KEITH MULLIN, KM CAPITAL MARKETS: ONE THING THAT HAS BEEN VERY CLEAR, THOMAS, IS THAT POLICYMAKERS AND BANK REGULATORS WOULD LIKE TO SEE BANKS CONTINUING TO LEND; POSITIONING THEM, AS HAS ALREADY BEEN MENTIONED, AS PART OF THE SOLUTION NOT PART OF THE PROBLEM. THEY’VE INTRODUCED A RANGE OF FORBEARANCE MEASURES, INCLUDING ENCOURAGING BANKS TO DRAW ON THEIR CAPITAL BUFFERS.
BUT ONCE THE DEBT MORATORIUMS HAVE EXPIRED, WE’VE ALREADY HEARD IN THIS DISCUSSION THAT WE SHOULD EXPECT SIGNIFICANT DOWNWARD RATINGS MIGRATION AND INCREASE IN NON-PERFORMING LOANS. THIS IS A STRANGE SCENARIO. REINHARD HAS SPOKEN OF A SENSE THAT WE’RE GOING BACK TO NORMAL; ULRICH IS TALKING ABOUT PROBLEMS BEING STORED FOR THE FUTURE. THE EXPECTATIONS DO APPEAR WEIGHTED TO THE DOWNSIDE IN TERMS OF HOW THE BANKS are GETTING PULLED INTO A VERY DIFFICULT SITUATION. HOW DO YOU SEE IT?
Thomas Wolff, BNP Paribas: I was quite surprised about the speed of recovery [between Q2 and Q3]. The bank market has been complaining about margins, which is something we saw in the financial crisis of 2008. At that time, margin levels were lifted to higher levels and it took a couple of years before they gradually went back down again. This year, margins went up very quickly but went down almost equally quickly. We’re not yet back to where we were in February but for the best credits we’re not too far off. We still have, as Ulrich said earlier, largely a three-year market rather than a five-year market, but pricing terms went down very, very quickly.
The competitive dynamic of the bank market is still intact. Maybe there were some market participants that were not quite as active in April and May but which maybe want to try and catch up. But this is all at the good end of the market, the Single A and Triple B equivalents.
We can definitely see and will continue to see higher risk differentiation, which I think is a good thing. Lack of differentiation was one negative of the long bull market we’d had in the loan market, probably for 12 years. Risk today is better priced than before. But it also means that access to the bank market will be different depending on credit quality. A diversified funding mix becomes more important.
Institutional flows, as Juergen pointed out, will increase. I think the capital markets are very often better suited to take lower risk classes than the bank market because the capital required goes up significantly the lower you go down the credit scale. The institutional market and the capital market are better suited to take some of these risks because they don’t have the same regulations as we have in the bank market. What we are advising our clients to do, and will continue to advise them to do, is diversify their funding and access the capital market. Our clients are definitely heeding that advice and largely following it.
Reinhard Haas, Commerzbank: It’s complicated. I think a lot of participants in the financial markets hoped pricing would go up and tenors would go shorter as an effect of the shock of this pandemic. But you might have expected some standardisation around price discovery. The fact that pricing came down so quickly is due to a great extent to the fact that there’s so much liquidity in the market provided by the ECB and governments. But this has hampered the natural price discovery that we had been seeking for a number of years. It’s a bit of a missed opportunity that this has come into play. I’m sure Juergen would agree that this is also a problem for institutional investors that natural price discovery has been blurred by the excess liquidity that we’ve seen in the market.
Juergen Breuer, Pemberton: That is correct, although, I would certainly have a lot more differentiated view around how that works in an institutional environment and how it works on the bank side.
