Strategic Storage Trust II, Inc. (“SST II”) announced strong increases in total revenues, same-store revenues, net operating income (“NOI”), and annualized rent per occupied square foot as part of its overall operating results for the three months ended March 31, 2018.
“Our first quarter same-store growth continues to be strong, following the re-branding of our properties in the United States under the SmartStop® Self Storage brand,” said H. Michael Schwartz, chairman and chief executive officer of SST II. “The increase in the first quarter of 2018 was primarily driven by an increase in rental rates, which demonstrates the institutional quality of the portfolio in conjunction with a solid property management team and platform.”
First Quarter 2018 Highlights:
- Increased total revenue by approximately $2.2 million, or 12%, when compared to the same period in 2017.
- Increased same-store revenues and NOI by 7.9% and 13.9%, respectively, compared to the same period in 2017.
- Increased same-store annualized rent per occupied square foot by approximately 12.8%, when compared to the same period in 2017, from $13.86 to $15.64.
- Increased modified funds from operations by approximately $1.6 million, or 45%, when compared to the same period in 2017.
Joint Venture with SmartCentres
In March of 2018, a subsidiary of SST II was assigned a contribution agreement with a subsidiary of SmartCentres Real Estate Investment Trust (“SmartCentres”), an unaffiliated third party, for a tract of land owned by SmartCentres and located in East York, Ontario in Canada. Upon closing, the land in East York will be owned by a limited partnership, in which SST II and SmartCentres, both through respective subsidiaries, will each be a 50% limited partner and each have an equal ranking general partner in the limited partnership (the “Limited Partnership”). It is intended that the Limited Partnership develops a self storage facility on the land. At closing, SST II will subscribe for 50% of the units in the Limited Partnership at an agreed upon subscription price of approximately $3.8 million CAD, representing a contribution equivalent to 50% of the agreed upon fair market value of the land. SST II expects the acquisition of the land in East York to close in the third quarter of 2018 after the land has been zoned so as to permit the self storage facility.
On March 19, 2018, SST II’s board of directors declared a distribution rate for the second quarter of 2018 of approximately $0.001644 per day per share on the outstanding shares of common stock payable to both Class A and Class T stockholders of record of such shares as shown on SST II’s books at the close of business on each day during the period, commencing on April 1, 2018 and continuing on each day thereafter through and including June 30, 2018. Such distributions payable to each stockholder of record during a month will be paid the following month.
On April 19, 2018, the board of directors of SST II, upon recommendation of its nominating and corporate governance committee, approved an estimated value per share of its common stock of $10.65 (a 4.2% increase from our previous estimated value per share of $10.22) for its Class A shares and Class T shares based on the estimated value of SST II’s assets less the estimated value of its liabilities, or net asset value, divided by the number of shares outstanding on a fully diluted basis, calculated as of December 31, 2017. See SST II’s Current Report on Form 8-K filed with the SEC on April 20, 2018 for a description of the methodologies and assumptions used to determine, and the limitations of, the estimated value per share.
|STRATEGIC STORAGE TRUST II, INC. AND SUBSIDIARIES|
|CONSOLIDATED BALANCE SHEETS|
|Real estate facilities:|
|Construction in process||92,447||92,519|
|Real estate facilities, net||786,299,137||795,085,023|
|Cash and cash equivalents||5,122,092||7,355,422|
|Other assets, net||7,534,239||5,563,600|
|Debt issuance costs, net of accumulated amortization||624,803||836,202|
|Intangible assets, net of accumulated amortization||2,897,058||4,144,601|
|LIABILITIES AND EQUITY|
|Accounts payable and accrued liabilities||7,794,092||7,451,849|
|Due to affiliates||2,933,255||2,965,904|
|Commitments and contingencies|
|Redeemable common stock||27,341,428||24,497,059|
|Strategic Storage Trust II, Inc. equity:|
|Preferred stock, $0.001 par value; 200,000,000 shares authorized; none issued and outstanding at March 31, 2018 and December 31, 2017||—||—|
|Class A common stock, $0.001 par value; 350,000,000 shares authorized; 49,653,836 and 49,386,092 shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively||49,654||49,386|
|Class T common stock, $0.001 par value; 350,000,000 shares authorized; 7,399,104 and 7,350,142 shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively||7,400||7,351|
|Additional paid-in capital||496,300,885||496,287,890|
|Accumulated other comprehensive income||1,820,322||1,369,208|
|Total Strategic Storage Trust II, Inc. equity||370,075,364||378,510,555|
|Noncontrolling interests in our Operating Partnership||4,347,179||4,427,469|
|Total liabilities and equity||$||807,410,442||$||817,497,838|
|STRATEGIC STORAGE TRUST II, INC. AND SUBSIDIARIES|
