Friday, 14 December 2018

Alternative avenues

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Despite ECB blandishments, Basel III requirements mean banks remain loath to lend to SMEs. But the direct lending market is booming.

In mid-May, British care homes group LNT Group wanted a 10-year £51m fixed-rate loan to refinance existing debt and release capital to build six to eight new care homes. The company could not find a lender at the tenor it needed.

“It used to be that you took out a medium-term loan. You would buy a care home, take out a MTL for 15 years and agree to a price. That product no longer exists,” said Lawrence Tomlinson, of the Yorkshire-headquartered group.

Tomlinson said the cheapest loan option that was put on the table was a three-year loan from a bank. But he was adamant that he did not want to go through the same rigmarole every three years. He wanted to concentrate on running the business, rather than having to spend time raising money to grow.

The company took out a loan, not from a financial institution but from insurance firm Legal & General. Given that it is a private deal, neither LNT nor L&G are especially forthcoming on the cost of the loan, but both companies say a useful marker is what other, unrated private-sector companies are paying for their 10-year debt. 

A happy ending for LNT Group, but the challenges that Tomlinson had in raising capital highlight the difficulties that face small and medium-sized companies. Although they make up the majority of companies in Europe – 70% is the most commonly cited figure – bank loans to corporations have been on a steady decline since 2008.

This is despite frequent encouragement from the European Central Bank. In August, ECB president Mario Draghi said at a meeting of leading central bankers in Jackson Hole, Wyoming: “I am confident that the package of measures we announced in June will indeed provide the intended boost to demand, and we stand ready to adjust our policy stance further.”

He was referring to the cut in European interest rates to record lows and a series of measures aimed at kick-starting lending to businesses.

He returned to the theme at his regular monetary meeting with members of the European parliament towards the end of September, where he emphasised a common monetary policy stance and to create favourable conditions for money to reach the real economy.

“Our measures are aimed at lowering interest rates for the private sector and 80% of its financing goes through banks,” he said.

It simply isn’t working. The Eurozone Purchasing Managers’ Index released towards the end of September, which reflects eurozone business activity, had dipped to a nine-month low of 52.3. Even worse, the manufacturing PMI for Germany, Europe’s largest economy, had crashed to 50.3, its lowest reading since June 2013. 

The elephant in the room is Basel III, the guidelines set by the Basel Committee on Banking Supervision in July 2011 to boost balance sheets and avoid another debt crisis.

Since the crisis, banks have retrenched considerably. And it is this that is at odds with any expectation that they might extend loans. In short, banks have neither the appetite nor impetus to increase lending.

As Anthony Fobel, head of direct lending at BlueBay Asset Management, put it in stark terms: “For a bank to invest in sub-investment-grade debt under Basel III, it needs to set aside 10 times the capital it does for investment-grade debt.”

What has been getting the attention is the idea that SMEs might issue debt. Not only has the ECB essentially introduced negative interest rates as a boost to the economy, but it is also using various ideas to engage in public debt type issuance. While this is fine in theory, the reality is rather different.

As one banker pointed out: “In the US, the bond market has been there for 100 years. It was set up to fund the railways. In Europe, it is only 40 years old. It is simply not mature or flexible enough yet”.

That might be harsh conclusion, but with a grain of truth.

“Accessing the rated market is not an option for SMEs,” says Allen Appen, DCM financing solutions at Barclays. “And the ability to access the unrated market is the preserve of only the larger SMEs.”

It is certainly a view that resonates with LNT’s Tomlinson. He says that he rejected a bond sale for a variety of reasons. Aside from the fact that it involved more money than LNT needed, there was also a complexity to raising money that way, with roadshows, numerous investors and negotiating with ratings agencies for what, in the end, was a fairly vanilla product. 

Naive expectations 

But the expectation that a market could be created entirely outside banks is not one that finds favour with bankers. It is naïve, they say. Of course, they would say that wouldn’t they, but this is not to say that it is not accurate. The point is that banks need to think differently about how they can help. The attention here from everyone from the ECB downwards has been on securitisation.

“Banks should focus on what they can do and do well. They can pass on the loans in a way that is attractive,” said one banker. But while great in theory, it might be an uphill struggle to get that message across.

Certainly, securitisation volumes are significantly down in 2014. The first quarter of the year saw €18.5bn of issuance in Europe, according to the Association for Financial Markets in Europe – a decline of 43.6% from the same period in 2013.

“Accessing the rated market is not an option for SMEs. And the ability to access the unrated market is the preserve of only the larger SMEs”

Total issuance in Europe last year was only €181bn, a fall of 28% from 2012. And less than half of this, only €76.4bn, was placed with investors, as the rest was retained by issuers (and used for repo purposes with the ECB or national central banks). 

There needs to be a shift in attitude and there are some signs that this is happening, that banks are thinking about securitisation in a different way. Banks themselves used to use it as a source of funding. But as funding markets have recovered since 2011, as an asset class it is much less interesting for them. Securitisation is both labour-intensive and can also be expensive. 

Meaningful shift

As the price points have moved, there are hints that banks are willing to take assets off their balance sheets. This is, says one securitisation banker, “a meaningful shift” adding that “the funding rates might not be attractive via securitisation, but the capital relief and the effects on leverage are”.

This is not likely to happen soon. Bankers estimate that it could take up to five years before the trends that we are starting to see become fully visible. The hope, of course, is for a banking system in Europe that relies on the securitisation market to exercise its comparative advantage without moving out of balance sheet capacity. 

Plenty of options

Until the bank market catches up, as LNT Group found, there are other options for funds other than banks or private equity. Six UK insurance companies have committed to investing £25bn in British SMEs over the next four years, and have invested more than £5.5bn to-date. Tenor is precisely where they can help.

“L&G is a natural provider of longer-term financing, given our long-term annuity liabilities,” said Laura Mason, director of direct investments at Legal & General Capital. It is a move that is being replicated across Europe.

But insurance companies are only one option. The direct lending market is expanding in every direction. Towards the end of 2012, BlueBay Asset Management, one of Europe’s largest managers of fixed-income credit, launched a €800m fund, a form of private capital funding. At the time of writing €500m has been disbursed, predominantly focused on the northern European countries and agnostic in terms of sector.

The majority of the debt has a tenor of two to seven years and although the maximum size of a loan is €100m, BlueBay is happy to lend with partners. 

“We can do things like lend for a tenor of seven years. We also provide loans for companies that are looking for further acquisitional capacity – in general banks don’t like to commit undrawn loans. We can do that because we are flexible,” explained Fobel.

On the plus side, there is scope for all to play. In the US, banks make up only 30% of the lending market. In Europe, banks make up 70%. It is estimated that the pot that the direct lending funds have either raised or are raising is only €33bn.

That is only a fraction of the overall lending market. Certainly, if you are an SME, just because the bank doesn’t return your calls, that doesn’t mean there are many people who won’t.

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