Alan McPherson is the chief executive of Tensator Group, a producer of queue-management products, such as retractable posts used at airports and point-of-sale display units. The firm employs 350 people, has its headquarters in the UK and has offices in the US, Germany, Poland, Paris and Dubai. Although successful and determined to expand, it is typical of many small and medium-size businesses in the UK and Europe in struggling to raise financing from traditional bank lenders as they delever.
|Benoit Coeure, executive board member of the European Central Bank (ECB)|
Our relationship with our bank deteriorated significantly after 2008, McPherson tells Euromoney. Our relationship manager changed, and the discussion around business development was limited to doing the minimum to keep the business running, as opposed to working together to find new growth opportunities and transform the platform from a hardware provider into a solutions leader. Essentially, we felt the bank was reneging on the strategy we discussed and agreed upon as part of the original investment rationale.
This experience chimes with anecdotal evidence elsewhere in the market. Banks are reducing credit, even to good businesses. One observer sums up the situation: If you are a good credit with a £10 million facility from a bank and you go to them to renew, they will probably say yes. But if you go to them and say you want to increase it to £20 million to build a new plant, then they will probably say no.
This certainly seems to have been Tensators experience. Although financing of external growth had been part of the original plan with the bank lender, after 2008 they had no appetite for additional financing, says McPherson. When we presented what we believed to be a quality and strategically essential add-on target in 2011 it was declined, causing us to seek an alternative lender. Our objective remained to grow and build Tensator into the global leader in customer journey solutions. We were not satisfied to just do the minimum, for the business or for our investors.
The firm subsequently secured acquisition finance from one of the asset managers now involved in the UK governments Business Finance Partnership (BFP) scheme. McPherson certainly seems happy with the change. He sees the acquisition loan not as a one-off resort to a new source of funds but, he hopes, the beginning of a more lasting arrangement with this new provider. In its new relationship, Tensator has a lender who makes great efforts to understand and support the business and its development by being a financing partner, and not just us sending them covenant certificates at the end of each quarter. This makes it much easier to discuss business requirements as things develop.
This is exactly the kind of relationship lending that high-street banks are supposed to specialize in. Tensators switch is an example of the profound change set to transform how companies raise finance as the banking system shrinks.
The US savings and loans crisis blew open the US banking market. This is Europes savings and loans crisis and it will have the same impact on the European banking market, says Anthony Fobel, partner and head of direct lending at BlueBay Asset Management, who is certain that the evolution now under way in European credit will be a lasting one. In 10 years time Europe will not be an 80% to 90% banked market, he predicts.
|Anthony Fobel, partner and head of direct lending at BlueBay Asset Management|
Fobel is referring not just to the disintermediation of bank lending to larger corporates and growth in corporate bond issuance. He sees a more important shift in how small and medium-size companies will raise loans. Investors have traditionally been invested in liquid credit and illiquid private equity, he says. The growth in non-bank direct lending now offers them the opportunity to invest in something else: illiquid credit.
BlueBay Asset Management is one of a small number of asset managers intensely focused on creating illiquid credit via direct lending to small and medium-size borrowers in the UK and continental Europe. Most government initiatives are focused on firms that need to borrow less than £20 million, says Arjan van Bussel, partner at boutique advisory firm Bishopsfield Capital in London. The opportunity for alternative forms of debt finance is with corporates that need to borrow between £20 million and £120 million.
These smaller, often bilateral facilities offer the kind of returns that are a distant memory in the larger, more liquid end of the market, but are not necessarily easy to come by or palatable to all.
Financing SME corporates has been an intractable problem across Europe since 2008. The UK government is one of several that have announced initiatives to tackle what it sees as the persistent reluctance of the banks to lend to these companies. The implications of Basle III capital charges on bank loan books are not pretty and have had a savage impact on the flow of credit to the SME sector. Under the standardized approach SME loans are treated like retail loans on the balance sheet and attract a 75% risk weighting. The implications of this are something that Brussels now seems to be waking up to the latest draft of CRD IV proposes to reduce the regulatory capital charge for bank exposures to SMEs (firms with revenues of less than 50 million) by 24%. But this will not derail the market evolution well under way as banks delever.
