Wednesday, 19 December 2018

Model in search of catwalk

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Private placements are increasingly seen as a solution to Europe’s SME financing conundrum, but authorities must first find a way to entice investors to these markets.

Europe’s patchwork of private placement markets is buoyant. Yet it remains a collection of small, national markets, with at least as many differences between them as similarities.

From the European private placement markets in France and the UK, Schuldscheine (SSD) in Germany, direct lending and even, arguably, MTN bond issuance, there is no clear definition of what is meant by the term private placement.

Italy is the latest to join the fray, adapting its legislation to encourage the emergence of a bond market for smaller Italian corporates, a move that has generated interest from non-bank lenders such as insurers. And all of these compete with the US market, sometimes referred to as the global private placement market because it welcomes issuers and investors from far beyond its own shores.

Many bigger issuers with access to the US market will instinctively look to go back to that market, but with more familiarity, one of Europe’s markets may provide an attractive alternative.

Each market has its own nuances. Schuldscheine, for example, predominantly attract financial institutions as investors, though institutional investors are increasingly active, partly because German SMEs have little trouble getting loans from their banks. It is therefore less relevant to the narrative of private placements replacing the declining bank market.

Alain Gallois, global head of DCM at Natixis, differentiates the legal definition from the practical one. “For the bulk of the market, private placements are non-liquid, small-sized, confidential transactions placed with a small number of investors,” he said.

Crucial step

A number of national governments have concluded that growing their own private placement markets will be crucial in ensuring their SMEs have access to capital in coming decades. They see it as a way to encourage investors such as debt funds, pension funds or even crowd funders to invest in SMEs.

This will require incentives being created, particularly tax incentives, to entice such investors into the market. If they can get these incentives right, private placements can continue to grow and play an important role in financing SMEs in the future.

“Private placements do play an important role in the financing of European SMEs already and will certainly do so even more,” said Stefan Rinauer, head of MTN private placements at Societe Generale.

“Bank lending will continue to be more restrictive and SME’s funding needs very often do not reach the necessary critical mass for Eurobond issuance.”

However, there is likely to be a limit to how far private placements can go in solving the SME financing squeeze.

“When we talk about SMEs we need to be more specific,” said Sebastien Palle, deputy head of public affairs at Societe Generale.

“For the larger medium-sized companies, and the high growth or very innovative institutions, or those operating across borders, market financing such as European private placement market will work. But smaller SMEs are always likely to rely on the bank market. Right now, the price of credit is very low, and small SMEs are better off turning to their banks for loans.”

In the short term, the priority is for authorities to develop their national markets. That requires reform of withholding tax, which has created a very uneven playing field not only within Europe, but particularly between Europe and the US.

Tax reform

The UK’s Treasury has indicated that it wants to reform its tax rules but remains concerned about the potential this could create for tax avoidance. Some have their doubts it can achieve this delicate balancing act.

David Shearer, a partner at Norton Rose Fulbright, said: “The private placement withholding tax exemption still requires the noteholder to be a financial institution and in most instances that will be a bank, so actually this reform has not opened this market up to new investors.”

According to one source: “Authorities need to either take a leap of faith and make the markets easier to use, or decide the issue of tax avoidance is more important and tell borrowers to make the most of the sources of capital that are already available.”

Tearing down the barriers

But many are already looking beyond the immediate concerns at longer-term goals.

“The next goal for Europe is to try and better unify the private placement markets, which will hopefully make them more efficient, transparent and flexible in terms of the size of deals that can be done,” said Angus Whelchel, co-head of private capital markets at Barclays. “By standardising the documentation and the marketing process it can hopefully entice new investors.”

“From a borrower’s perspective, the heterogeneity does not look like a big issue at first sight,” said Rinauer. “So far modest volumes have easily been absorbed by mostly domestic investors – except for the already significantly internationalised SSD market.” It allows issuers to pick from the different formats the one most suitable for its needs, he said.

This arrangement has the advantage of encouraging innovation, as different markets try different approaches, leaving issuers and investors to decide what works and what doesn’t.

“The US private placement market has been very innovative over the past few years,” said Whelchel. It allows delayed drawdowns, where issuers can lock in rates today but not actually draw funds until later; funding in other currencies such as euros and sterling; and the ability to structure offerings with amortising structures. Issuers have been keen to take advantage of such features.

“It’s these kinds of innovations that make the market so competitive,” said Whelchel.

However, having a number of smaller markets is less convenient for investors, said Rinauer. “An increasing number of European real money investors have decided to set up dedicated funds or portfolios for unrated credit in the hunt for a few extra basis points,” he said. To this end they are looking to expand their research coverage of private placement deals.

“The co-existence of many different legal formats across various jurisdictions adds further complexity to their already time-consuming credit analysis process and this still prevents a high number of investors from taking a closer look at unrated private placements,” he said.

Fragmented range

“What we have now is like the Eurobond market before the single currency, with the market fragmented into differing national currencies, so francs, Deutsche marks, lire, etc,” said Phil Smith, partner at Allen & Overy.

“Issuers borrowed in a range of currencies from national pools of liquidity. Now we have a single currency so it should be simpler to move to a more liquid European PP market.”

In January the ICMA released a guide for the creation of a pan-European private placement market outlining a voluntary code of best practice, how the process works and what information should be shared, for example. It looks very like best practice for a public bond issue, without the emphasis on exchanges.

This seems to be a stepping stone towards that goal. “I expect to see the emergence of a single European market but that allows for national variance,” said Smith.

“For example, if you have a French investor and a French borrower the deal would most likely be done with French documentation, which all sides will be comfortable with. But if the deal is cross-border, I’d expect it would use international standard documentation, which would probably be under English law, and again most institutions are comfortable with this.”

Some way to go

However, private placements have some way to go before they reach this point. Besides tax incentives, more needs to be done to demystify the sector for investors.

“Much more due diligence can be needed for a private deal,” said Smith. “This means investors need to be properly resourced to do it. Whether they do that depends on how many such deals they expect to do, which in turn depends to some extent on the yield environment. If rates look set to stay low there is a greater incentive to invest resources into this.”

Investors would also find it easier to make the jump into private placements if there was some form of independent information available. For public deals there are ratings. In the US private placement market most issuers are unrated, so there is no reason Europe cannot develop along similar lines.

To meet this demand for independent information, S&P has a kind of quasi rating system for SMEs called Mid Market Evaluation, offering an independent opinion – but not a formal rating – of medium-sized companies. Although take-up has been limited, that is principally indicative of the relatively modest levels of interest in European PP at this stage. As more investors look at the asset class, interest in S&P’s opinion about SMEs is likely to grow.

Smith said: “The amount of information available varies between countries. In France, you have a centrally held credit book covering the credit histories of companies, whereas in the UK there is nothing centrally held and banks have most of the information. This is an important issue because if you want to create a snowball effect in this market, access to information is key. That is what will help generate interest among investors.”

Such issues take time to iron out. “The European PP market will take time to provide a substantive model for issuance,” said Whelchel. “There does seem to be momentum in the right direction though. At this stage participants need to see how the newly drafted documentation pans out with both issuers and investors in the context of other alternatives that currently exist.”

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