IFR German SME Funding Roundtable 2014: Part 2
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IFR: Marion, can I ask you to comment on this issue of institutional lending? It’s very hard to track the volumes that are going through but one of the issues that comes up in conversation with banks around this is that whereas banks have an ancillary driver around how they approach corporates, institutional investors don’t have that driver, which leads to a pricing discrepancy in that banks can price ancillary into the margin. Is that the case?
Marion Schiller, Unicredit: Well, as liquidity in the banking market is so high, and the competition is so fierce, pricing is coming down so pricing is currently not of interest to institutional investors. The question is whether new funds are raised that can invest in cheaper loans.
From a corporate perspective there is no need to accept the institutional investor bid because the banks are there with deep pockets. As we said, new banks are coming in to bank this market. Banks like BNP Paribas and HSBC, for example, are entering the German mid-cap market and pushing quite hard. So as the market is so liquid, I don’t see that institutional investors can lend at those levels.
Reinhard Haas, Commerzbank: I agree with that completely. I would dare to venture, though, that that this will only be a temporary phenomenon. You can be as foreign as you want, but at a certain point, you need to make money. We’ve seen attempts on and off by US or UK banks to enter the mid-cap segment, just to shut up shop after a couple of years. At this point, it’s open season, so once again we’re seeing these banks trying to enter a market which is already well banked.
It’ll probably work for a certain amount of time because they will have a certain amount of money to spend. If the returns do not come their way we will see those banks pull out again. That’s my bet.
Marion Schiller, Unicredit: I think one question to ponder is: how much cross-selling is out there? How much cross-sell does an SME have? That’s a big question. Is there really a wallet for more than five or six banks? I doubt it. I would agree with Reinhard.
Willi Doerges, LBBW: I agree, too. Although a lot of banks are making Schuldschein investments and are trying to get their share of cross sell, there’s a limited wallet that SMEs can offer. Even if you have some Asian investors in the Schuldschein, you might only need one Asian bank for your local banking needs. What would be the point of having two, three, four, five more banks in that area? Corporates realise that their wallet is limited as well. Maybe in the past they made a lot of promises on future wallet and cross-sell which they simply cannot fulfil.
IFR: I was actually going to ask about the cross-sell. It’s hard for someone outside the banks to really understand how that works. Michael, how is that cross sell story changing?
Michael Wiedmann, IKB: I can only talk about IKB and for us cross sell is a big no-no. We look at each transaction and each transaction has to be profitable. We cannot engage in lending where we say: “OK we can take a huge loss on this and hopefully make it up on the cross sell”. Fine, we’re a small bank, we don’t have a full and global product set so we need to live with what we have. From that point of view we’re very strict on pricing.
Oliver Rupprecht, Nord/LB: The Schuldschein market is often used for cross-selling purposes. We see a lot of investment from banks from abroad, from Asia, China, and other places. They typically buy Schuldschein to gain access to companies and of course the main topic for them is cross selling.
Reinhard Haas: I disagree that participating in Schuldschein issuance entitles you to any kind of cross sell because the allocations you get are just too small. It does happen in syndicated lending, since most of the time these are club-style facilities with a limited amount of banks providing the liquidity to the SME. In that sense, among that smaller group, you can definitely divide the wallet into fair shares, whereas in a Schuldschein issue, for as little as €50m you can have between 40 and 50 investors. There is no way this entitles you to substantial cross sell.
Marion Schiller, Unicredit: Exactly. That’s my point. If a client chooses Schuldschein, the expectation is that the banks aren’t participating and demanding cross sell. I think that’s exactly the expectation of a client issuing Schuldschein. I think it’s completely different to syndicated loans where banks have to bring money to the table and then get cross sell, but I don’t think that’s the case for a Schuldschein.
IFR: One product that we haven’t mentioned yet, although which have been actively used in the past by growth companies, particularly when we’ve got strong equity markets, is convertibles, Jens. Why don’t we see more convertibles from the SME segment? Is it just that they don’t want to sell away equity optionality?
Jens Voss, Commerzbank: I wouldn’t say it’s not an active market; it’s pretty active for the real estate sector, where it has been used constantly over the past few years as a growth instrument, allowing them to dilute above NAV in most cases, which makes it a perfect growth financing instrument for them.