After appointing Legal & General chief executive Tim Breedon to chair a taskforce to examine alternative debt markets for these firms, the UK government launched the Funding for Lending Scheme (FLS) last July following the failure of a previous initiative, Project Merlin, to stimulate bank lending. The ill-conceived FLS scheme has so far merely succeeded in subsidizing mortgage lending and has had little impact on bank lending to corporates. Indeed, according to the Bank of England, during the last quarter of 2012 bank lending actually contracted by £2.4 billion ($3.7 billion). Not surprisingly, the banks refute the charge that they have withdrawn from lending to creditworthy corporates and assert that the market is merely normalizing after the excesses of the pre-2008 boom.
High risk investment requires equity or patient capital. Lending from banks is designed for working capital, explains Stephen Pegge, director of SME banking at Lloyds Banking Group and chairman of the small firms advisory panel at the British Bankers Association. In 2006/07 we saw many banks particularly Icelandic and Irish banks lending to high-risk borrowers and anything could get done. This is the type of lending that is no longer possible; the market has returned to normal.
Pegge is a staunch supporter of FLS and says that the scheme will bear fruit in time. Funding for lending has worked. It had to be structured in a broad-based way to avoid any challenge under state-aid rules. It has helped to lower the cost of funding for the banks. Interest rates have fallen, but sometimes it takes a while for the impact of this to be felt. There is always a counterfactual question and there has undoubtedly been deleverage in some parts of the business market. But SME Finance Monitor research shows that 20% of businesses say that they are more likely to finance because of FLS.
Nevertheless, Breedons conclusions, which were published in March 2012, identified a financing gap in the country of between £84 billion and £191 billion over the next five years. For non-bank lenders this is fuel to the fire. We are on the cusp of a structural change in the mid-market, says Graham Delaney-Smith, head of European direct lending and mezzanine investments at London-based Alcentra, a BNY Mellon investment management boutique. The European mid-market is very sizeable between 8% and 9% of global GDP and banks are reducing their exposure to the sector. This is a long-term opportunity as the banks change how they operate and people get used to institutions such as ourselves being there. According to the ECB SME firms make up 98% of all Eurozone companies and employ 75% of its workforce.
Alcentra is one of five asset managers that have set up funds under the UK governments Business Finance Partnership. Under the scheme the state matches funds raised by the private sector to lend to mid-sized corporates. Other asset managers that have been selected are Haymarket Financial, Ares Capital Management, M&G Investment Management and Pricoa Capital. Alcentra raised a £200 million fund last year for UK investments and has also closed a 500 million pan-European direct lending fund. A second group of asset managers will be appointed to the BFP scheme soon.
If the Breedon Report is right, this is still just a drop in the ocean. Van Bussel tells Euromoney that by 2015 non-bank lending in Europe could account for around 40% of mid-market financing. The banks are very much domestically focused and repatriating, concurs the chief operating officer at another firm involved in the BFP. There are a lot of credit opportunities in the mid-market, and we are now fundraising for a vanilla direct lending product. Price has reached an equilibrium. Banks are penalized more heavily, so they have to make the maths work; they are rational creatures. There will be nuances where we have capital available. We are not trying to compete with banks; we want to build relationships and grow assets.
The banks are also keen to emphasise the collaborative nature of their relationship with alternative financing providers. A range of different and varied providers of finance to SMEs is nothing new. In most cases we would regard these forms of finance as complementary to bank lending, says Pegge at Lloyds. But non-bank lending is quite embryonic there is £100 billion of SME lending from the big banks out there; other lenders could never be expected to take the weight of SME financing from the banks.