|CONSOLIDATED STATEMENTS OF OPERATIONS|
|Three Months Ended
|Self storage rental revenue||$||19,432,415||$||17,612,186|
|Ancillary operating revenue||434,042||95,360|
|Property operating expenses||5,946,103||5,937,345|
|Property operating expenses – affiliates||2,556,377||2,358,997|
|General and administrative||1,202,934||995,913|
|Intangible amortization expense||1,180,502||3,714,656|
|Other property acquisition expenses||49,351||265,763|
|Total operating expenses||16,010,116||18,259,683|
|Operating income (loss)||3,856,341||(552,137)|
|Other income (expense):|
|Interest expense—accretion of fair market value of secured debt||114,360||8,634|
|Interest expense—debt issuance costs||(319,383)||(1,029,326)|
|Net loss attributable to the noncontrolling interests in our Operating Partnership||5,844||30,366|
|Net loss attributable to Strategic Storage Trust II, Inc. common stockholders||$||(661,203)||$||(5,191,114)|
|Net loss per Class A share – basic and diluted||$||(0.01)||$||(0.09)|
|Net loss per Class T share – basic and diluted||$||(0.01)||$||(0.09)|
|Weighted average Class A shares outstanding – basic and diluted||49,501,089||48,261,978|
|Weighted average Class T shares outstanding – basic and diluted||7,375,319||7,139,168|
|STRATEGIC STORAGE TRUST II, INC. AND SUBSIDIARIES|
|NON-GAAP MEASURE – COMPUTATION OF MODIFIED FUNDS FROM OPERATIONS|
|Net loss (attributable to common stockholders)||$||(661,203)||$||(5,191,114)|
|Amortization of intangible assets||1,180,502||3,714,656|
|Adjustment for noncontrolling interests||(54,240)||(53,631)|
|FFO (attributable to common stockholders)||5,468,646||3,210,157|
|Accretion of fair market value of secured debt(2)||(114,360)||(8,634)|
|Foreign currency and interest rate derivative gains, net(3)||(91,055)||—|
|Adjustment for noncontrolling interests||1,508||(1,239)|
|MFFO (attributable to common stockholders)||$||5,322,395||$||3,678,624|
SST II’s results of operations for the three months ended March 31, 2018 and 2017 were significantly impacted by a favorable increase in same-store net operating income and their acquisitions.
|(1)||In evaluating investments in real estate, SST II differentiates the costs to acquire the investment from the operations derived from the investment. Such information would be comparable only for publicly registered, non-traded REITs that have generally completed their acquisition activity and have other similar operating characteristics. By excluding any expensed acquisition related expenses, SST II believes MFFO provides useful supplemental information that is comparable for each type of real estate investment and is consistent with management’s analysis of the investing and operating performance of SST II’s properties. Acquisition fees and expenses include payments to SST II’s advisor and third parties. Acquisition related expenses that do not meet SST II’s capitalization policy under GAAP are considered operating expenses and as expenses included in the determination of net income (loss) and income (loss) from continuing operations, both of which are performance measures under GAAP. All paid and accrued acquisition fees and expenses will have negative effects on returns to investors, the potential for future distributions, and cash flows generated by SST II, unless earnings from operations or net sales proceeds from the disposition of other properties are generated to cover the purchase price of the property, these fees and expenses and other costs related to such property.|
|(2)||This represents the difference between the stated interest rate and the estimated market interest rate on assumed notes as of the date of acquisition. Such amounts have been excluded from MFFO because SST II believes MFFO provides useful supplementary information by focusing on operating fundamentals, rather than events not related to SST II’s normal operations. SST II is responsible for managing interest rate risk and does rely on another party to manage such risk.|
|(3)||This represents the mark-to-market adjustment for SST II’s derivative instruments not designated for hedge accounting and the ineffective portion of the change in fair value of derivatives recognized in earnings. These derivative contracts are intended to manage SST II’s exposure to interest rate and foreign currency risk.|
Non-cash Items Included in Net Loss:
Provided below is additional information related to selected non-cash items included in net loss above, which may be helpful in assessing SST II’s operating results:
- Debt issuance costs of approximately $0.3 million and $1.0 million, respectively, were recognized for the three months ended March 31, 2018 and 2017.
STRATEGIC STORAGE TRUST II, INC. AND SUBSIDIARIES
NON-GAAP MEASURE – COMPUTATION OF SAME-STORE OPERATING RESULTS
The following table sets forth operating data for SST II’s same-store facilities (those properties included in the consolidated results of operations since January 1, 2017 excluding Oakville I, which completed development during the second quarter of 2016) for the three months ended March 31, 2018 and 2017. SST II considers the following data to be meaningful as this allows for the comparison of results without the effects of acquisition or development activity.
