The Netherlands: Real economy investment
Towards the end of 2012, the Dutch exchange Euronext and two large pension providers, MN and Syntrus Achmea, took a decision to facilitate the financing of Dutch small and mid-cap (SMEs) companies. The trigger was the conviction that banks, now represent a bottleneck in the provision of credit to this part of the corporate sector. Anecdotal evidence indicates that SMEs are not able to raise the credit they need. Moreover, it is our conviction that future stronger capital requirements for banks may mean that lending will continue to fall short.
There are other initiatives with the same objective, but this idea is unique to the Netherlands, as institutional investors will invest in tandem with the banks. The motivation for this comes from different angles.
In the first place, banks have an outstanding reputation in lending to corporates. This traditional key activity is the heart of banking and it would be a waste not to use the expertise available.
Second, it is important to circumvent the question of blame. During our preparations, it became obvious that banks and pension institutions are not competitors in the lending business. Banks now, and in the future, want to increase lending capacity because of their weaker solvency and higher required solvency ratios. Disintermediation, much more developed in the US, will increase in Europe and our initiative fits that trend. An additional source of finance is welcome because it prevents supply problems and offers more diversification in available creditors.
Our fund serves the objectives of several parties. Only the larger SME entities can enter financial markets directly and the rest depend on bank lending for more than 90% of their needs. More choice is obviously good. The accompanying shortening of banks’ balance sheets is not an objective in itself, but a favourable side effect.
For institutional investors, our fund offers access to a new asset class. Only the largest institutions invest in loans and the rest mostly confine themselves to investing in public corporate bonds. Additionally, participation enables pension funds to become a positive news item in that they become a pillar for the domestic economy.
Banks can also show that they are supporting corporate lending, their traditional key function. The importance of this argument is underlined by the fact that three of the large Dutch banks are participating.
When defining the target group of recipients, the pension funds encountered disappointment. In principle, the fund would finance small and mid-caps overall, but we discovered that loans to smaller companies are problematic, at least for this first tranche of the fund.
First is the issue of complexity. Many analysts would have to be employed and this kind of scale might be more suitable for a possible second phase. Second, margins on loans turn out to be thinner, the smaller the debtor.
This phenomenon is explained by banks’ cross sales in areas such as current accounts, cash management. However, smaller businesses can still benefit from our initiative – as banks only have to provide half of the required capital, the banking system as a whole has more capacity left to finance smaller companies.
Pragmatic considerations led to define the upper segment of smaller and mid-caps as a target for a first tranche, implying companies with a turnover from €30m in need of loans of some €10m or higher. Loan recipients must be genuine Dutch companies, with at least 70% of their activity in the Netherlands.
Extensive co-operation between the banks and the fund is essential. Both not only participate to 50% of each loan, they also work under exactly the same conditions with respect to information, collateral management, relative creditor positions in possible failures, and so on.
For the far larger part, the fund will invest in direct loans together with banks but it can participate in so-called syndicated loans, or club deals. for up to 25% of capital invested. On average, these will be larger in size than €10m. The advantage of mixing club deals in the portfolio is in diversification in debtor (higher implicit rating) and yield (loans are against floating rates, syndicated loans are usually fixed rate).
The fund decides whether or not to accept a loan totally independently, based on proprietary analysis of company and sector and paying attention to diversification. Moreover, the fund makes use of the banks’ expertise and experience in documentation. Using proprietary loan analyses, of course, is an expensive way of operating, but regarded as a necessary condition.
The fund will not have its own marketing efforts in selling loans and potential recipients will present to the banks. This might lead to a suspicion that most favourable deals will be done by the banks and the rest handed over to the fund with a 50% risk reduction.
But, the fund’s initiators are not afraid. The fund has its own standards and the bank will not want to be the owner of a less qualified investment, even at half price. Further, it is not in the bank’s interest to jeopardise this initiative.
A company can indicate whether, or not, it wants the fund to be involved. Diversity may be an advantage, but an additional party has to be provided with information and communicated with during the loan period. The fund will restrict itself to new financing or refinancing present facilities. This best serves underlying objectives – new money for sound economic growth.
The vehicle is a completely legally transparent body (fonds voor gemene rekening) with the participants as owners. The manager and custodian are service providers.
A separate foundation facilitates partner meetings during which all operational issues will be assessed. Participants’ interests are considered in a separate department as participants should be able to evaluate suppliers without their presence.
The goal is to reach a size of €1bn by the end of 2015. Loans will not be larger than €10m in total. Exposure to each company may not exceed 2.5% of the fund’s capital; together with participation in private placements, the average position size is expected to be €15m. In the end, 60-70 loans will offer an attractive degree of diversification.
Most of the allocation will be in BBB and BB segments with a maximum of 25% in B. As the target group excludes the largest companies, customers will have an implicit rating. This co-financing will be mixed with private placements, mostly BBB rated. This participation is less than 50%, as is the case in normal loans, as more parties are likely to take a stake than just one bank and the fund.
The fund will exclude loans to the financial and real estate sectors because of specific expertise. Semi-public customers, are also excluded for the time being, as the long maturities for hospitals, schools and the like do not fit the fund’s character. However, the basic idea of the fund could be replicated for this client group in the future.
When co-participations are concerned, the ESG policy of the bank will prevail; in the case of private placements the manager’s policy will lead.
The maximum loan maturity will be 10 years, longer than the current average of seven years. This also seems to be an advantage for companies, made possible by the fact that only 50% of the loans will be on the banks’ books.
Participation in the fund is an illiquid investment as no listing is being considered. Investors can only leave when other participants want to increase their stake, or when new participants enter. In due course, illiquidity will partly be compensated if more vintages are created.
Analysis of market practice tells us that investors will receive adequate compensation for illiquidity against the same investment risk in a public vehicle. Diversification is offered without yield reduction. In comparison to the returns of publicly quoted loans, investment in the fund represents less risk as the recovery rate for bank loans is higher.
More than 75% of investments will generate floating yields. This could be advantageous when rates rise in the future, which would create losses in fixed contracts. Finally, of course, the non-cash argument is valid as pension funds are contributing to the health of the Dutch economy.
It is to be expected that stronger Basel III capital requirements will raise future yields because margins will widen from two sides. Debtors will have to pay more as more expensive equity has to be reserved by banks and the decline in supply will add to margins for the same reason. This initiative will reduce the second effect and that is positive for business.
Anton van Nunen is director of strategic pension management at Syntrus Achmea