Small corporates squeezed
Capital markets disintermediation in Europe may be well under way for larger borrowers but for small corporates access to the bond markets remains very limited. If you are a business with an enterprise value of less than 500 million you have no access to the high-yield market and very limited access to leveraged loans in Europe, Fobel at BlueBay says. In the US, the high-yield market is accessible to firms with an enterprise value as low as $100 million. Those smaller companies can also raise debt from many direct lending funds, an active private placement market, business development companies (publicly traded private equity and venture capital funds) and an active collateralized loan obligations market all of which are so far absent in Europe. The process by which European SME companies might move away from dependence on bank lenders is therefore still at a very early stage. In addition to non-bank lending their options include going to the private placement market, the retail bond market or relying on government initiatives. The availability and attractiveness of each is heavily dependent on the size of the borrowing required.
|Implied loss given default rate from data on mid-market loans across Europe and the US 2002-2010|
|Loan size||Nominal recoveries||Default rate||Implied loss given default|
|Syndicated leveraged loans||>200m||81%||8.60%||171bp|
|Recovery rates in Europe|
|Q42008 - Q12011||Q42008 - Q2 2010||1998-2011|
|Loans (predominantly mid-market)||77.20%||77.80%||80.30%|
|Senior unsecured bonds||42.60%||31.20%||45.70%|
Source: BlueBay Asset Management
The cost to credit-starved UK and European borrowers of this type of alternative funding can range anywhere from around 450 basis points to 1,000bp depending on the quality of the company and extent of the borrowing. Fobel believes that for many businesses this is still good value. If you are building a plant and estimate a 30% IRR on it, then it is worth the cost of the loan, he says. The funds can certainly offer more flexibility than the banks.
Paul Bail, managing director at Robert W Baird, says: Non-bank lenders often offer unitranche deals (single loans that are senior/mezz hybrids). These are more expensive, but they are finding opportunity in the deals that the banks wont do. They can be more flexible around amortization and covenants. but they cost: the margin can be between 6.5% and 10%. This is also very flexible capital and some funds can write very large cheques one can go up to £150 million. The typical hold level for a bank is £25 million.
The banks themselves are starting to sit up and take notice. Direct lending started to gather pace this time last year, says one banker at a large UK high street lender. They came to the banks and said: We dont have the infrastructure to do this, so will partner with you in your deals. However, they very quickly realised that this approach is a very slow way to get their business off the ground. They are therefore now having direct conversations with private equity sponsors. He says that these firms are now seen as genuine competition to bank lenders. They now have a real place in the market. They are proper competition. If we are bidding on a deal and we see a unitranche lender coming in half a turn [of leverage] ahead of us, then they will likely succeed. But if were the borrower on a deal in trouble I would still rather have a bank on my side, he says.
As some banks row back, the number of funds looking at doing direct lending will inevitably grow. One of the big myths is that banks are not lending, they are, but on a very restricted basis, says Fobel. But there is an opportunity for people that can play outside that very narrow remit. The returns are very attractive if you can step into that financing gap. You can achieve north of 10% on senior debt in an all-important cash yield. Senior debt default risk has historically been very low and recoveries are more than 60%. This is a very robust asset class and returns are all in cash. If you are a pension fund, the fact that you can get this return profile in senior loans is very attractive.
Not all pension funds agree, however. For some the process of getting comfortable with mid-market illiquid credit will be a long one. Over the last 12 months a lot of people have asked us our view on lending to the mid-market, says an asset manager at a leading US firm. It is a question of whether the market is theoretically there or demonstrably there. The opportunity can be clearly demonstrated at the larger end, but there is a lot of theory in the mid-market. You have to demonstrate that the opportunity is there. When you start a conversation with a pension fund, things do not move quickly, he adds. If from the first conversation to them writing you a cheque takes a year, that is very fast.