|Same-Store Facilities||Non Same-Store Facilities||Total|
|Property operating expenses(2)||6,166,286||6,290,794||(2.0)||%||969,063||717,978||N/M||7,135,349||7,008,772||1.8||%|
|Number of facilities||76||76||7||7||83||83|
|Rentable square feet (3)||5,433,400||5,433,400||596,200||596,200||6,029,600||6,029,600|
|Average physical occupancy(4)||88.7||%||92.1||%||N/M||N/M||88.5||%||90.1||%|
|Annualized rent per occupied square foot (5)||$||15.64||$||13.86||N/M||N/M||$||15.70||$||13.67|
|N/M Not meaningful|
|(1)||Revenue includes rental revenue, ancillary revenue, and administrative and late fees.|
|(2)||Property operating expenses excludes corporate general and administrative expenses, asset management fees, interest expense, depreciation, amortization expense, and acquisition expenses, but includes property management fees.|
|(3)||Of the total rentable square feet, parking represented approximately 540,000 square feet as of March 31, 2018 and 2017. On a same-store basis, for the same periods, parking represented approximately 530,000 square feet.|
|(4)||Determined by dividing the sum of the month-end occupied square feet for the applicable group of facilities for each applicable period by the sum of their month-end rentable square feet for the period.|
|(5)||Determined by dividing the aggregate realized rental revenue for each applicable period by the aggregate of the month-end occupied square feet for the period. Properties are included in the respective calculations in their first full month of operations, as appropriate. SST II has excluded the realized rental revenue and occupied square feet related to parking herein for the purpose of calculating annualized rent per occupied square foot.|
SST II’s increase in same-store revenue of approximately $1.3 million was primarily the result of increased annualized rent per occupied square foot of approximately 12.8%, net of decreased average physical occupancy of 3.4% for the three months ended March 31, 2018 over the three months ended March 31, 2017.
SST II’s same-store property operating expenses decreased by approximately $0.1 million for the three months ended March 31, 2018 compared to the three months ended March 31, 2017 primarily due to a decrease in repairs and maintenance and payroll expenses.
The following table presents a reconciliation of net loss to net operating income as presented on SST II’s consolidated statements of operations for the periods indicated:
|For the Three Months Ended March 31,|
|Adjusted to exclude:|
|Asset management fees (1)||1,367,131||1,287,570|
|General and administrative||1,202,934||995,913|
|Intangible amortization expense||1,180,502||3,714,656|
|Other property acquisition expenses||49,351||265,763|
|Interest expense—accretion of fair market value of secured debt||(114,360)||(8,634)|
|Interest expense—debt issuance costs||319,383||1,029,326|
|(1)||Asset management fees are included in Property operating expenses – affiliates in the consolidated statements of operations.|
ADDITIONAL INFORMATION REGARDING NOI, FFO, and MFFO
Net Operating Income (“NOI”)
NOI is a non-GAAP measure that SST II defines as net income (loss), computed in accordance with GAAP, generated from properties before corporate general and administrative expenses, costs incurred in connection with the property management change, asset management fees, interest expense, depreciation, amortization, acquisition expenses and other non-property related expenses. SST II believes that NOI is useful for investors as it provides a measure of the operating performance of its operating assets because NOI excludes certain items that are not associated with the ongoing operation of the properties. Additionally, SST II believes that NOI is a widely accepted measure of comparative operating performance in the real estate community. However, SST II’s use of the term NOI may not be comparable to that of other real estate companies as they may have different methodologies for computing this amount.
Funds from Operations (“FFO”) and Modified Funds from Operations (“MFFO”)
Due to certain unique operating characteristics of real estate companies, the National Association of Real Estate Investment Trusts, or NAREIT, an industry trade group, has promulgated a measure known as funds from operations, or FFO, which SST II believes to be an appropriate supplemental measure to reflect the operating performance of a REIT. The use of FFO is recommended by the REIT industry as a supplemental performance measure. FFO is not equivalent to SST II’s net income (loss) as determined under GAAP.
SST II defines FFO, a non-GAAP measure, consistent with the standards established by the White Paper on FFO approved by the Board of Governors of NAREIT, as revised in February 2004, or the White Paper. The White Paper defines FFO as net income (loss) computed in accordance with GAAP, excluding gains or losses from sales of property and asset impairment write downs, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect FFO on the same basis. SST II’s FFO calculation complies with NAREIT’s policy described above.
The historical accounting convention used for real estate assets requires straight-line depreciation of buildings and improvements, which implies that the value of real estate assets diminishes predictably over time. Diminution in value may occur if such assets are not adequately maintained or repaired and renovated as required by relevant circumstances or other measures necessary to maintain the assets are not undertaken. However, SST II believes that, since real estate values historically rise and fall with market conditions, including inflation, interest rates, the business cycle, unemployment and consumer spending, presentations of operating results for a REIT using historical accounting for depreciation may be less informative. In addition, in the determination of FFO, SST II believes it is appropriate to disregard impairment charges, as this is a fair value adjustment that is largely based on market fluctuations and assessments regarding general market conditions which can change over time. An asset will only be evaluated for impairment if certain impairment indications exist and if the carrying value, or book value, exceeds the total estimated undiscounted future cash flows (including net rental revenues, net proceeds on the sale of the property, and any other ancillary cash flows at a property or group level under GAAP) from such asset. Testing for impairment is a continuous process and is analyzed on a quarterly basis. Investors should note, however, that determinations of whether impairment charges have been incurred are based partly on anticipated operating performance, because estimated undiscounted future cash flows from a property, including estimated future net rental revenues, net proceeds on the sale of the property, and certain other ancillary cash flows, are taken into account in determining whether an impairment charge has been incurred. While impairment charges are excluded from the calculation of FFO as described above, investors are cautioned that due to the fact that impairments are based on estimated future undiscounted cash flows and that SST II intends to have a relatively limited term of operations; it could be difficult to recover any impairment charges through the eventual sale of the property. To date, SST II has not recognized any impairments.
