can be broadly classified into two categories:

  • Traditional Investments – These are also sometimes called ‘public markets investments’. The traditional investments are the commonly known and easily accessible investments such as stocks, government and corporate bonds and bank deposits. Anyone can easily call their broker or stop by a bank and access them. They are usually in the public domain and can be distributed through public avenues such as TV, newspaper ads, and banking halls, hence are highly regulated, and,
  • Alternative Investments – As an “alternative” to traditional / public market investments, there are alternative investments, which typically include private equity, real estate, commodities and Structured Products. These investments are usually not in the public domain, they tend to be complex and illiquid, but also tend to have higher and more stable returns compared to traditional investments. They tend to be distributed through private avenues such as pre-screened investors and investment clubs.

As per the definition of Alternative Investments, Structured Products are a subset of Alternative Investments. Simply defined, a Structured Product is a highly customized / tailor made investment product that is packaged by investment professionals to enable the investor access returns or meet investment objectives that are not accessible in the traditional / public / conventional markets such as stocks, bonds and bank deposits.

The process of structuring starts by traditional products such as equities, bonds and bank deposits, either alone or in combination with a non-traditional product, such as real estate, and creating cash flows and returns that are supported by the underlying products, but whose features are different from the underlying product because of the structuring that is done.

Here is a very simplified example of two scenarios of how a Traditional / Conventional Transaction can be structured to become a Structured Transaction:

Traditional / Conventional Transaction Scenario: A saver with money takes it to the bank and gets little to no return on their deposit. The bank in turn lends the money to, say, a developer and charges market rate cost of borrowing. The bank enjoys the difference between the cost of the deposit paid to saver and the yield on loan received from the developer. This is illustrated below:

  • Mr. Saver has Kshs. 10 million; he can go deposit it in a bank and get at best 7% per annum return on the deposit,
  • Mr. Developer can then go to the bank and borrow the Kshs. 10 million from the bank. Remember the bank will be lending to Mr. Developer the same Kshs. 10 million that the bank got from Mr. Saver, but the all-in cost after all bank charges and loan fees comes to about 18% per annum,
  • Mr. Developer will then use the money to develop a house and sell it for Kshs. 12.5 million, essentially making a gross return of 25%, or Kshs. 2.5 million on the Kshs. 10 million loan,
  • Mr. Developer will then pay to the bank the Kshs. 10 million loan plus 18% total cost of loan, equal to Kshs. 1.8 million, so a total of Kshs. 11.8 million goes back to the bank, leaving Mr. Developer with Kshs. 0.7 million of profit.

A Structured Transaction Scenario: In the structured scenario, the facts remain essentially the same, except that the intermediary is not a bank but an investment vehicle; the saver with money takes it to an investment professional, through an Investment Vehicle, who gives the money directly to the developer. The developer will still pay the usual cost of borrowing, but instead of paying it to the bank, it will be paid to the Investment Vehicle, which will pass the returns to the saver. By structuring out the bank, the saver has been able to increase the returns from the typical rate of return given on deposits, to the typical rate of borrowing paid by developers. This is illustrated below:

  • Mr. Saver has changed to Mr. Investor and channels his Kshs. 10 million to an Investment Vehicle managed by an investment professional,
  • Mr. Developer can then go borrow the Kshs. 10 million from the Investment Vehicle and pay the same 18% per annum they would have paid to the bank in the conventional scenario,
  • Mr. Developer will then use the money to develop a house and sell it for Kshs. 12.5 million, essentially making a gross return of 25% or Kshs. 2.5 million on the Kshs. 10 million loan,
  • Mr. Developer will then pay to the Investment Vehicle the Kshs. 10 million loan plus 18% total cost of loan, or Kshs 1.8 million, which will be paid to Mr. Investor,
  • As a result, a total of Kshs 11.8 million goes to Mr. Saver turned Mr. Investor, leaving Mr. Developer with Kshs 0.7 million of profit.

The difference between the Traditional Transaction and the Structured Transaction is that the parties with money have come up with a private Investment Vehicle to be able to transact directly, by structuring out the bank. For the party with money, they get a much higher return, and for the party needing the money, the developer, they are able to transact very quickly and move faster than other developers relying only on conventional bank funding; that is the key essence of a Structured Product / Transaction: Using highly customized features, it brings together two parties through innovative features and delivers to them superior results than they would otherwise get in conventional channels.




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