Sunday, 21 October 2018

IFR German SME Funding Roundtable 2015: Part 1

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IFR: Welcome to IFR’s 2015 German SME Financing Roundtable. Our focus today is on the extent to which modes of financing and financing conditions for mid-caps may be changing within Germany. One of the elements that struck me when we had this discussion in 2014 was that while the European policy debate around mid-cap financing is axed around the notion of banks no longer lending thereby requiring capital markets and alternative solutions, the issue in Germany is that mid-caps don’t have any problems accessing bank finance.

If anything, competition has intensified as foreign banks have returned to the fray and become increasingly active lenders to the mid-cap space. This is presenting itself not just in lower absolute financing costs but also in looser deal structures. Borrowers in addition have a range of other funding options. Stefan: can you kick off with some general comments?

Stefan Bund, Scope Ratings: I think there are two or three trends. As you pointed out, there is not really a lack of supply of liquidity to German corporates. So first of all, we continue to see strength in bank funding, the traditional loan business. There is significant appetite for balance sheet funding from banks.

Second, the Schuldschein market, which was very strong in 2014, got off to a good start this year. Looking at first-quarter numbers, we saw strong growth in issuance volumes and there was also a trend towards the SME segment accessing this market as well.

The third element of the discussion is around what is going to happen with the German bond market for small and medium enterprises which, as everyone knows, saw significant growth in 2010 and 2011. But in that euphoric atmosphere, the market did not have the requisite standards and there were a significant number of defaults.

There have also been a number of initiatives with regards to domestic stock exchanges (the mid-market segment at the Duesseldorf Stock Exchange, the Entry Standard bond market at the Frankfurt Stock Exchange and others, for example).

In all of these discussions, I would stress that we’re talking about the mid-market element as opposed to the small company element. In summary, for mid-caps, financing choices are quite broad and there’s a lot of competition between bankers and investors, too. If I have a concern it’s that this is not necessary healthy for the long-term stability of the market.

Reinhard Haas, Commerzbank: When you compare the experience we have within our loans team in the Mittelstand market, it’s a matter of scale. While I understand what Stefan said about the different types of investors and the different types of products available to SME clients, it’s a matter of how you define the SME segment.

When we’re talking about enterprises with a turnover of around €500m, they still finance themselves in the traditional manner. The scope isn’t so broad; they will typically revert to bank finance – be that bilateral or multilateral – or Schuldschein. Developments in the recent corporate bond segments are a little exotic and quite rare and as Stefan pointed out, the experience of that launch around 2010 has not been very fortunate for a number of borrowers.

IFR: Joachim, how is the competitive landscape evolving? Is it as difficult as ever to book assets at the right price?

Joachim Erdle, Landesbank Baden-Wuerttemberg: Absolutely, given that there is a huge amount of liquidity in the market driven by banks, funds and other liquidity providers which are increasing on a day-to-day basis. We are in a highly competitive environment at the moment. Nevertheless, while there’s no lack of liquidity in the market, the key challenge, independent of whether you are on the loan or on the capital market side, is to find a right combination of the various products in order to create a custom-made solution. That’s the best answer to the current market.

IFR: Marion, what about the mind-set of mid-cap borrowers as they approach financing? Is it different these days with so much liquidity on the bank side and so many alternatives? Are borrowers becoming more demanding because there are so many options?

Marion Schiller, UniCredit: Borrowers are certainly becoming more demanding because of high competition between banks. They are clearly trying to optimise their funding costs particularly regarding funding in the bank market. And they’re certainly comparing that with the Schuldschein market or even with the bond market.

Borrowers are trying to optimise financing costs and can do so because of high competition. We all want to do business; banks are under-lent and a lot of liquidity is available to SMEs in today’s market. Competition in this customer segment has increased: the new players that entered the German mid cap market last year – like HSBC and BNP Paribas – are still trying to increase market share, which has clearly increased competition in the last couple of months. Prices are declining and structures are loosening, which  is to the benefit of the SME borrowers.

IFR: Thomas: competition is a great thing but to Marion’s point while I’m sure it’s good for borrowers is it leading the banks to take more risks to book business than perhaps they might?

Thomas Haas, Bayerische Landesbank: That is a good question. Nobody has a crystal ball and we don’t know how the economy will develop in the future. First of all, mid-caps companies can be world market leaders but in tiny market segments. Being a key player in your market helps on the risk side, of course, not least because at some point you might become an attractive target for a bigger company in case of trouble.