Historical accounting for real estate involves the use of GAAP. Any other method of accounting for real estate such as the fair value method cannot be construed to be any more accurate or relevant than the comparable methodologies of real estate valuation found in GAAP. Nevertheless, SST II believes that the use of FFO, which excludes the impact of real estate related depreciation and amortization and impairments, assists in providing a more complete understanding of SST II’s performance to investors and to management, and when compared year over year, reflects the impact on SST II’s operations from trends in occupancy rates, rental rates, operating costs, general and administrative expenses, and interest costs, which may not be immediately apparent from net income (loss).
However, FFO or modified funds from operations (“MFFO”), discussed below, should not be construed to be more relevant or accurate than the current GAAP methodology in calculating net income (loss) or in its applicability in evaluating SST II’s operating performance. The method utilized to evaluate the value and performance of real estate under GAAP should be considered a more relevant measure of operational performance and is, therefore, given more prominence than the non-GAAP FFO and MFFO measures and the adjustments to GAAP in calculating FFO and MFFO.
Changes in the accounting and reporting rules under GAAP that were put into effect and other changes to GAAP accounting for real estate subsequent to the establishment of NAREIT’s definition of FFO have prompted an increase in cash-settled expenses, specifically acquisition fees and expenses. Prior to January 1, 2018, when SST II adopted new accounting guidance, such costs were entirely expensed as operating expenses under GAAP. Subsequent to January 1, 2018, certain of such costs continue to be expensed. SST II believes these fees and expenses do not affect SST II’s overall long-term operating performance. Publicly registered, non-traded REITs typically have a significant amount of acquisition activity and are substantially more dynamic during their initial years of investment and operation. The purchase of properties, and the corresponding expenditures associated with that process, is a key feature of SST II’s business plan in order to generate operational income and cash flow in order to make distributions to investors. While other start-up entities may also experience significant acquisition activity during their initial years, SST II believes that publicly registered, non-traded REITs are unique in that they typically have a limited life with targeted exit strategies within a relatively limited time frame after the acquisition activity ceases. SST II has used the proceeds raised in our Offering, including our DRP Offering, to acquire properties, and expects to begin the process of achieving a liquidity event (i.e., listing of their shares of common stock on a national securities exchange, a merger or sale, the sale of all or substantially all of their assets, or another similar transaction) within three to five years after the completion of their Primary Offering, which is generally comparable to other publicly registered, non-traded REITs. Thus, they do not intend to continuously purchase assets and intend to have a limited life. The decision whether to engage in any liquidity event is in the sole discretion of SST II’s board of directors. Due to the above factors and other unique features of publicly registered, non-traded REITs, the Investment Program Association, or the IPA, an industry trade group, has standardized a measure known as MFFO, which the IPA has recommended as a supplemental measure for publicly registered, non-traded REITs and which SST II believes to be another appropriate supplemental measure to reflect the operating performance of a publicly registered, non-traded REIT having the characteristics described above. MFFO is not equivalent to net income (loss) as determined under GAAP, and MFFO may not be a useful measure of the impact of long-term operating performance on value if SST II does not ultimately engage in a liquidity event. SST II believes that, because MFFO excludes any acquisition fees and expenses that affect their operations only in periods in which properties are acquired and that they considers more reflective of investing activities, as well as other non-operating items included in FFO, MFFO can provide, on a going-forward basis, an indication of the sustainability (that is, the capacity to continue to be maintained) of their operating performance after the period in which they are acquiring their properties and once their portfolio is in place. By providing MFFO, they believe they are presenting useful information that assists investors and analysts to better assess the sustainability of their operating performance after their primary offering has been completed and their properties have been acquired. SST II also believes that MFFO is a recognized measure of sustainable operating performance by the publicly registered, non-traded REIT industry. Further, they believe MFFO is useful in comparing the sustainability of their operating performance after their primary offering and acquisitions are completed with the sustainability of the operating performance of other real estate companies that are not as involved in acquisition activities. Investors are cautioned that MFFO should only be used to assess the sustainability of SST II’s operating performance after their primary offering has been completed and properties have been acquired, as it excludes any acquisition fees and expenses that have a negative effect on SST II’s operating performance during the periods in which properties are acquired.
We define MFFO, a non-GAAP measure, consistent with the IPA’s Guideline 2010-01, Supplemental Performance Measure for Publicly Registered, Non-Listed REITs: Modified Funds From Operations (the “Practice Guideline”) issued by the IPA in November 2010. The Practice Guideline defines MFFO as FFO further adjusted for the following items included in the determination of GAAP net income (loss): acquisition fees and expenses; amounts relating to straight line rents and amortization of above or below intangible lease assets and liabilities; accretion of discounts and amortization of premiums on debt investments; non-recurring impairments of real estate related investments; mark-to-market adjustments included in net income; non-recurring gains or losses included in net income from the extinguishment or sale of debt, hedges, foreign exchange, derivatives or securities holdings where trading of such holdings is not a fundamental attribute of the business plan, unrealized gains or losses resulting from consolidation from, or deconsolidation to, equity accounting, adjustments relating to contingent purchase price obligations included in net income, and after adjustments for consolidated and unconsolidated partnerships and joint ventures, with such adjustments calculated to reflect MFFO on the same basis. The accretion of discounts and amortization of premiums on debt investments, unrealized gains and losses on hedges, foreign exchange, derivatives or securities holdings, unrealized gains and losses resulting from consolidations, as well as other listed cash flow adjustments are adjustments made to net income (loss) in calculating cash flows from operations and, in some cases, reflect gains or losses which are unrealized and may not ultimately be realized.