For other corporates, it’s mainly used as acquisition finance where you’re basically happy, at some stage, to have the dilution to strengthen your equity in the medium term. So it’s not that it hasn’t been used; it probably hasn’t been used to the extent it should have by small and mid-cap names because it has
been one of the most attractive segments and it has done well.
This was demonstrated by German healthcare company Fresenius, which sold a €500m convertible in March 2014 [to finance its acquisition of hospitals from Rhön-Klinikum]. The company made an economic gain by issuing a synthetic convertible that ended up being cheaper than a straight bond. That says a lot about the attractiveness of the equity linked market.
Also worth highlighting is the €45m convertible, also issued in March, by independent IT systems provider Cancom, which was unusual in that it wasn’t the old-style deal where you need to raise at least €100m.
That’s the main argument as to why you haven’t seen more issuance from mid-caps: you need a certain size, which usually starts at €100m and sufficient liquidity in the shares. In the German mid-cap market, you only want to issue convertibles on a non-prospectus basis, so up to 10% of your share capital. For that, you need a market capitalisation of at least €800m-plus to reach that €100m mark including the premium.
So convertibles may not work for the smallest names. It is certainly there. It should be growing given the attractiveness of the market. And there is more work to be done by banks to explain to the market the advantages of this product.
Britta Holt, Scope Rating: There’s also a lot of equity in corporate hybrids. There was a trend towards hybrids seven or eight years ago. They were very fashionable and a lot of companies – BUPA, Fresenius, Henkel – issued them. But they were mostly investment-grade companies. There are no non-investment grade companies issuing hybrids because of the risk.
Jens Voss, Commerzbank: That’s on the hybrid side. If you look at convertibles, we’ve seen more unrated and cross border issues as the typical investors are not that focused on having a rating. So there has been a tendency towards unrated issues, largely because a large part of the investor base in the equity linked product are hedge funds that manage their credit exposure by over or under-hedging via delta-hedging the stock.
On the classic non-dilutive hybrid side, which is debt, you basically need a rating or implicit rating and a clear investment-grade category. When you look at the dilutive convertibles, you don’t need it and we’ve witnessed a clear trend towards non-rated or cross border investment-grade companies having actively used that instrument, particularly in the last 12 months.
Marion Schiller, Unicredit: But isn’t the hype about hybrids more driven by investors because they’re looking for yield, and getting more yield on the hybrid side than on the straight bond side? Bayer, for example, did a huge [€3.25bn] hybrid in July, [to part-finance the acquisition of Merck’s consumer care business], which was purely driven by investors looking for yield.
Jens Voss, Commerzbank: You see exactly the same trend in the convert market where it’s not about the coupon but the equity kicker that people are buying into and looking for. You see a lot of outright demand usually by long-only investors for that particular asset class, not due to the coupon but really looking for yield and at least trying to make their performance higher than the equity performance if the share price goes up.
IFR: I wanted to touch on the topic of SME securitisation, which has had a lot of airtime recently. As we move towards this definition of high quality securitisation for Solvency II purposes there’s a very clear political bias in favour of securitisation in Europe as a way of unlocking bank lending.
We’ve seen some interesting SME developments recently, such as IKB Leasing’s German Mittelstand Equipment Finance No2, a large chunk of which went to the EIB as part of the latter’s mission to promote SME Funding. Another was the Viveracqua Hydrobond 1, which saw eight Italian water utilities issue a pooled ABS backed by the minibonds of the underlying obligors that provided them with 20-year funding at a very good levels.
How are structured solutions impacting the landscape in Germany? Will securitisation save you all? Or is the fact you don’t need saving going to play into developments?
Matthias Hellstern, Moody’s: It’s an additional tool to diversify funding, which could be of use if it’s applicable.
Michael Wiedmann, IKB: The question is, are you looking for funding or are you looking for risk transfer? If you are looking for risk transfer, yes, it would be interesting for banks. But then there’s a question of price. So at that point you need to look at the margin you can generate from the client and you need to look at securitisation and what investors expect as a margin. If the two don’t come together and add up, it doesn’t make sense. So yes it is a great instrument and there’s a lot of public debate, but for practical purposes there’s not much to be done currently.
Reinhard Haas, Commerzbank: I think Michael’s completely right, it’s a matter of pricing. Straightforward financing is easy to do, easy to think about and so readily available. The more structured solutions will have to wait. I think it’ll kick in at a time when liquidity comes at a higher price.