This is certainly not an area to enter lightly. Detailed credit work is needed to lend to the mid-market, says Delaney Smith. You need a team for due diligence and to understand credit. He argues, however, that with private equity yielding in the mid-teens and liquid investments 5%, then investors should be looking at this as it offers 10% to 12% and is a combination of both. And Fobel argues that the assumption that if it is a higher return it is higher risk is not always the case here. In the last cycle, mid-market loans had lower default rates than syndicated leveraged loans, he says.
Non-bank mid-market lending is so far bifurcating between two types of fund: event-driven funds looking to provide bespoke lending and more commoditized senior loan funds. The former are being managed by firms such as BlueBay, Haymarket Financial, Ares and Macquarie, while the latter are taken care of by, among others, ICG, Alcentra, M&G, Oaktree and Blackstone GSO. There has been much speculation about the extent to which private equity firms are investigating this part of the market as they diversify away from traditional private equity. The challenge for private equity firms looking to move into mid-market direct lending is, according to the chief investment officer at a BFP firm: What is your proposition? Are you going to source risk? Do you have the scale to make a difference? Do you have enough money under management to charge the fee to lock up institutional money? Individuals have been hired by these firms to look at direct lending. We are hearing about it, but so far we are not seeing it.
Bank dominance of the smaller end of Europes corporate financing market has been expected to ease ever since the financial crisis given the higher capital charges for banks of lending to SMEs. Borrowers that went for the cheapest lender five years ago and now need to refinance are going to be in for a shock, points out van Bussel. The question remains as to how far and how fast non-bank lenders can chip away at this business. But with the UK government now firmly behind the evolution of non-bank finance for small firms there is only one direction of travel.
Fobel at BlueBay argues that the wider implications for the whole market are positive. Shadow banking in a fund format creates no systemic risk. We dont apply leverage, he says. If we do badly only our investors will have lost money. Systemic risk came from the banks leveraging themselves, in many cases exposing their deposit holders, which, as we have seen, causes contagion. The fund format is a very good way of aligning interest with your investors, he adds. It is too early to say if these alternative lending vehicles will be successful, but those with good investment teams, a clear strategy and prudent underwriting principles should be able to take advantage of the current attractive market environment.
Small firms plagued by debt void
In the US, business development companies were created in 1980 as a form of publicly traded private equity. BDC funds are open to small investors and provide capital to start-ups and for venture capital-type opportunities.
Not surprisingly, the large private equity firms are active in the BDC sector, with Apollo, Ares Capital and BlackRock Kelso Capital and Kohlberg Capital all running funds.
There is, so far, no equivalent of the BDC in Europe. But there are certainly signs that private equity firms in the region are looking closely at the smaller end of the market. The Riverside Company is a private equity investor focused on companies with an enterprise value of less than 200 million. In the UK the firm is targeting SMEs looking for expansion capital globally. There are companies out there looking for smart capital, partner Trey Vincent says. I have been impressed by the number of very strong management teams that are bucking the trend. Exceptional companies can fund ordinary companies cant. Vincent explains that these firms are below the radar of most non-bank lenders, which want to do deals between £100 million and £200 million. He therefore reckons that this is an area ripe with opportunity for private equity. It is still more talk than action, but a handful of players will come to the market, he predicts.
The dearth of debt finance at the very small end of the UK market is acute and has driven government plans for a £1 billion government-backed UK business bank to address the longstanding, structural gaps in the supply of finance that were identified in the Breedon Report. Given that the taskforce for this report was charged with identifying non-bank, alternative forms of debt finance for small enterprises it is telling that the solution being proposed is... lending from a state-supported bank. It looks like an indictment of initiatives such as Project Merlin and FLS.
New companies or those wanting second-round funding are finding it very hard, John Williams, managing partner at Kuber Ventures, tells Euromoney.