SST II’s MFFO calculation complies with the IPA’s Practice Guideline described above. In calculating MFFO, SST II excludes acquisition related expenses, the amortization of fair value adjustments related to debt, mark to market adjustments recorded in net income related to their derivatives, and the adjustments of such items related to noncontrolling interests. The other adjustments included in the IPA’s Practice Guideline are not applicable to SST II for the periods presented. Acquisition fees and expenses are paid in cash by SST II, and they have not set aside or put into escrow any specific amount of proceeds from their offering to be used to fund acquisition fees and expenses. SST II does not intend to fund acquisition fees and expenses in the future from operating revenues and cash flows, nor from the sale of properties and subsequent re-deployment of capital and concurrent incurrence of acquisition fees and expenses. Acquisition fees and expenses include payments to SST II’s Advisor and third parties. Certain acquisition related expenses under GAAP are considered operating expenses and as expenses included in the determination of net income (loss) and income (loss) from continuing operations, both of which are performance measures under GAAP. All paid and accrued acquisition fees and expenses will have negative effects on returns to investors, the potential for future distributions, and cash flows generated by SST II, unless earnings from operations or net sales proceeds from the disposition of other properties are generated to cover the purchase price of the property, these fees and expenses and other costs related to such property. In the future, if SST II is not able to raise additional proceeds from their DRP offering or other offerings, this could result in them paying acquisition fees or reimbursing acquisition expenses due to their Advisor, or a portion thereof, with net proceeds from borrowed funds, operational earnings or cash flows, net proceeds from the sale of properties, or ancillary cash flows. As a result, the amount of proceeds available for investment and operations would be reduced, or may incur additional interest expense as a result of borrowed funds.
Further, under GAAP, certain contemplated non-cash fair value and other non-cash adjustments are considered operating non-cash adjustments to net income (loss) in determining cash flows from operations. In addition, SST II views fair value adjustments of derivatives and the amortization of fair value adjustments related to debt as items which are unrealized and may not ultimately be realized or as items which are not reflective of on-going operations and are therefore typically adjusted for when assessing operating performance.
SST II uses MFFO and the adjustments used to calculate it in order to evaluate their performance against other publicly registered, non-traded REITs which intend to have limited lives with short and defined acquisition periods and targeted exit strategies shortly thereafter. As noted above, MFFO may not be a useful measure of the impact of long-term operating performance if SST II does not continue to operate in this manner. SST II believes that their use of MFFO and the adjustments used to calculate it allows them to present their performance in a manner that reflects certain characteristics that are unique to publicly registered, non-traded REITs, such as their limited life, limited and defined acquisition period and targeted exit strategy, and hence that the use of such measures may be useful to investors. For example, acquisition fees and expenses are intended to be funded from the proceeds of SST II’s offering and other financing sources and not from operations. By excluding any expensed acquisition fees and expenses, the use of MFFO provides information consistent with management’s analysis of the operating performance of the properties. Additionally, fair value adjustments, which are based on the impact of current market fluctuations and underlying assessments of general market conditions, but can also result from operational factors such as rental and occupancy rates, may not be directly related or attributable to their current operating performance. By excluding such charges that may reflect anticipated and unrealized gains or losses, SST II believes MFFO provides useful supplemental information.
Presentation of this information is intended to provide useful information to investors as they compare the operating performance of different REITs, although it should be noted that not all REITs calculate FFO and MFFO the same way, so comparisons with other REITs may not be meaningful. Furthermore, FFO and MFFO are not necessarily indicative of cash flow available to fund cash needs and should not be considered as an alternative to net income (loss) or income (loss) from continuing operations as an indication of our performance, as an alternative to cash flows from operations, which is an indication of our liquidity, or indicative of funds available to fund SST II’s cash needs including their ability to make distributions to stockholders. FFO and MFFO should be reviewed in conjunction with other measurements as an indication of performance. MFFO may be useful in assisting management and investors in assessing the sustainability of operating performance in future operating periods, and in particular, after the offering and acquisition stages are complete.
Neither the SEC, NAREIT, nor any other regulatory body has passed judgment on the acceptability of the adjustments that SST II uses to calculate FFO or MFFO. In the future, the SEC, NAREIT or another regulatory body may decide to standardize the allowable adjustments across the publicly registered, non-traded REIT industry and SST II would have to adjust their calculation and characterization of FFO or MFFO.
TCI: A time of critical importance
By Fabrice Desnos, head of Northern Europe Region, Euler Hermes, the world’s leading trade credit insurer, outlines the importance of less publicised measures for the journey ahead.