Britta Holt, Scope Ratings: You’ll see securitisation deals in countries where bank credit is not easily available to corporates.
IFR: Two years ago, people were screaming that pricing has hit the bottom and we can’t go lower. Two years later pricing has gone lower, for all of the dynamics and the reasons we know about. But I’m just curious to understand a little about the pricing tension between loans, Schuldschein and bonds.
Reinhard Haas, Commerzbank: There is definitely competition between the pricing of the different products, but in a sense they all move in the same way; they’re interlinked. There’s not one product category which easily out-prices the others. They usually move together and are inter-dependent in a way. When pricing a capital markets product you have to have market comparables. What are those? The other products and issues that are in the market.
They go in sync. It is only over time we will see changes. We’re in a technical situation of over-competitiveness right now; there’s too much liquidity available for borrowers. Over time, with interest rates rising – although I don’t see that happening any time soon – that’ll probably come into play. But we don’t have that happening right now because of the differences in macroeconomic development across Europe. There is no way that the ECB could easily do that without killing the fragile growth you have in some of the Southern European countries. So that’s going to hamper that.
Marion Schiller, Unicredit: To your point about two years, ago, what’s key here is that in comparison to 2012 the funding costs of the banks were much higher than today. There’s been deleveraging since then and the liquidity of the banks has increased dramatically. So deleverage, liquidity and competition are high; funding costs are down. So I think we’re talking about a different story today than in 2012.
Willi Doerges, LBBW: Bond prices have been under pressure for quite some time now. You see very tight issue prices and IPTs. On the Schuldschein side, we’ve been proved wrong on what we thought was the pricing floor. We’ve seen a handful of transactions recently, albeit for very high investment-grade companies coming to market with credit spreads well below 100bp.
That’s quite critical because if there’s no floor then you can just open up and say: “OK there’s a new auction process; who’s the cheapest lender out there?” That would definitely change the character of the Schuldschein product where you would actually try to manage the risk of the corporate with the pricing that you offer.
Oliver Rupprecht, Nord/LB: I agree with that. Pricing is determined by the market and as long as you have multiple levels of over-subscription in both Schuldschein and bonds, the pricing is the pricing. But I see a big problem emerging because it’s not just about pricing: a lot of covenant protection has evaporated. We’re not seeing any more structural covenants, financial covenants and we have companies going to banks and saying: “I don’t want any covenants”. That’s a problem because we’re creating high-risk products with small spreads.
Britta Holt, Scope Ratings: We looked at the average coupons paid in the SME bond market across 165 bonds and it came out at 7%, so it’s a very high rate. But if you look at refinancing, it will be even higher. There is €4.8bn of refinancing needed out to 2018, and the trend is towards higher interest rates. So if these companies move away from bonds they need to go somewhere else to secure refinancing. This can only get more expensive than it is today. This puts pressure on these companies.
IFR: I wanted to keep on this issue of lack of covenants. It’s become a very big talking point. The regulators have now flagged it as an issue in the US and elsewhere because it leaves investors open to lots of risk. Matthias, could you talk about this from your perspective? It’s a dangerous development in a lot of ways.
Matthias Hellstern, Moody’s: Actually it’s not even the lack of covenants but the introduction of clauses, such as portability clauses, which basically allow a company to be sold to another with even higher leverage, and investors can’t get out of the bond. We just saw a French medium sized company with €400m turnover go to market to issue a bond, which was very difficult because of the lack of covenants, or because of the addition of portability clauses. Investors demanded a higher spread than the company was prepared to pay.
Reinhard Haas, Commerzbank: I think you can see a certain counter movement to what you were just describing in the American leveraged market, especially with all of the covenant-lite issuance we’ve seen. We are getting very clear signals from our New York desk that the weaker structured leverage financings are finding it hard to gain market access.
I wanted to also come back to the prospects of pricing developments here in Europe. I believe that certain regulatory issues will probably force the market into a different direction, specifically the leverage ratio under Basel III, which we already have to abide by but which will be formally introduced in 2018. The minimum requirement is 3% [during the parallel run period ended January 1 2017], although a lot of banks have said they will hold to 4%.
Sooner or later, this will have repercussions on the pricing of debt products especially on the loan side. So we will probably have a discussion intensifying over the coming years as implementation takes place from 2018 on.
