Europe's Mid-Market Explores New Funding Sources
By Taron Wade, Associate Director, Corporate Ratings & Alexandra Dimitrijevic, Managing Director, Standard & Poor’s Ratings Services
Posted: 10th July 2013 10:52The funding landscape for European mid-market businesses is changing rapidly. As banks deleverage across Europe, the treasury and finance departments of mid-market companies – defined as companies with revenues between €100 million and €1.5 billion and outstanding debt between €50 million and €500 million – must look outside traditional banking relationships to secure funding for growth. And as yields in credit markets have recently been at record lows, investors’ appetite for this emerging asset class has never been greater. Yet despite a small amount of progress, a cohesive pan-European funding market remains elusive.
A fully-fledged European funding market for mid-market companies will require significant cultural and operational changes on the part of potential issuers and investors. Mid-market firms often find the interest rates demanded by institutional investors to be too expensive, yet lower rates will require a level of financial disclosure higher than that to which they are accustomed. This is particularly important for smaller investors without the means to build internal research and risk management capabilities. At the same time, differing regulatory and accounting environments across Europe also make establishing a cohesive funding market an uphill struggle.
A Crucial Sector for Regional Economies
New capital adequacy regimes – coupled with more general bank deleveraging throughout Europe – mean that European banks are limiting their lending to major clients, usually domestic companies with which they have strong relationships. The same deleveraging process also has the effect of restricting capital- and cost-intensive wholesale and international businesses. According to our research, this strategy is partly a result of pressure from national governments to prioritise domestic lending and increase purchases of domestic government debt to replace thinning foreign investment.
For these reasons, it is vital that Europe’s mid-market businesses secure alternative funding sources – for their own benefit, and that of the region’s economies. A critical engine for economic growth and employment in Europe, mid-market firms generate around one-third of private sector revenue and employ a third of the workforce across France, Germany, Italy, and the UK, according to research from GE Capital.
Alternative Funding Avenues Are Emerging
At present, the alternatives to bank borrowing for Europe’s mid-market vary wildly in maturity. Major markets include the developing loan fund market, the U.S. private placement market, the German private placement market (the "Schuldschein" market), the nascent private placement markets in the U.K. and France, and – to some extent – regional bond platforms on exchanges.
However, the loan fund market has seen limited growth in Europe since the global financial crisis. Before 2008, this sector was led by collateralised loan obligation (CLO) funds, mezzanine funds - which specifically lend subordinated debt to companies - and some non-leveraged loan funds. But new entrants to this market were derailed by the crisis, particularly as new types of loan investors struggled to find capital while buyout activity stagnated and new deal flow slowed.
However, investors’ interest in lending to smaller companies in Europe has experienced a small resurgence over the past year. Indeed, Five Arrows Credit Solutions – a Rothschild investment fund set up in 2010 specifically to lend to Europe’s mid-market – announced its first close with commitments totalling €235 million recently.
Private Placement Markets Provide Stability
Of private placement markets in Europe, the German Schuldschein market is by far the most established and mature. A Schuldschein – the market’s unique debt instrument – can be either fixed or floating, ranging up to 10 years in maturity and €500 million in size. Schuldschein investors enjoy a healthy secondary market, and a variety of German companies have issued Schuldscheine, from large multinationals to midsize domestic companies.
Elsewhere, the UK’s Association of Corporate Treasurers (ACT) is leading a working group to explore the development of an equivalent private placement market. Citing clear demand for this type of market – from both investors and issuers – the group released an interim report outlining some of the changes that will be necessary to facilitate its creation, 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. In its report, the ACT concludes that these barriers will be quickly overcome with a determined push from the borrowers, regulators and investors active in this space already.
In France, the private placement market for mid-market businesses is also relatively immature, but growing. While most private placements were actually too big to fall within our mid-market definition, those within it are becoming more frequent: the third quarter of 2012 and the first quarter of 2013 saw six issues in this classification.
Meanwhile in Italy, a developed private placement market is altogether absent. While there is potential for such a market – given investor appetite has been spurred by recent pension reform approved by the legislature in 2012 – it may require regulatory changes to align fiscal treatment with those of listed bonds, given that private placement issues are generally not listed.
Bond Platforms on Exchanges Are Developing
This fragmented picture persists when it comes to borrowing via exchanges – an area in which German business leads the way again. In fact, over 55 companies have debt of approximately €3 billion traded actively across the three main exchanges in Germany: BondM, Mittelstandsmarkt, and Entry Standard.
The nearest equivalent in the UK – the Orderbook for Retail Bonds – was set up by the London Stock Exchange in February 2010 to allow private investors to buy into individual corporate bonds in small denominations. It began with large issuers such as Royal Bank of Scotland, Tesco Bank, and National Grid, but some mid-market companies are beginning to enter the market, such as International Personal Finance PLC.
Meanwhile in France, NYSE-Euronext launched its bond market in 2012, which is open to retail investors. It has seen three transactions so far; from agricultural commodities company AggroGeneration S.A., family-owned property developer Capelli, and camping resort firm Homair Vacances.
Also launched last year, the Italian stock exchange’s multilateral trading system for market specialists saw €2 billion in midsize bond issues over the second half of 2012. Yet this has attracted little interest from domestic investors, with foreign investors accounting for more than 80% of the total. However, as the domestic sovereign spread continues to decline, we believe an increasing number of domestic investors will look for more attractive investment assets, such as midsize corporate bonds.
Pan-European Funding Markets Remain Vital, But Elusive
While mid-market companies have taken tentative steps towards the establishment of a pan-European funding market, a cohesive solution remains some way off. For their part, issuers can find expansion beyond a long-term banking relationship to be a significant cultural shift, which can come hand in hand with a reluctance to disclose financials.
Nonetheless, we believe it is vital for the future of the European mid-market that these obstacles are met. Bank lending to this sector will not disappear, but severe economic and regulatory pressures mean it is likely be increasingly unavailable to mid-market companies for some time. 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 into market activity and financial information is crucial, along with reliable regulatory oversight and – eventually – a strong record of investment performance and defaults.