Deutsche Bank continued to sell risky foreign exchange derivatives to companies in Spain that had suffered big losses from such products even after an internal inquiry found long-standing mis-selling.

An internal probe that began in 2019 after a whistleblower complaint found that staff exploited flaws in the bank’s controls and broke EU rules, pushing small and medium-sized Spanish companies to buy highly complex products that were promoted as safe and cheap hedges against foreign exchange risks.

The products generated huge profits for Deutsche but exposed clients to extensive risk and losses in some cases.

Deutsche has disciplined about a dozen staff in response and also paid tens of millions of euros in settlements to larger clients that bought the derivatives from its investment bank.

But according to people close to the businesses involved and documents reviewed by the Financial Times, smaller companies that bought the products from Deutsche’s international private bank are still being asked to pay up on large losses caused by derivatives that were mis-sold starting more than five years ago.

“No foreign exchange market professional would ever buy this kind of instrument,” said Prosper Lamothe, a finance professor at the Autonomous University of Madrid, who has investigated some of the cases. He added, that Deutsche had been “exploiting” the ignorance of its customers.

In one case that was reviewed in detail by the Financial Times, a family-owned fruit and vegetable wholesaler with €3mn in annual sales was sold derivatives over the past five years covering €19mn of foreign exchange exposure.

The Canary Islands business, which has just four employees, sells pumpkins, carrots, oranges and other produce to clients in Switzerland. It wanted to hedge its Swiss Franc exposure and, according to the owner, was offered products that Deutsche said would be low cost and low risk. He said he only realised what he had been sold in early 2023 and that the product had caused the business €1.5mn of trading losses.

“Deutsche Bank has long brushed aside pleas to settle those cases, arguing that the contracts signed by the affected clients are legally binding,” said Julio Ribelles, a Valencia-based lawyer who represents some of the affected companies.

People familiar with Deutsche Bank’s internal discussions said the bank had stopped selling the products to new clients after the probe found mis-selling. They added that until this summer, the bank did continue to offer new derivatives to existing clients in an attempt to offset previous losses. Ribelles said this created a risk of losses “snowballing over time”.

According to these people, Deutsche stopped offering derivatives to these existing clients only after the Financial Times made an inquiry in August. They also pointed to a recent rule change by the Spanish regulator CNMV that has made it harder and more expensive to sell complex derivatives to SMEs. They added that the bank was now trying to settle the remaining cases. “We are in talks with a small number of clients regarding outstanding transactions,” said one of the people, acknowledging some of the cases were “not easy to solve”.

Other people with knowledge of the bank’s policy told the FT that some senior managers were unimpressed with how the bank had treated affected clients, blaming the lender’s international private bank for the slow response and saying that the investment bank had been quicker off the mark.

These people also said that the cost to Deutsche of waiving client losses was large and that it had been trying to spread the impact on profits over a longer time, hoping losses would become smaller and easier to settle if the Euro strengthened with rising interest rates.

Until earlier this year, Deutsche’s international private bank was run by former Credit Suisse banker Claudio de Sanctis, who was then promoted to the management board and is now in charge of the bank’s retail operations.

Chief executive Christian Sewing has been promising to put past misconduct problems, which include the manipulation of benchmark interest rates and the mis-selling of mortgage-backed securities, to rest. He has said he wants to reposition the bank as the “global Hausbank” of corporate clients and has promised “to support our clients in a spirit of partnership and remain part of the solution”.

“Deutsche Bank’s treatment of SME clients in Spain has long been completely at odds with this promise by Sewing,” said Ribelles. Sewing and De Sanctis declined to comment.

Some of the affected companies have been pushed to the brink of insolvency, people familiar with the cases told the FT.

A Madrid-based importer of sporting goods made in Asia told the FT that it had to fire a quarter of its 40-strong workforce after its auditor earlier this year uncovered €1.5mn in trading losses on Deutsche derivatives that it needed to provision for.

The company imports sporting goods worth $7mn a year but was sold derivatives covering an import volume of €35mn by Deutsche Bank, according to documents seen by the FT. The company only sells products in Spain, but Deutsche also sold it €27mn in derivates to hedge exports.

Lamothe estimated that Deutsche earned more than €2mn in fees from derivative trades with that client. “We’re facing an existential crisis,” a senior manager of the business told the FT.

Lamothe told the FT that he was personally aware of “at least 15 such cases”, adding that there could be hundreds of other companies that were still unaware, because trading losses might not have come to light yet.

Alfonso Ramos, a Madrid-based lawyer representing the fruit and vegetable wholesaler, estimated that on the Canary Islands alone there were up to 50 companies in a similar situation. “But only very few have the power and determination to take legal steps,” he added. Spain is one of the biggest markets for Deutsche Bank’s international private bank, which has more than 650,000 clients and 2,300 employees in the country.