Of course lending to smaller entities per se brings with it higher risk versus lending to blue-chip companies. On the other hand, as a bank you’re offering smaller tickets at the same time as you’re diversifying your portfolio. So the risk is fair. What is helping is these companies are becoming more and more minded to look at capital markets solutions, which helps the bank allocate debt to global markets.

IFR: Martijn, as a representative of a foreign bank in Germany, how do you segment your core client base between large and mid-caps given current conditions?

Martijn Kamps, ING: We are relatively selective, so we base our selection on clients with good forward prospects based on industry analysis. We have a strong sector approach and that enables us to approach smaller and larger companies. Traditionally we’ve focused more on larger companies but we are certainly looking to move down the size spectrum.

IFR: Just picking up some of the comments made so far about the level of competition, the looser structures and the pricing, is the mid-cap space an attractive market for foreign banks?

Martijn Kamps, ING: Yes, it is, There are a couple of angles to a highly liquid market. First of all it’s moving us towards more underwriting appetite. The market will show up if prices are right. And that’s the crux in the whole story. If prices are right the market is there. That’s a good thing. The de-risking component and underwriting self confidence that banks have – including ING – is picking up.

The other thing is loosening of structures. In investment grade territory you saw a bit of bottoming out from a pricing perspective. Things like covenant-lite structures are late credit-cycle signals because we normally don’t see them. We are also moving tenors in directions where we are also less comfortable. Part of the game is thinking for ourselves to what extent we have appetite to participate.

IFR: Ingo, having heard about the competitive landscape, which from a lender’s perspective potentially makes the market actually look quite unattractive, how does the dialogue play out on the DCM side? It’s been a fantastic market in the past couple of years and one that has been receptive to new and unrated borrowers including mid-cap companies. Can you review the last year and bring us up to date in terms of mid-cap DCM?

Ingo Nolden, HSBC: As a general point, we’ve been witnessing a trend to disintermediation for the large caps, although we aren’t close to a US structure of 80% capital markets; 20% bank market. As Stefan said, deals in the Schuldschein market are getting smaller and we are seeing more SME issuers. There’s certainly some pressure on the banks from DCM taking market share away [from the lending market]. I think that’s going to continue.

The question for me is when is the cost of the DCM take-out or the cost of financing too high for SMEs? There will be cost-benefit analysis and at a certain size level it might be unattractive for individual issuers. DCM might be a funding opportunity via ABS structures but that remains to be seen.

A very new development we’re seeing from a DCM perspective is the emergence of debt funds. Private debt funds are coming in and going down the [size] curve. We’ve been aware of them for quite some while on the high-yield side but they’re now more active on the lending side and I think that means more pressure on the banks.

The question for all of us is what is our unique selling point? Liquidity isn’t a USP any more, because monetary policymakers are providing abundant liquidity to the market, to the point where I think it’s time for the banks to look for a new business model.

Marion Schiller, UniCredit: But don’t you think SMEs prefer bank funding, leaving Schuldschein aside for a moment, to liquidity from funds? First of all, they have a focus on relationships and secondly, so far they’re not prepared to pay the price or accept the structures the funds are requesting. How long that situation remains is a good question but I do think as long as liquidity in the bank sector is at such a high level, especially on the SME side, the funds will remain on the outside.

Reinhard Haas, Commerzbank: My experience around credit funds is that you would typically see them in the leveraged segment rather than in investment grade territory. Their return requirements push them into this higher risk area rather than into the investment-grade corporate loans space, which will not meet their needs.

What would give credit funds a boost is if liquidity was scarce, which is not the case right now. For the time being, funds will continue to look for opportunities but will focus on where higher yields can still be realised, which is in the high-yield environment. That might change after the full introduction of Basel III in 2018: that may be the moment when you see alternative investors gaining territory on banks.

IFR: In the meantime, Michael, looking at the dynamics in the bond market where we’ve seen periods of negative yields not just at the level of the German government but in large-cap corporates, that was creating a real issue for investors. Did that push them in the direction of small and mid-cap opportunities?

Michael Bures, Raiffeisen Bank International: Not so much into the small caps but certainly into the mid-cap territory and even more into high-yield territory. That said, I agree that SMEs do not have a lot of incentive currently to diversify away from their core banks. Mind you, we are having this discussion at an interesting point in time because the extremely strong correction on the long end of the curve shows it’s good to diversify your funding base.

In the liquidity euphoria SMEs are currently experiencing, this element is under-estimated because even if you are an investment-grade corporate, the bond market is shut for you right now. So it would be good for SMEs to do a bit of homework and look at other options. I agree that with banks’ current lending policies and the liquidity in the market we’re in a very favourable position and borrowers are not motivated to go that extra mile.