Kuber Ventures is a private equity-backed firm that specializes in investing in Enterprise Investment Scheme (EIS) portfolios. It launched the first EIS multi-manager platform last December. The EIS offers tax incentives for investment in corporates with a balance sheet no greater than £15 million and with no more than 250 employees. It offers income tax relief at 30%, tax-free gains, full inheritance tax relief and the rollover of existing capital gains. The scheme was launched in 1994 and its terms were changed in April 2012 to increase the size of company eligible for relief, increase the maximum investment to £1 million a year and introduce greater incentives for investment in seed capital for start-up companies.
It is early days for FLS, but the returns so far have been disappointing, says Williams, a veteran of wealth management at UBS, Barclays and Credit Suisse. He describes the lack of commercial funding to small businesses as the elephant in the room that is stifling growth in the UK economy; he views a business bank as a welcome development, emphasizing that there is a complete void in the market on the debt side.
UKs retail bond market still out of reach for many SMEs
Improving access to capital markets financing was a key recommendation of the Breedon Report. In addition to mezzanine loan funds the UK government is also promoting online receivables exchanges and peer-to-peer lending platforms. In March it awarded £5 million to Market Invoice, an online receivables platform; £10 million to Urica, a supply-chain finance platform; and £17 million to Beechbrook Capital to establish a mezzanine fund focused on growth capital for SMEs.
The UK government has also launched a feasibility study into an aggregation platform for SME loans known as the Agency for Business Lending (ABL), which would then sell securities backed by these assets essentially a big SME CLO. The private placement market in the UK is woefully undeveloped, with those corporates that do issue relying on US investors. It also tends to be limited to deals over £50 million in size for firms with turnover greater than £350 million.
The US private placement market prices relative to secondary trading levels on US public securities, says David Cleary, senior director, corporate DCM at Lloyds Bank in London. As these tend to price inside UK public securities, going to the US enables UK borrowers to access low cost long-term debt. The UK private placement market is modest relative to its US counterpart and remains hindered by investment restrictions in place on many UK funds that have to remain in listed, tradable securities. They are therefore prevented from investing in private placements.
Ever since the London Stock Exchange launched the Orderbook for Retail Bonds (ORB) in February 2010 the hope has been that the retail bond market in the UK can become a more robust source of finance for small firms, as it is elsewhere in Europe, particularly in Italy. There have been very small scale exercises in the past such as the £627,000 raised by shaving products company King of Shaves and £3.7 million by retailer Hotel Chocolat.
By March this year the ORB had raised £3.2 billion from 34 issues and four taps, but issuance has been dominated by large firms that already have good capital markets access, such as Tesco, National Grid and RBS.
Gillian Walmsley, head of fixed-income products at the London Stock Exchange, tells Euromoney that this is understandable given the nature of the exchange. ORB was launched to provide an alternative source of funding for firms. It offers companies access to a growing pool of retail investors, many of whom may be new to fixed income. Because of this ORB has initially been developed as part of the main market, not as an AIM-type bond market. ORB requires the highest level of disclosure and transparency so tends to be used by mid- to large-cap firms, she says. This is in stark contrast to the recent development of the retail bond market in Germany, where the five different exchanges have developed platforms for small-scale issuance. It will therefore be some time before the bond market is a regular source of funding for mid-caps and it will likely remain out of reach for smaller firms.
Bonds listed on the ORB are public securities, so the process will probably be too expensive for issuers wanting to raise less than £25 million, says Lloyds Cleary. However, creditworthy SMEs looking to raise such sums will be able to raise it from the bank market. Indeed, it is the liquidity in the bank market that has resulted in many such companies not needing to consider the retail bond market.
Retail investors in Germany have a greater understanding of fixed-income and structured products, explains Walmsley at the LSE. There is also a larger base of SME corporates. She does, however, concede that it is important to diversify ORB issuers. We are targeting mid-caps along with large caps, and there is potential for SMEs. But ORB requires EU regulated market standards of disclosure, and although there are moves to streamline the process and to standardize documentation, this can only reduce costs so far. Currently we estimate that the market many not be economical for issues less than £25 million the combined costs for smaller amounts may be prohibitive.