One of the lawyers for the Spanish companies said that changes to derivatives contracts made by Deutsche last year mean it is now harder to sue the bank. The bank added new clauses stipulating conflicts must be resolved in private arbitration tribunals rather than public courts. While private-sector tribunals can work faster than courts, they act without public scrutiny and can be expensive.

According to Ribelles, a company with an average loss of €1mn could expect to pay about €70,000 in arbitration costs plus legal fees, and could have to cover the bank’s costs if it lost. He added that it was impossible to appeal tribunal decisions and that Deutsche Bank had failed to make the implications of the new rules clear to clients. “Deutsche Bank effectively sneaked in new rules that are severely limiting the SME’s legal rights”, he said.

Deutsche Bank declined to comment on the specific cases but said the facts as described by the FT were “largely taken out of context”. It added that it had “taken appropriate action including improving our processes and enhancing our controls” after reviewing “parts of our sales activities in structured FX derivatives”. The bank added that implementing changes that came out of the mis-selling probe was “an ongoing process”.

People familiar with the bank’s view pointed out that the type of derivatives sold “are widely used by many organisations and sold by many banks”. They added that some of the clients made financial gains from the products in the past, and disputed the claim that the clients were unaware of the risks or treated unfairly by Deutsche.

These people also denied that the bank changed the contracts to make it harder for clients to sue, but acknowledged that “there was an exercise last year to update all [Master Agreements for Financial Transactions],” and that this had followed recommendations from the Spanish Banking Association. They also said the bank’s preferred option of arbitration over open court was “not uncommon or unreasonable for derivatives disputes”.

Private equity firms have started to borrow against their funds to backstop overly indebted portfolio companies, a new financial engineering tactic meant to cope with higher interest rates and a slowdown in dealmaking.

The manoeuvres, which lenders have dubbed “defending the portfolio”, have cropped up as many older private equity funds run low on cash just as the companies they own struggle with their own debt loads.

Buyout firms have turned to so-called net asset value (NAV) loans, which use a fund’s investment assets as collateral. They are deploying the proceeds to help pay down the debts of individual companies held by the fund, according to private equity executives and senior bankers and lenders to the industry.

By securing a loan against a larger pool of assets, private equity firms are able to negotiate lower borrowing costs than would be possible if the portfolio company attempted to obtain a loan on its own.

Last month Vista Equity Partners, a private equity investor focused on the technology industry, used a NAV loan against one of its funds to help raise $1bn that it then pumped into financial technology company Finastra, according to five people familiar with the matter.

The equity infusion was a critical step in convincing lenders to refinance Finastra’s maturing debts, which included $4.1bn of senior loans maturing in 2024 and a $1.25bn junior loan due in 2025.

Private lenders ultimately cobbled together a record-sized $4.8bn senior private loan carrying an interest rate above 12 per cent. The deal underscores how some private equity firms are working with lenders to counteract the surge in interest rates over the past 18 months.

Vista borrowed money at what it felt were more attractive prices that would allow it to cut Finastra’s interest costs, according to a person familiar with thinking at the firm. The person added that the dislocation in the riskiest corners of credit markets was a “market issue” that Vista believed was unrelated to Finastra.

While it was unclear what rate Vista had secured on its NAV loan, it is below a 17 per cent second-lien loan some lenders had pitched to Finastra earlier this year.

Executives in the buyout industry said NAV loans often carried interest rates 5 to 7 percentage points over short-term rates, or roughly 10.4 to 12.4 per cent today.

Vista declined to comment.

The Financial Times has previously reported that firms including Vista, Carlyle Group, SoftBank and European software investor HG Capital have turned to NAV loans to pay out dividends to the sovereign wealth funds and pensions that invest in their funds, or to finance acquisitions by portfolio companies.

The borrowing was spurred by a slowdown in private equity fundraising, takeovers and initial public offerings that has left many private equity firms owning companies for longer than they had expected. They have remained loath to sell at cut-rate valuations, instead hoping the NAV loans will provide enough time to exit their investments more profitably.

But as rising interest rates now burden balance sheets and as debt maturities in 2024 and 2025 grow closer, firms recently have quietly started using the loans more “defensively”, people involved in recent deals told the FT.

“This is early days for this asset class and as it becomes more mainstream and people employ these facilities more frequently, it’s only natural that you’ll see different uses of them,” said Richard Sehayek, managing director at Ares, one of the world’s largest private lenders. “The defensive play is just one of the drivers for it and as the universe itself grows, that particular part will as well.”

Relying on NAV loans is not without its risks.

Private equity executives who spoke to the FT noted that the borrowings effectively used good investments as collateral to prop up one or two struggling businesses in a fund. They warned that the loans put the broader portfolio at risk and the borrowing costs could eventually hamper returns for the entire fund.

