Getting out of the bank’s shadow – alternative financing sources for the European SME sector
May 2015 | SPOTLIGHT | BANKING & FINANCE
Financier Worldwide Magazine
The emergence of direct lending instruments and private debt placements provides an alternative to bank borrowing for companies without access to the capital markets and is set to bring major changes to the European refinancing system.
Since the global financial crisis, the amount of credit available to non-finance sector companies in the eurozone has fallen by 10 percent to €4.3 trillion. Although demand for credit decreased due to the economic downturn after the mortgage and Lehman crises, the euro crisis is the main factor on the supply side.
At the same time, Basel III requirements are forcing banks to increase their capital base or dilute their risk positions. The banks have been suffering from a significant loss of confidence, which has substantially increased their refinancing costs. All this has meant that financial institutions have been making huge cuts in their balance sheets and therefore reducing their supply of credit. This so-called bank deleveraging trend is still in full swing and will have far-reaching consequences in Europe, particularly for companies without direct access to the capital markets.
Strong dependence on banks in Europe
European corporations have traditionally relied on bank finance, with the banks’ share of corporate finance representing around 80 percent of external third party finance. According to the European Investment Fund (EIF), this proportion has decreased since the financial crisis. Yet, this still contrasts to the situation in the US where finance by bond issue (around 80 percent) is preferred over bank credit. The credit shortage presents a huge challenge to European corporations, potentially jeopardising future investment in growth.
According to data from the European Central Bank (ECB), there are already signs of a trend away from a bank-oriented system in Europe, in the direction of the capital markets. Between 2009 and 2013 the volume of bank credit decreased in terms of European GDP by 7.4 percent, while bond volumes rose by 2.4 percent.
Bonds – an alternative for the privileged few
Research by Deutsche Bank shows that finance through bond issue is still only a privilege enjoyed by large corporations. High issue costs and reporting duties mean that bond issue is only viable for corporations with volume above around €50m. This is an insurmountable hurdle for most SMEs in Europe, which represent 99 percent of all companies and around two-thirds of total employees.
SME financing left behind?
Where does this leave SMEs that cannot access the traditional capital markets? Most face tight bank lending conditions. Access to finance was the second most frequently cited problem for SMEs in the 2013 ECB opinion survey, and in 2014, access to finance remained the most important concern of 13 percent of EU SMEs – a drop of 2 percent.
Recent initiatives are aimed at making debt financing available for SMEs with financing needs. Since 2010, several German stock exchanges have installed SME loan segments. Yet, due to some defaults with correspondingly high losses for private investors, German Mittelstand bonds have lacked a decent market reputation. Other stock exchanges have chosen a different strategy, restricting access to the SME loan segment to qualified institutional investors only. Italy’s ExtraMOT Pro and Spain’s MARF segment allow SMEs to place bonds without extensive prospectus requirements. Furthermore, the pan-European stock exchange NYSE Euro Next launched Alternext EnterNext in 2012. On this platform, SMEs are able to emit their bonds publicly and through private placements. However, the volumes on all these platforms are still very modest compared to other asset classes.
Getting out of the bank’s shadow – alternative sources of funding
Alternatives to bank borrowing and market-listed bond instruments already exist in the form of direct lending instruments and private debt placements with medium to long-term durations.
This poses two major questions: who are these new lenders, often referred to as shadow banks, jumping in where the banks are slowly retreating? And what can shadow banks do better than ordinary banks?
Shadow banks consist of financial intermediaries with access to investment capital, which is not subject to the strict regulations and requirements of the banking industry. This circle of capital providers includes institutional investors such as life insurers, pension funds, hedge funds and private debt funds. According to the Financial Stability Board (FSB), global financial intermediation by non-banks grew at $5 trillion to respectable $75 trillion in 2013 alone.
Limited access to bank funding for SMEs has made corporate lending an extremely attractive investment avenue for investors due to the very low credit-default probabilities of SMEs in certain countries in Europe, such as Switzerland. In addition, the low correlation between direct lending instruments and the bond and stock markets means that this low-risk investment category offers enhanced diversification and thus an improved risk-return structure for an investor’s portfolio. These positive investment characteristics mean that investors are often willing to accept the lack of liquidity in such instruments.
New funding models
Market regulators, as well as institutional investors, have welcomed this diversification of investment channels. The new financial intermediaries use Europe’s bank deleveraging to penetrate traditional bank dominated lending. In recent years, private debt funds have proliferated across Europe. According to ratings agency Moody’s, up to July 2014 over 60 new private debt funds in Europe had provided a total of $33bn in capital and this upward trend continues.
The latest example is Switzerland’s Zurich Insurance Group which has this year announced its market entrance with some hundreds of millions of euros. However, European private placement markets have a long way to go to catch up with the US. Private placements have long been an established source of alternative funding in the US, with a market volume of $54bn in 2013. European corporations account for roughly a quarter of this.
The greatest handicap in the private debt market for European institutional investors is the lack of ratings for medium-sized corporations and of transparency in the SME market. New business models are required in order to overcome these handicaps. Early cooperation between shadow banks and traditional banks – for example, BlueBay Asset Management has announced cooperation with Barclays and AXA is working with Société Générale – show that the private placement trend is not only creating competition but also new cooperation models in corporate funding.
How can SMEs benefit from this trend?
Classic direct lending instruments and private debt placements have a number of advantages for medium-sized corporations without direct access to the capital markets. Firstly, placement costs are lower than for public debt issues due to reduced legal and regulatory stipulations. Secondly, smaller volumes, generally starting at €10m can be placed. Finally, negotiation of loan conditions can often be relatively easily coordinated since the investor base consists of just a few professional investors. On the other hand, investors with a time horizon of at least five years benefit from attractive illiquidity premiums along with interesting risk-adjusted yields.
Small companies will often benefit from specialist advice to help them overcome the barriers mentioned above. They can obtain efficient corporate analysis, structure their credit needs for presentation to investors and cover corporate financing requirements as professional intermediaries. This requires sound credit and capital market know-how to ensure that investment proposals meet the demanding requirements of private debt investors, including transaction track record, company and sector analysis, financial models and rating details. Such specialist advisers should also be familiar with the investment profile of professional private debt investors and have direct access to decision-makers.
It’s critical that an adviser is able to build a bridge between the business model and individual situation of the company on the one hand, and the requirements of the investors as the potential source of capital on the other, in order to provide finance and security for the SME’s long-term growth possibilities.
Pascal Böni is a partner and chairman, Ayhan Güzelgün is head of Debt Advisory & Structured Finance and Linus Schenk is a corporate finance consultant at Remaco Advisory Services. Mr Böni can be contacted on +41 (0) 61 319 5151 or by email: email@example.com. Mr Güzelgün can be contacted on +41 (0) 61 319 5188 or by email: firstname.lastname@example.org. Mr Schenk can be contacted on +41 (0) 61 206 9970 or by email: email@example.com.
© Financier Worldwide
Pascal Böni, Ayhan Güzelgün and Linus Schenk
Remaco Advisory Services