KEITH MULLIN, KM CAPITAL MARKETS: THAT IS A GREAT SEGUE BECAUSE I WAS GOING TO ASK YOU, JUERGEN, HOW YOU SEE THE INTERPLAY BETWEEN DIRECT LENDERS AND BANKS? FOR A LONG TIME, THERE HAVE BEEN TWO OPPOSING NARRATIVES. THE FUNDS SAY THE BANKS ARE WITHDRAWING FROM LENDING, LEAVING A GAP THAT THEY ARE FILLING. BY CONTRAST, THE BANKS SAY THE LENDING MARKET CONTINUES TO BE VERY COMPETITIVE AND THAT THE FUNDS FOCUS ON SITUATIONS THE BANKS DO NOT NECESSARILY WANT TO GET INVOLVED IN. THERE HAS BEEN SOME COLLABORATION BETWEEN BANKS AND FUNDS IN HYBRID UNITRANCHE AND OTHER SITUATIONS, BUT HOW DO YOU SEE THE INTERPLAY?
Juergen Breuer, Pemberton: I could fill a whole session with this topic of where we sit, where the banks sit, where we come together today and where might we come together in the future. The focus of debt funds has so far been on leveraged lending and buyout financing. Why? Because that’s ultimately where we can get the returns that investors are seeking in their search for yield and their desire to diversify their investment portfolios into this asset class. Why are we not active in investment-grade lending or in other parts of the market? The simple answer is I wouldn’t be able to raise a fund to do that because the returns I can get are not what investors are demanding. That’s an absolute statement, but it’s also a relative statement.
One of the reasons it doesn’t work for us is because I don’t think the risk margins in some of these parts of the market are right, in the sense that the risk margins coming out of the banking system are artificially low. The reality right now is for financing of buyouts and leveraged credits; that is, primarily Single B credits, the funds are able to offer unitranche facilities with a bit more leverage than the banks.
Where we’ve worked together with the banks is where the fund provides the term debt and the bank provides the revolving credit facility. And we’ve obviously seen the arrival of first-out, second-out structures where the bank takes a small piece of the term debt at a super-senior level, which is an interesting risk position for them. They get a decent margin for the risk and it works. If we want to bring the capital that is available in the institutional market to bear in broader segments of the lending market, we have to come up with the situations where the fund and bank paths can come together.
As a starting point, we have established a new lending strategy where we’re looking at more moderately leveraged deals, maybe 3.5x, no more than 4x for larger Single B Plus or Double B Minus names. If we go into those with a seven-year bullet tranche at, say, 475bp, 500bp, 525bp and combine that with a tranche that’s one year shorter with a 50bp-75bp lower margin, it might be feasible for a fund tranche and a bank tranche to be pari passu rather than have the fund take a subordinated position.
We’re having discussions with people like Reinhard and others about where we find these transactions, where can we bring our liquidity to bear such that for a €150m deal we do €120m, the bank does €30m and they’re the only bank in the relationship. I think that should work because at the level of leverage I’m talking about, to get 425bp-450bp on a six-year loan or maybe even on an amortising tranche for that kind of risk, why wouldn’t a bank look at that?
But if I ask my bank friends if they have good Single B Plus situations in their portfolio but would need 500bp-525bp, often times the answer is: “that’s not where we’re lending; we’re lending at significantly cheaper rates”.
The point I wanted to make is about risk-return and cost of capital. It comes back to what Thomas was saying, which we hear a lot, that the funds can choose what they do because they’re not regulated. We’re regulated differently from banks, but I don’t think that’s the reason for my thesis about bank lending margins not being right. If they were right, the lending would stack up in terms of return on risk capital in itself. In many cases, that is not the situation. Banks need to find other sources of revenue that either don’t tie up any capital or tie up less capital to make the returns work. As I said, I wouldn’t able to raise a fund to lend at the rates banks lend at in those rating categories because there is, in my mind, an imbalance.
Thomas Wolff, BNP Paribas: You make some very valid points, Juergen. But if this crisis has shown one thing, it is the value of bank relationships. What clients have discovered is that there is great value in having a defined number of relationship banks they can turn to if they need to. The model of providing a syndicated loan as a loss leader with access to ancillary business is very much intact. In fact, I think it will probably increase. I can clearly see the focus on ancillary business becoming stronger.
Banks are increasingly questioning the returns they’re making on client relationships. I think there have been too many banks that were not honest to themselves or their shareholders. This is clearly changing. It may be that a single lending transaction is not profitable but the overall relationship has to be profitable. I would expect a stronger focus on this. I would expect bank groups to become smaller and for clients to become more focused on the partners they choose.
