By Alan Burke, Nathaniel M. Zilkha Jun 30, 2014
A lasting consequence of the 2008–’09 financial crisis is a precipitous drop in bank lending in many parts of Europe. According to the European Central Bank (ECB), lending to nonfinancial corporations declined by nearly 12 percent from January 2009 to March 2014. In contrast, demand for credit from businesses of all sizes continued to increase during the first quarter of this year.
Overall, we believe the euro zone crisis and changing regulatory landscape show the need for a much broader financial services ecosystem, particularly as it relates to Europe’s middle-market companies and its small and medium-size enterprises (SMEs), defined as those with €50 million ($68 million) or less in turnover. Europe’s corporate sector depends on banks for 75 percent of its funding needs — which is in sharp contrast to the U.S., where bank loans account for only about 30 percent of corporate debt.
The present environment has created more awareness of the need for nonbank lenders to offer financing for companies. The change we are seeing is likely more of a systemic shift than a short-term trend. Over the long term, we believe, companies are likely to have more options when they attempt to secure funding — a development that could herald stronger and more sustainable economic growth in Europe.
The most immediate concern for many European businesses is access to credit, which has pushed a growing number of companies to seek alternative avenues for capital. On the macro scale, global cross-border capital flows have dropped steeply, from €8.5 trillion in 2007 to a scant €3.3 trillion in 2012. With euro zone banks scaling back cross-border lending, the increase in domestic lending and bond buying has slowed market integration in Europe.
A number of governments and public institutions that are concerned about the challenging bank funding climate, such as the ECB and International Monetary Fund, have stated that alternative sources of financing need to be both identified and developed. A growing number of European businesses are tapping alternative-credit sources for funding. Providers of alternative capital are not carbon copies of banks. They work through the long-term capital needs of companies and can offer a variety of sophisticated funding instruments.
The European market for private placements, the sale of securities to a select group of private investors, is embryonic compared with the €36.6 billion ($49.8 billion) in private debt placements that take place every year in the U.S. But a growing number of European companies, especially middle-market companies shut out of bank loans, appear to be negotiating euro- and sterling-denominated private placements.
Schuldscheins are a floating- or fixed-rate debt instrument common in Germany; they share some characteristics with U.S. private placement loans yet do not require a sales prospectus. Recently, Schuldscheins have begun to attract a number of international borrowers. In 2012 corporate-issued Schuldscheins jumped 104 percent over the previous year, with the total approaching €13.6 billion. The number of Schuldscheins issued by non-German companies increased 356 percent, accounting for a total of €5 billion. Last year French electrical parts distributor Sonepar issued a €400 million Schuldschein. Other noteworthy issuers include Swiss specialty-chemicals maker Clariant and U.K. grocer Sainsbury’s.
Private placements also seem to be addressing the lending void in France. The French private debt market has raised €5.8 billion since its launch about a year ago. Large insurers, including AXA and CNP Assurances, are among the most active investors in the country’s nascent private placement market.
SMEs are also turning to Italian retail bonds, called MOTs, and other, similar investment vehicles, such as the London Stock Exchange’s Order Book for Retail Bonds (ORB). Since their 2010 inception, ORBs have raised more than £3.4 billion ($5.8 billion). In late 2013 U.K.-based Premier Oil, an oil and gas company with a market capitalization of £1.6 billion, also explored the retail bond market by offering a £150 million, seven-year note priced at 5 percent.
A number of asset managers with dedicated credit funds see an opportunity to lend to middle-market borrowers across Europe. There are three types of alternative-credit providers. Mezzanine funds extend hybrid loans, which can be converted into equity. Special situation funds, which provide capital based on specific market events, are another funding channel. These strategic investments can take the form of rescue financing designed to address a cash crunch, as well as loans triggered by other milestones, such as debt refinancing. Finally, some alternative credit is allocated by direct-lending funds, which typically give loans to middle-market companies that cannot secure a competitively priced bank loan. These funds usually show up as senior debt on companies’ balance sheets.
Alternative-investment firms can provide financing across the spectrum of early-stage and mature companies and can channel capital through credit instruments as varied as direct loans, private placements or even hybrid debt like mezzanine financing. We believe that alternative-investment firms are poised to play an important role in Europe’s emerging alternative-funding sector. The European Commission singled out equity financing as an effective and underdeveloped source of funding for start-up companies. Data show that just 7 percent of Europe’s SMEs tap early-stage equity investors for capital.
The capital extended by these alternative lenders comes largely in the form of long-term equity from the fund’s investors. Although funds do not typically have the same safety net commercial banks have, such as access to liquidity funding from the ECB or government-backed investor protection regimes, they do aim to tightly manage risk.
There is an emerging opportunity for nonbank lenders to provide the credit facilities middle-market companies and SMEs need. But spreading the word is also critical. Corporate treasurers, especially at middle-market companies and SMEs, should be made aware of opportunities to tap the ecosystem of alternative, competitively priced, nonbank financing.
Finally, we believe capital providers with long-term investment approaches, such as alternative-investment firms, could also help companies grow and provide them with strong operational assistance. The emergence of these and other providers of alternative capital could help address structural deficiencies in the lending markets and potentially bolster European economic growth.