After months of lockdown, Europe is shifting towards rebuilding economies and resuming trade. Amongst the multibillion-euro stimulus packages provided by governments to businesses to help them resume their engines of growth, the cooperation between the state and private sector trade credit insurance underwriters has perhaps missed the headlines. However, this cooperation will be vital when navigating the uncertain road ahead.
Covid-19 has created a global economic crisis of unprecedented scale and speed. Consequently, we’re experiencing unprecedented levels of support from national governments. Far-reaching fiscal intervention, job retention and business interruption loan schemes are providing a lifeline for businesses that have suffered reductions in turnovers to support national lockdowns.
However, it’s becoming clear the worst is still to come. The unintended consequence of government support measures is delaying the inevitable fallout in trade and commerce. Euler Hermes is already seeing increase in claims for late payments and expects this trend to accelerate as government support measures are progressively removed.
The Covid-19 crisis will have long lasting and sometimes irreversible effects on a number of sectors. It has accelerated transformations that were already underway and had radically changed the landscape for a number of businesses. This means we are seeing a growing number of “zombie” companies, currently under life support, but whose business models are no longer adapted for the post-crisis world. All factors which add up to what is best described as a corporate insolvency “time bomb”.
The effects of the crisis are already visible. In the second quarter of 2020, 147 large companies (those with a turnover above €50 million) failed; up from 77 in the first quarter, and compared to 163 for the whole of the first half of 2019. Retail, services, energy and automotive were the most impacted sectors this year, with the hotspots in retail and services in Western Europe and North America, energy in North America, and automotive in Western Europe
We expect this trend to accelerate and predict a +35% rise in corporate insolvencies globally by the end of 2021. European economies will be among the hardest hit. For example, Spain (+41%) and Italy (+27%) will see the most significant increases – alongside the UK (+43%), which will also feel the impact of Brexit – compared to France (+25%) or Germany (+12%).
Companies are restarting trade, often providing open credit to their clients. However, there can be no credit if there is no confidence. It is increasingly difficult for companies to identify which of their clients will emerge from the crisis from those that won’t, and whether or when they will be paid. In the immediate post-lockdown period, without visibility and confidence, the risk was that inter-company credit could evaporate, placing an additional liquidity strain on the companies that depend on it. This, in turn, would significantly put at risk the speed and extent of the economic recovery.
In recent months, Euler Hermes has co-operated with government agencies, trade associations and private sector trade credit insurance underwriters to create state support for intercompany trade, notably in France, Germany, Belgium, Denmark, the Netherlands and the UK. All with the same goal: to allow companies to trade with each other in confidence.
By providing additional reinsurance capacity to the trade credit insurers, governments help them continue to provide cover to their clients at pre-crisis levels.
The beneficiaries are the thousands of businesses – clients of credit insurers and their buyers – that depend upon intercompany trade as a source of financing. Over 70% of Euler Hermes policyholders are SMEs, which are the lifeblood of our economies and major providers of jobs. These agreements are not without costs or constraints for the insurers, but the industry has chosen to place the interests of its clients and of the economy ahead of other considerations, mindful of the important role credit insurance and inter-company trade will play in the recovery.
Taking the UK as an example, trade credit insurers provide cover for more than £171billion of intercompany transactions, covering 13,000 suppliers and 650,000 buyers. The government has put in place a temporary scheme of £10billion to enable trade credit insurers, including Euler Hermes, to continue supporting businesses at risk due to the impact of coronavirus. This landmark agreement represents an important alliance between the public and private sectors to support trade and prevent the domino effect that payment defaults can create within critical supply chains.
But, as with all of the other government support measures, these schemes will not exist in the long term. It is already time for credit insurers and their clients to plan ahead, and prepare for a new normal in which the level and cost of credit risk will be heightened and where identifying the right counterparts, diversifying and insuring credit risk will be of paramount importance for businesses.
Trade credit insurance plays an understated role in the economy but is critical to its health. In normal circumstances, it tends to go unnoticed because it is doing its job. Government support schemes helped maintain confidence between companies and their customers in the immediate aftermath of the crisis.
However, as government support measures are progressively removed, this crisis will have a lasting impact. Accelerating transformations, leading to an increasing number of company restructurings and, in all likelihood, increasing the level of credit risk. To succeed in the post-crisis environment, bbusinesses have to move fast from resilience to adaptation. They have to adopt bold measures to protect their businesses against future crises (or another wave of this pandemic), minimize risk, and drive future growth. By maintaining trust to trade, with or without government support, credit insurance will have an increasing role to play in this.
What Does the FinCEN File Leak Tell Us?
By Ted Sausen, Subject Matter Expert, NICE Actimize
On September 20, 2020, just four days after the Financial Crimes Enforcement Network (FinCEN) issued a much-anticipated Advance Notice of Proposed Rulemaking, the financial industry was shaken and their stock prices saw significant declines when the markets opened on Monday. So what caused this? Buzzfeed News in cooperation with the International Consortium of Investigative Journalists (ICIJ) released what is now being tagged the FinCEN files. These files and summarized reports describe over 200,000 transactions with a total over $2 trillion USD that has been reported to FinCEN as being suspicious in nature from the time periods 1999 to 2017. Buzzfeed obtained over 2,100 Suspicious Activity Reports (SARs) and over 2,600 confidential documents financial institutions had filed with FinCEN over that span of time.
