Taron Wade and Alexandra Dimitrijevic look into efforts to expand Germany’s Schuldschein debt private-placement market to the rest of Europe
Asea change is under way in European credit markets. Mid-market companies – which we define as companies with revenues between €100m and €1.5bn and outstanding debt between €50m and €500m – must diversify their funding sources as new capital adequacy regimes force banks to deleverage.
As such, many are turning to debt issuance for the first time. Meanwhile, yields in corporate credit markets sit at record lows – indicating investors’ strong appetite for exposure to this emerging asset class. But despite their corresponding ambitions, willing parties have yet to create an efficient, pan-European funding market for mid-market companies.
This is because of a number of obstacles. For a start, expanding outside of long-term banking relationships can require a significant cultural shift for potential issuers – not least due to financial disclosure requirements. And, in many cases, companies find the interest rates demanded by institutional investors too expensive. A fairer, more efficient market will require better access to timely financial information – particularly for small investors without the means to build internal research and risk-management capacities – and a cohesive approach to the varying regulatory and accounting environments across Europe.
New capital requirements for banks under Basel III regulations, combined with more general deleveraging across the European banking sector, mean that European financial institutions are limiting lending to core clients. For the most part, these are domestic companies with which they have strong relationships. According to our research, this strategy is partly a result of pressure from national governments to prioritise domestic lending while, in some cases, increasing purchases of domestic government debt to replace thinning foreign investment.
Therefore, companies across Europe’s mid-market are searching for alternatives to bank loan funding, presenting a great opportunity to investors. The mid-market is a critical engine for economic growth in Europe, generating about one third of private-sector revenue in France, Germany, Italy, and the UK, according to research from GE Capital.
But investment funds have little exposure to this productivity at present.
Before 2008, many investors gained access to the mid-market through collateralised loan obligation (CLO) funds, mezzanine funds – which specifically lend subordinated debt to companies – and some non-leveraged loan funds. However, the financial crisis disrupted new entrants to this market, as loan investors struggled to raise capital due to stagnant buyout activity and a lack of new deal flow. That said, smaller European companies are experiencing a resurgence in appetite from private-equity houses and asset managers, such as Axa Private Equity, Ares Capital, and Amundi. Indeed, Rothschild investment fund Five Arrows Credit Solutions – set up in 2010 to lend to Europe’s mid-market – recently announced its first close with commitments totalling €235m.
Unfortunately, most investors seeking exposure to Europe’s mid-market must negotiate a fragmented marketplace. Aside from the developing loan fund market, avenues are limited to the private-placement market in Germany (the ‘Schuldschein’ market), the very young private-placement markets in the UK and France and, to some extent, regional bond platforms on exchanges.
Of European private-placement markets, Germany’s Schuldschein market is the most developed. A Schuldschein – the market’s unique type of debt instrument – is either floating or fixed, with maturities ranging up to 10 years and sizes up to €500m. A variety of German companies have issued Schuldscheine, from large multinationals to mid-size domestic companies, and there is a healthy secondary market.
Meanwhile, the UK’s Association of Corporate Treasurers (ACT) formed a working group in 2012 to explore the development of an equivalent market in the UK. An interim report, published in December, pointed to clear demand for this type of market from issuers – already tapping overseas equivalents such as the US private-placement market – and from investors, for whom such a market provides an attractive means to diversify credit risk away from the larger mainstream issuers of international bonds.
The report also outlined some of the elements necessary for the UK to create its own Schuldschein market, such as: consistent regulatory oversight for insurance company investors; standardised documentation; readily available market activity information; a track record of performance and defaults built up by individual investors; and investors willing to set up the internal resources necessary to participate. The report concludes that these barriers will prove insubstantial with a concerted push from borrowers, regulators and investors already active in this space.
In France, the private-placement market differs from those of both the UK and Germany – in fact, most private placements are too big to fall within our mid-market definition.
Nevertheless, our research shows growing activity among smaller issuers: there were six issues that fell within the mid-market classification at the end of 2012 and in the first quarter of this year.
The story is much the same when it comes to mid-market bond platforms on exchanges –
Germany leads the way. Over 55 businesses have debt of approximately €3bn traded across three exchanges in Germany – BondM, Mittelstandsmarkt, and Entry Standard.
Similar exchanges exist in both France and the UK, albeit in less developed forms.
Launched in February 2010, the London Stock Exchange’s Orderbook for Retail Bonds allows private investors to buy individual corporate bonds in small denominations. It began with large issuers such as the Royal Bank of Scotland, Tesco Bank, and the National Grid.
But mid-market companies such as International Personal Finance are beginning to tap the market.
A similarly nascent trend is evident in France, where NYSE-Euronext launched its bond market last year. Open to retail investors, this market has executed three transactions so far – from agricultural commodities company AggroGeneration SA, family-owned property developer Capelli, and camping resort firm Homair Vacances.
While these steps have gone some way to link mid-market companies with willing capital, a truly cohesive, pan-European solution remains some way off. For their part, issuers can feel reluctant to publish financial information, adding to the significant cultural shift necessary to expand beyond long-term banking relationships. Nevertheless, severe economic and regulatory pressures mean bank lending is likely to become increasingly unavailable to mid-market companies. And while investors continue to show strong appetite for the asset class, it is in both parties’ interests to succeed in establishing an efficient funding market. To do this, transparency concerning market activity and financial information is essential, along with consistent regulatory oversight and – in time – a strong track record of investment performance and defaults.
Taron Wade is an associate director in corporate ratings, and Alexandra Dimitrijevic is a managing director, at Standard & Poor’s Ratings Services