Marion Schiller, Unicredit: Covenant-lite structures have been driven by the private equity market. So far, we still have financial covenants in the German SME corporate market, where in the case of loans, most companies still have at least a leverage cover test in their structure. It’s different with Schuldschein and bonds, but there still is a structure that somehow secures the credit quality of those clients. I think it’s different in the private equity market, so we are a bit safer here, I would guess.
IFR: This issue of regulation, it’s a very broad topic, and let’s not go into the detail of regulation but it has first of all created an unlevel playing field because regulators have focused on their home country banks and don’t really care about a global level playing field.
Second, regulators are also forcing a utilitarian business model on banks. They don’t particularly want banks to get involved in so-called casino banking activities. I’m curious to understand how you see this. What is the impact of this regulatory onslaught on you as operators and as intermediators of money transmission? I know it’s a very broad question, but it has been articulated as an issue around SME lending.
Reinhard Haas, Commerzbank: Regulation after a period of turmoil is a normal thing. Certain things had to be done, for sure, but the usual human reaction to turmoil is to over-regulate. I see the dangers of this being actively discussed amongst colleagues in the debt capital markets. We have to stay in touch with the agencies that formulate regulations.
When I think about the loan market and the way Basel III treats certain kinds of loan purposes in a very punitive way and others very differently, it doesn’t make a whole lot of sense when you really look behind it. So I think it’s a call-out to all market participants to stay in a dialogue, and not just complain but try to be creative and supportive in making the capital markets a safe place; a place where you have product ingenuity and can develop new products and not just have red tape and blocks all over.
Michael Wiedmann, IKB: I think the initial reaction is very clear, it will lead to higher costs for banks that they won’t currently be able to offload onto their clients. That means margins will get lower. They will have to see, over time, how competition develops and how they will be able to pass on those extra costs to customers.
IFR: Would you sense be that, over time, once the regulations have bedded down and you see the true impact of this all do you think there’ll be a process of deregulation? Do you think this cyclical, in other words?
Michael Wiedmann, IKB: It’s a long way off. Hopefully, but for the next five years I wouldn’t expect it.
Reinhard Haas, Commerzbank: There is political back and forth. The regulators want to save clients from any mischief coming from the banks or whoever, but on the other side they want these mid-caps and other companies, to be financed. When you render that too difficult or too expensive it’s not going to happen. This is where the dialogue needs to take place.
Marion Schiller, Unicredit: But regulators will think about regulations when they know liquidity has shrunk. As soon as banks can’t lend to SMEs, for sure, we will talk about deregulation because that’s what they need and what is important for the German economy.
Reinhard Haas, Commerzbank: I would add to that that if you keep the banks from being able to provide liquidity to companies, companies will look for other sources. You will have shadow banks or different sources of money which are less regulated and don’t fall under the same authority as banks. You may discover that that may be more perilous than working with banks.
IFR: But that’s where we’re headed. There’s a sense that creativity and innovation are being stifled from the banks and being forced into shadow banking where the regulatory process is years behind.
I wanted to touch on the theme of corporate-to-corporate lending. I was wondering, in a German context, about the extent to which supply chain finance is alive and kicking.
Matthias Hellstern, Moody’s: If you’re basically referring to the financing of customers, this is happening but not to a huge extent. Companies like Siemens have their own financing entity; while Kion, the forklift producer, has its own financing arm to help customers buy its products. But I don’t see customer financing by companies increasing strongly.
I think corporates have also learned the lesson of the last two crises, that to have too much risk on
their balance sheet is probably not a good idea. So they are trying to invent creative solutions for their customers.
Michael Wiedmann, IKB: I think you need to differentiate between corporate-to-corporate, which I don’t think is a big topic apart from the big Siemens’s of this world. If you talk about vendor financing, yes, it’s getting bigger and bigger. If you look at our leasing business we see more competition, companies like [engineering group] Trumpf getting its own banking licence earlier this year, and also obviously providing vendor financing. We will see a lot more competition [from this area] going forward.
IFR: In what form is it growing and what kind of companies are taking advantage of this?
Michael Wiedmann, IKB: Well, it’s typical the larger Mittelstand companies, those with turnover of €1bn and which have the financial strength to say, “Yes, we can do our own banking business”.