Similar such leaks have occurred previously, such as the Panama Papers in 2016 where over 11 million documents containing personal financial information on over 200,000 entities that belonged to a Panamanian law firm. This was followed up a year and a half later by the Paradise Papers in 2017. This leak contained even more documents and contained the names of more than 120,000 persons and entities. There are three factors that make the FinCEN Files leak significantly different than those mentioned. First, they are highly confidential documents leaked from a government agency. Secondly, they weren’t leaked from a single source. The leaked documents came from nearly 90 financial institutions facilitating financial transactions in more than 150 countries. Lastly, some high-profile names were released in this leak; however, the focus of this leak centered more around the transactions themselves and the financial institutions involved, not necessarily the names of individuals involved.
FinCEN Files and the Impact
What does this mean for the financial institutions? As mentioned above, many experienced a negative impact to their stocks. The next biggest impact is their reputation. Leaders of the highlighted institutions do not enjoy having potential shortcomings in their operations be exposed, nor do customers of those institutions appreciate seeing the institution managing their funds being published adversely in the media.
Where did the financial institutions go wrong? Based on the information, it is actually hard to say where they went wrong, or even ‘if’ they went wrong. Financial institutions are obligated to monitor transactional activity, both inbound and outbound, for suspicious or unusual behavior, especially those that could appear to be illicit activities related to money laundering. If such behavior is identified, the financial institution is required to complete a Suspicious Activity Report, or a SAR, and file it with FinCEN. The SAR contains all relevant information such as the parties involved, transaction(s), account(s), and details describing why the activity is deemed to be suspicious. In some cases, financial institutions will file a SAR if there is no direct suspicion; however, there also was not a logical explanation found either.
So what deems certain activities to be suspicious and how do financial institutions detect them? Most financial institutions have sophisticated solutions in place that monitor transactions over a period of time, and determine typical behavioral patterns for that client, and that client compared to their peers. If any activity falls disproportionately beyond those norms, the financial institution is notified, and an investigation is conducted. Because of the nature of this detection, incorporating multiple transactions, and comparing it to historical “norms”, it is very difficult to stop a transaction related to money laundering real-time. It is not uncommon for a transaction or series of transactions to occur and later be identified as suspicious, and a SAR is filed after the transaction has been completed.
FinCEN Files: Who’s at Fault?
Going back to my original question, was there any wrong doing? In this case, they were doing exactly what they were required to do. When suspicion was identified, SARs were filed. There are two things that are important to note. Suspicion does not equate to guilt, and individual financial institutions have a very limited view as to the overall flow of funds. They have visibility of where funds are coming from, or where they are going to; however, they don’t have an overall picture of the original source, or the final destination. The area where financial institutions may have fault is if multiple suspicions or probable guilt is found, but they fail to take appropriate action. According to Buzzfeed News, instances of transactions to or from sanctioned parties occurred, and known suspicious activity was allowed to continue after it was discovered.
How do we do better? First and foremost, FinCEN needs to identify the source of the leak and fix it immediately. This is very sensitive data. Even within a financial institution, this information is only exposed to individuals with a high-level clearance on a need-to-know basis. This leak may result in relationship strains with some of the banks’ customers. Some people already have a fear of being watched or tracked, and releasing publicly that all these reports are being filed from financial institutions to the federal government won’t make that any better – especially if their financial institution was highlighted as one of those filing the most reports. Next, there has been more discussion around real-time AML. Many experts are still working on defining what that truly means, especially when some activities deal with multiple transactions over a period of time; however, there is definitely a place for certain money laundering transactions to be held in real time.
Lastly, the ability to share information between financial institutions more easily will go a long way in fighting financial crime overall. For those of you who are AML professionals, you may be thinking we already have such a mechanism in place with 314b. However, the feedback I have received is that it does not do an adequate job. It’s voluntary and getting responses to requests can be a challenge. Financial institutions need a consortium to effectively communicate with each other, while being able to exchange critical data needed for financial institutions to see the complete picture of financial transactions and all associated activities. That, combined with some type of feedback loop from law enforcement indicating which SARs are “useful” versus which are either “inadequate” or “unnecessary” will allow institutions to focus on those where criminal activity is really occurring.
We will continue to post updates as we learn more.
How can financial services firms keep pace with escalating requirements?
By Tim FitzGerald, UK Banking & Financial Services Sales Manager, InterSystems
Financial services firms are currently coming up against a number of critical challenges, ranging from market volatility, most recently influenced by COVID-19, to the introduction of regulations, such as the Payment Services Directive (PSD2) and Fundamental Review of the Trading Book (FRTB). However, these issues are being compounded as many financial institutions find it increasingly difficult to get a handle on the vast volumes of data that they have at their disposal. This is no surprise given that IDC has projected that by 2025, the global “datasphere” will have grown to a staggering 175 zettabytes of data – more than five times the amount of data generated in 2018. As an industry that has typically only invested in new technology when regulations deem it necessary, many traditional banks are now operating using legacy systems and applications that haven’t been designed or built to interoperate. Consequently, banks are struggling to leverage data to achieve business goals and to gain a clear picture of their organisation and processes in order to comply with regulatory requirements. These challenges have been more prevalent during the pandemic as financial services firms were forced to adapt their operations to radical changes in customer behaviour and increased demand for digital services – all while working largely remotely themselves.