IFR: On that point of window markets, Ingo, the bond market has a reputation for being open one day and closed the next given prevailing macro or other circumstances. Do you think this is something that will always ultimately make the bond market a fair-weather market for corporate borrowers?

Ingo Nolden, HSBC: Compared to the loan market, the bond markets are certainly more volatile taking into consideration what I would call the more timely effects on the market. But what we have observed if you compare the dollar market with the euro market is that the euro market has become more resilient over the last three or four years.

At the moment, the euro market is under severe stress but there were situations a couple of years ago where it would have closed down much earlier. The effect earlier in the year where US companies tapped the euro market shows very much the level of maturity the euro market has reached.

But yes compared to the Schuldschein and loan markets, bonds are still much more volatile and that is certainly playing out now. By comparison, the Schuldschein market is functioning pretty well.

IFR: Sven, you work for a bank that specialises in the mid-cap space. What’s your angle on the issue of SME market access?

Sven Janssen, Oddo Seydler Bank: I agree with Marion that the preferred funding options, despite the attractiveness of capital markets products, are from the loan side. Opening up towards the capital markets is a strategic decision. Schuldschein is a hybrid; maybe it’s the first step towards opening up and diversifying. The decision to launch a bond is culturally a milestone for any mid-cap company with regards to transparency, with all the requirements that come with it.

If a corporate makes that decision and is acting out of strength then it really is a fundamental strategic decision that says they want to diversify in the long term. This doesn’t mean they want to abandon their traditional funding bases but that it should be a certain proportion and complementary to their other funding sources and one that enables them to flex their muscles towards the banks if things get tough again.

What struck me, listening to the initial comments in the discussion, is that everybody agrees it’s a competitive landscape. But when did we not have a competitive landscape? Is competition greater because more foreigners have moved into the German market? Or is it a reflection of monetary policy and liquidity? I haven’t come to an answer but I am wondering. I put that question to everybody: what would be your initial reaction?

Reinhard Haas, Commerzbank: Our market is intrinsically competitive; I would agree with that. But when you think back to the time from 2008 to 2010, there were restrictions on liquidity and competition was around quite different topics. We were nonetheless all out there trying to do business even with internal restrictions on how much liquidity we could make available.

So, discussions with clients at that time were completely different from what we have at present. Right now it’s a matter of appraising an overall relationship with the client to see whether the credit that you make available is making enough money in connection with all of the other cross-sell you might generate to make the overall relationship positive.

The years following the crisis gave a very different picture where there’s no question that pricing was at a different level than it is right now. The liquidity that we had to give out to clients was so scarce that you really had to look at how much you could give to an individual address and still have enough for your other clients.

Marion Schiller, UniCredit: In addition the markets were much more local than they are today. Everybody was focused on core markets so liquidity was labelled to your core clients in core markets. That has changed completely. Today we have crossed borders again and extended our base of clients. It’s the same for Germany: the foreigners have come back.

Michael Bures, Raiffeisen Bank International: When we talk about competitiveness, there is a clear sign that we are in a hot market phase: discussions and negotiations with clients have not stopped at pricing; they’ve gone on to covenant-lite, short documentation, ease of execution etc. That is a clear sign that we are really at the peak of the cycle. Day-to-day, discussions on documentation and execution are heating up and borrowers are getting much more demanding.

Joachim Erdle, Landesbank Baden-Wuerttemberg: I’d like to add an additional aspect to the question of how competitive the market is and how this has changed in the last couple of years. It is not only a question of competition driven by foreign banks or additional products in the market at the moment. A clear sign to me is the role and the importance of debt advisers also for small and mid-cap businesses.

You’d often see debt advisers on large-cap business in former times. But now on 60-70% of our deals we have a debt adviser at the table. These guys clearly drive transparency and competition; so for me there is no doubt that we are in a significantly more competitive situation compared to even 2006-07.

Martijn Kamps, ING: And if you compare to, let’s say, 2006-2007 when most of us were already here, conditions today are simply the result of a huge supply-demand imbalance. That, combined with very low interest rates and the search for yield, has brought a lot of players to the market with a lot of liquidity.

Thomas Haas, Bayerische Landesbank: The point about nationality is very interesting. If you look before the crisis in 2007, 30% of all German SMEs were financed by German banks. That changed during the financial crisis to 46%; foreign banks had left and the markets were not so liquid. In 2015, German banks are providing 35% of SME financing. It is becoming more and more domestic although less so than during the crisis.