Reinhard Haas, Commerzbank: I would concur with that. As I said, by and large, the symbiotic weight of cooperating with institutional lenders is mostly in the sponsor-driven area. That works pretty well and that’s where you see the institutional piece on the rise. And in the mid-market space, where direct lending is taking a bigger share of the market every year. This is pretty dominant in the US market, but it’s growing quite quickly in the European market. That’s probably where it works best.
As Thomas said, when it comes to lending to non-sponsor-owned corporates, the relationship aspect is key and will continue to be key. The bulk of that lending isn’t taking place in the risk bracket that Juergen was alluding to; that’s actually a relatively small portion of the market. A big share of it is high-grade and crossover where the returns that institutions are looking for can rarely be achieved because of the effect that Thomas was explaining: the cross-sell and the evaluation of the return on a client basis not on a product basis.
KEITH MULLIN, KM CAPITAL MARKETS: ULRICH, LOOKING AGAIN AT THE SMALLER END OF OUR CORPORATE SEGMENT, ARE YOU SEEING FUNDS PLAYING MORE IN NON-SPONSOR SITUATIONS?
Ulrich Kittmann, DZ Bank: My experience is actually quite rare. We rarely see funds contributing offering or unitranches to our client segment. We may see more of that when our clients’ ratings go south but for the time being, clients are trying to solve problems with their core bank groups. This is the main difference between the bank approach and the PE approach: banks have long-lasting relationships and we try to steer the ship through any stormy weather. We’ll see what the outcome will be and what the future will bring. We have had big support from KfW loans in terms of the 80% risk-release, which has helped us frame our own risk attitudes and where the banks have 20% at risk. We are doing what we can to help our clients get through the storm. If they don’t, I can probably give Juergen a call.
Juergen Breuer, Pemberton: Not in that situation.
KEITH MULLIN, KM CAPITAL MARKETS: BUT SMALLER COMPANIES HAVE LESS ANCILLARY BUSINESS TO GIVE AWAY TO RELATIONSHIP BANKS.
Ulrich Kittmann, DZ Bank: That’s correct. And this leads to the question about whether margins will cover the risk taken by the banks. That will be an interesting development for next year. My expectation is they won’t. Speaking for our institution, what we’ve seen over the last 10 years is that we have written back existing loan-loss provisions, given how the economy has performed. There’s not much left to write back. The time is probably coming to build new loan-loss provisions, especially when you look at certain industries. The big question is: can we carry this load with such thin margins?
Juergen Breuer, Pemberton: This situation cannot be sustainable. Ulrich is saying margins are insufficient. If banks can’t make the right returns through lending alone, presumably it should be in their interest to increase margins across the board. That would have the twin benefit of opening up significant pools of institutional capital to the more classic parts of the lending spectrum.
Reinhard Haas, Commerzbank: Thomas has described the mechanism that is probably going to emerge over time, which is a concentration of the number of lenders from the bank side that participate in syndicates so the relationship aspect pays for itself as clients distribute to fewer banks. This will be an ongoing process. We’ve seen this to some extent over the last 10 years. The past 10 months haven’t changed that tendency; they may in fact have accelerated this move.
KEITH MULLIN, KM CAPITAL MARKETS: YOU’RE IN THE PROCESS OF BUDGETING FOR 2021. I IMAGINE IT’S INCREDIBLY DIFFICULT TO FIGURE OUT WHAT THE BUSINESS IS GOING TO BRING IN THE COMING YEAR, WHICH IS ANOTHER WAY OF ASKING WHAT YOUR EXPECTATIONS ARE FOR 2021. WE’RE COMING UP TO THE END OF THE YEAR WITH A VERY UNCERTAIN FUTURE. WHAT’S YOUR READ OF THE TAKE-UP AMONG YOUR CLIENTS OF REFINANCING, BALANCE SHEET SUPPORT, ACQUISITION FINANCING OR LEVERAGED FINANCING? ARE YOU TAKING A CAUTIOUS APPROACH TO BUDGETING AND FIGURING OUT HOW MUCH MONEY YOU’RE GOING TO MAKE IN THE COMING YEAR? THOMAS, WHAT’S YOUR PROGNOSIS?