As more stringent regulations come in to play and financial services firms look to keep pace with escalating requirements from regulators, consumer demand for more online services, and the ever-evolving nature of the industry and world at large, it’s vital they do two things. Firstly, they must begin to invest in the technology and processes that will allow them to more easily manage the data that traditional banks have been collecting and storing for upwards of 50 years. Secondly, they must innovate. For many, the COVID-19 pandemic will have been a catalyst for both actions. However, the hard work has only just begun.
Traditionally, due to tight budgets and no overarching regulatory imperative to change, financial institutions haven’t done enough to address their overreliance on disconnected legacy systems. Even when faced with the new wave of regulation that was implemented in the wake of the 2008 banking crash, financial services organisations generally only had to invest in different applications on an ad hoc basis to meet each individual regulation. However, as new regulations require the analysis of larger data sets within smaller processing windows, breaking down any and all data siloes is essential and this will require financial institutions that are still reliant on legacy systems to implement new technologies to meet the regulatory stipulations.
With this in mind, solutions which offer high-quality data analytics and enhanced integration will be key to the success of financial institutions and crucial to eliminate data silos. This will enable organisations to achieve a faster and more accurate analysis of real-time and historical data no matter where they are accessing the data from within smaller processing windows to keep pace with regulatory requirements, while also benefiting from low infrastructure costs.
This technology will also play a huge part in helping financial institutions scale their online operations to meet demand from customers for digital services. According to PNC Bank, during the pandemic, it saw online sales jump from 25% to 75%. Therefore, having data platforms that are able to handle surges in online activity is becoming increasingly important.
Real-time analysis of data
While the precise solution financial services institutions need will differ based on the organisation, broadly speaking, the more data they are storing on legacy solutions, the more they are going to require an updated data platform that can handle real-time analytics. Even organisations that have fewer legacy systems are still likely to require solutions that deliver enhanced interoperability to help provide a real-time view across the business and enable them to meet the pressing regulatory requirements they face. Let’s also not lose sight of the fact that moving transactional data to a data warehouse, data lake, or any other silo will never deliver real-time analytics, therefore, businesses making risk decisions based on this and thinking it is real-time is completely inappropriate.
As such, financial services firms require a data platform that can ingest real-time transactional data, as well as from a variety of other sources of historical and reference data, normalise it, and make sense of it. The ability to process transactions at scale in real-time and simultaneously run analytics using transactional real-time data and large sets of non-real-time data, such as reference data, is a crucial capability for various business requirements. For example, powering mission-critical trading platforms that cannot slow down or drop trades, even as volumes spike.
Not only will having access to real-time data enable financial institutions to meet evolving regulatory requirements, but it will also allow them to make faster and more accurate decisions for their organisation andcustomers. With many financial services firms operating on a global basis, this is vital to help them keep up not only with evolving regulations but also changing circumstances in different markets in light of the pandemic. This data can also help them understand how to become more agile, help their employees become productive while working remotely, and how to build up operational resilience. These insights will also be vital as financial institutions need to consider the likelihood of subsequent waves of the virus, allowing them to gain a better understanding of what has and hasn’t worked for their business so far.
The financial services sector is fast-paced and ever-changing. With the launch of more digital-only banks, traditional institutions need to innovate to avoid being left behind, with COVID-19 only highlighting this further. With more than a third (35%) of customers increasing their use of online banking during this period, it is those banks and financial services firms with a solid online offering that have been best placed to answer this demand. As financial institutions cater to changing customer requirements, both now and in the future, implementing new technology that provides access to data in real-time will help them to uncover the fresh insights needed to develop new and transformative products and services for their customers. In turn, this will enable them to realise new revenue streams and potentially capture a bigger slice of the market. For instance, access to data will help banks better understand the needs of their customers during periods of upheaval, as well as under normal circumstance, which will allow them to target them with the specific services they may need during each of these periods to not only help their customers through difficult times but also to ensure the growth of their business. As financial institutions not only look to keep pace with but also gain an advantage over their competitors, using data to fuel excellent customer experiences will be essential to success.
With the current economic uncertainty and market volatility, it’s critical that financial services are able to meet the changing requirements coming from all angles. With COVID-19 likely to be the biggest catalyst for financial institutions to digitally transform, they will be better able to cater to rapidly evolving landscapes and prepare for continued periods of remote working. As they look to achieve this, replacing legacy systems with innovative and agile technology solutions will be crucial to ensure they can gain the accurate and complete view of their enterprise data they need to comply with new and changing regulations, and better meet the needs of consumers in an increasingly digital landscape, whether they are located in an office or working remotely.
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