“We get pitched left and right,” said one executive at a large US buyout firm that has resisted such loans. “To me, it seems like pretty risky financial engineering.”

Large banks like Goldman Sachs and JPMorgan have long provided NAV loans, but there has been a growing number of lenders entering the space broadening the usage of the debt. Banks now compete with a specialised group of private NAV lenders like 17 Capital and Whitehorse Liquidity Solutions, in addition to new entrants to the marketplace like private lenders Apollo Global, Ares and HPS.

“Everyone is talking about it,” said a senior banker who advises large US private equity firms. “It is easier to borrow at the fund level with all the NAV financing available than it is at the portfolio company level for certain companies facing distress.”

Executives in the NAV lending industry said that most new loans were still being used to fund distributions to the investors in funds. One lender estimated that 30 per cent of new inquiries for NAV loans were for “defensive” deals.

Private equity executives warned that rising interest rates were making the loans expensive and could come back to haunt investors.

“It could be a big drag to overall performance,” warned one executive.

“People are going to start to feel tight,” predicted the buyout firm executive. “In this cycle, we haven’t seen any car crashes yet.”

Decades ago when I was a sellside analyst in the City of London doing the rounds of my firm’s fund management clients, I would regularly ask them a simple question: what did they want in research?

The answer back then was: every conceivable option. The fund managers’ desks were often overflowing with mounting stacks of unread research and their phones besieged by brokers brimming with ideas. But the investors still wanted more. Why? Because there was little direct cost to them. It was all largely paid for with commissions on trades. In turn, these were paid out of the pockets of fund manager’s clients — pensions funds and the like.

Eventually, regulators thought this was not such a great idea and in came Europe’s much heralded Markets in Financial Instruments Directive II — or Mifid II — from 2018. This aimed to shine a light on research expenses, unbundling research fees from trading commissions and making the costs explicit.

Now, though, regulators are carrying out what is known in my current trade as a “reverse ferret”. Pushed by the UK Treasury that is seeking to take advantage of its post-Brexit freedom from EU rule-setting, regulators at the Financial Conduct Authority have begun to rethink this unbundling of research and trading expenses. The European Securities and Markets Authority is carrying out a similar exercise.

The main driver of this extraordinary turnaround is the realisation of the unintended consequences that Mifid II has wrought. The directive undoubtedly brought more transparency. But there also have been complaints that the changes have damaged the financial ecosystem and diminished the supply of equity research, particularly for smaller companies.

Initially, Mifid II unbundling promised a means of promoting higher quality analysis and reducing any redundant reports. But it also began a period of vicious price cutting on research by the largest brokerage firms. 

As small, independent research houses watched with horror, prices for their services plummeted. Asset managers, who found they had to pay more explicitly for research costs, happily grasped at any chance for discounts. Bulge-bracket brokers tackled any competition from independents head on with all-inclusive research packages at very low prices. 

And even for large investment banks, there were downsides to Mifid II. It added layers of administration to win the research battle. Regardless of any subsidies provided by other parts of investment banks, research became even larger cost centres than they had been previously. 

“I would think that quite a few research heads will be happy to see the previous system go,” says Steve Kelly, an adviser to the European Association of Independent Research Providers.

Research remains a big business. Last year, global cash equities research was estimated to cost around $11bn annually, according to Kelly’s analysis of Integrity Research data. About $6bn comes from the US, with Europe and the UK providing $3bn or so. But research clients have become more careful with their budgets, even in the US. “When you go from an all-you-can-eat model to à la carte, you think more carefully about what you consume,” says one senior executive at a large US fund manager.

In the US, the investment community has long bundled research costs with trading commissions. Under the US Investment Act of 1940, professional investors cannot pay for research directly. Local concerns that US brokerages would have to create special investment advisers to accept direct payments under Mifid II were put to rest recently. A workaround will leave any UK and European research money paid sequestered in that region.

In Europe, things will not return to pre-Mifid II days. Even in the UK, a government-commissioned review by financial services lawyer Rachel Kent did not recommend a mandatory return to the commission-sharing agreements (via trading) of the past. But Kent did suggest more payment flexibility is needed. And even independent research groups are not expecting business will suddenly improve radically. “I expect an uplift of perhaps 5 to 6 per cent in our global revenues,” says Iain Johnston, chair at New Street Research. 

Having seen the backtracking by the government on Mifid II for research, many investment managers will want to delay having any cost discussions until confirmation of changes. Those discussions will no doubt be tricky. If their clients expect their asset managers to do in-depth analysis, shouldn’t this cost be shared? 

When seen as part of trading expenses the cost may be only a few hundredths of a per cent. Not so fast, asset owners may say. Mike Carrodus at Substantive Research quips that pension fund bosses ask, “If it’s so little, why don’t you pay for it?” Who forks out for research, not just how much, is the real issue.

alan.livsey@ft.com