Thomas Wolff, BNP Paribas: I think you’ve hit a very good point about budgeting, which is obviously a subject right now. We’ve had an exceptional year, not only on the loan side but also on the bond side. In fact, we’ve probably had one of our best years ever. It’s very difficult to predict what revenues will be next year. But we’re still quite positive.
First of all, we’ve seen no opportunistic refinancings this year because of price levels being still higher than in previous years. That will return soon. From next year, we will have more opportunistic refinancings. We are also reasonably positive on M&A activity. Obviously, what this crisis didn’t do was force valuations down: valuations remain high so it has been more challenging to engage in value-creating M&A but I think we will continue to see more. We are reasonably optimistic but conscious that this year has been exceptional and that the activity of this year cannot be repeated next year.
Ulrich Kittmann, DZ Bank: Speaking for the general corporate purposes section of activity, especially Mittelstand, from the demand side, the borrower’s side, I would say there will be a lot of deals in the market. Many companies have postponed their testing of the market until next year. Second, we have some non-executed extension options that will come to the market. Third, we have some liquidity lines that will expire and be picked up next year as liquidity back-up. I’m really curious how companies will act around this. From the demand side, the perspective is not that bad; in fact it’s rather good.
From the supply side, from the banking side, as I mentioned we will see an impact on RWAs because of the rating deterioration in certain industries. The question is whether we can get the remuneration on our credits that we need in times of RWA inflation.
Juergen Breuer, Pemberton: As I said earlier, it’s extremely active right now. Some of that can be explained by pent-up demand. Going into next year, and given the current situation, we’re going back into a period where there will be challenges. That usually provides good opportunities for people with flexible, locked-up capital. Second, when we think about the LBO segment, there’s still lots of dry powder in private equity so they will obviously continue to look for ways to get that invested. That is therefore something for us to work with. I think that’s quite relevant.
We’re also seeing a lot of activity in our portfolio companies in terms of making add-on acquisitions. Again, times when things are a bit more difficult can be times to strengthen your platform, and for companies to look for interesting acquisitions. This is an area where debt funds can play at strength in terms of providing significant committed facilities. That’s what we have seen this year and expect to see next year.
You heard me talking about a repricing of risk in March and April that didn’t quite come through. If we go into a prolongation of this crisis, the story may turn out differently. I think one of the reasons we came back so quickly was there was so much liquidity, as Reinhard alluded to. But also it stemmed from relief that things were not going to be that bad as companies were already starting to recover. If that scenario is different, I would be optimistic that we will see a repricing of risk after all and that we will benefit from some of the effects that we witnessed after the financial crisis. That was a great time to do business.
Reinhard Haas, Commerzbank: I think what is likely to be different in 2021 is a higher degree of uncertainty with respect to timing. A lot will depend on when there’s a remedy available to fight the pandemic. That will be a determining factor in how 2021 plays out. The quicker it comes, the quicker, for example, we get to what Thomas was talking about: the valuation process for potential targets in M&A becomes possible. How can you evaluate an asset when you don’t know what the turnaround of that asset is going to be? The prognostics aren’t there. When you know that the pandemic is going to die off, that valuation becomes firmer and the possibilities of doing business in these areas, be that on the sponsor side or on the strategic side, will multiply.
I think we will see the usual activity that follows a crisis: companies will try to deleverage. We will probably see a rise in spin-offs and carve-outs, in the sponsor world or on the strategic side. And as Juergen said, companies will have better visibility. This could be the moment they resolve to make investments, so they’ll do add-ons or other things that they hadn’t progressed during the pandemic.
This is what will make 2021 very special. In the syndicated loans world, we live mostly for scheduled refinancing. We always hope for a surge in opportunistic financing. I can see reasons why that should occur but there is a timing component that’s going to be decisive for 2021.
KEITH MULLIN, KM CAPITAL MARKETS: THANK YOU. LET ME BRING OUR DISCUSSION TO A CLOSE. THANK YOU FOR YOUR FABULOUS INSIGHTS.
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