The markets are more competitive because we are forcing it. It’s the banks that are selling Schuldschein and executing bond mandates. Often companies will say: “Oh I’m fine with a club deal which I am happy to self-arrange” but we like to generate fees.

Stefan Bund, Scope Ratings: People talk about having long memories but I question whether that’s actually true. What I’ve heard so far is there is more competition; there’s more transparency – although I’m not sure about that – and I’ve heard it’s a borrower’s market. Of course from the perspective of spread developments, it’s been very good for borrowers but from my credit perspective, I’ve heard terms like senior documentation, covenant-lite – if there are covenants at all – several times in the past.

We suffered a leveraged loan crisis and we’ve seen several covenant-lite deals in the past. We also had that issue a few years ago with the [domestic SME] bond market. Everybody welcomes competition and everybody welcomes cheaper funding for corporates but we have to keep in mind that we can’t repeat the mistakes of the past.

In the Schuldschein market, there is a clear trend towards sub-investment grade borrowers. When you look at the number of rated borrowers in the Schuldschein market, 70% are investment grade whereas in the unrated space – we analysed the credit quality of a sample of 30 corporates – the vast majority of unrated Schuldschein borrowers are sub-investment grade.

Another trend is towards Kreditersatzgeschaefte, where banks move into other products to boost their balance sheets, so if on the corporate lending side margins are not high enough or certain documentary standards are not met you grant a loan in another format; such as Schuldschein, for instance. These are trends we have to consider and [we need to] ensure the market is not overshooting today to come back and hurt us in a few years.

Reinhard Haas, Commerzbank: I understand what you are saying, Stefan, but I disagree with a portion of your comments about Schuldschein. We need to differentiate between the risk appraisal behind what we call investment grade and sub-investment grade.

Schuldschein as a product is more suitable for investment-grade borrowers than anything below that risk category. Saying that the majority of unrated issuers are sub-investment grade may be true from a public ratings perspective because these issuers tend to be small and don’t meet the qualifications for being investment grade in the views of the ratings agencies.

What is key, though, in the risk appraisal is the internal bank rating. As far as I can see, the overwhelming majority of Schuldschein issues that we have done fall into a category, which – in our minds – is equivalent to investment-grade risk even though there is no public rating for it. And because of the lack of majority voting rights that you have in a Schuldschein, that is the most appropriate answer.

It is not a high-yield product, it is not a sub-investment grade product because of the cyclicality often times observed in those business models and it is not equipped for that on a structural basis. This is why I think for the time being it will remain an investment-grade equivalent product; maybe eligible for certain crossover names but in general not a high-yield product.

Stefan Bund, Scope Ratings: I didn’t say the Schuldschein market as such is investment or sub investment grade; my observation was that if you separate the market between rated entities and unrated entities, our observation is that non-rated issuers tend to have lower credit quality.

Sven Janssen, Oddo Seydler Bank: I would agree on that. I clearly see a dilution of standards that is driven by investors who are just desperate [for yield].

Ingo Nolden, HSBC: But partly speaking to Reinhard’s point, the Schuldschein market is a professional market. Even if a credit rating agency comes to the conclusion that an issuer isn’t investment-grade quality according to general rating standards, investors in Schuldschein are most likely banks. Even if we’re talking about crossover credits or high-yield credits, we don’t see institutional investors unless it’s on a very selective basis; we mostly see banks.

And I would expect banks to be able to gauge the risk they are taking. So while the observation is correct that there is a tendency to go down the credit curve, the Schuldschein market is at its roots an investment-grade market. There might be cycles where there is something out there that wouldn’t fly in a stressed scenario but contrary to other markets that have been tested in the past, the SSD market will be much more resilient to stress because you have professional investors, and arrangers are pre-selecting.

Of course competition is about testing the boundaries of what is possible but I think for the wider good of the market structure, if a high-yield Schuldschein issuer were to go bust – and we have seen them going bust – I think professional investors will take the pain. It’s not nice, of course, but that’s the nature of giving credit and receiving a spread for it.

Marion Schiller, UniCredit: To be honest, the Schuldschein market can’t be the main financing instrument for a high-yield issuer because of the single decision rights in the Schuldschein, which makes lending for banks less attractive. The syndicated loan has majority votes and basically you don’t have that in the Schuldschein market. In a crisis scenario the risk of single investors dropping out is much higher than in a syndicated loan, which is an inherent risk of lenders in a syn-loan. So for me, it can’t really be a broad financing instrument for the high-yield market.

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