Corporate cash reserves are at record levels yet for many companies seeking funding, the world has changed to one with less certainty but more options. Why has this happened and what does this mean for treasurers?
It is well-understood that some corporates are sitting on vast stockpiles of cash. But the truth behind this is that the list of the super cash-rich includes mainly the largest companies – to the extent that the Pareto Principle (the 80/20 law) almost fits to a ‘T’. Deloitte has reported that 75% of cash reserves in EMEA (in the region of €1trn) are held by just 17% of the region’s corporates.
This trend broadly replicates corporate cash concentration worldwide, with approximately one third of the world’s companies holding 80% of its $3.5trn corporate cash reserves. That the cash is held in such imbalance explains why most corporates still have to worry about their funding mix rather than self-financing projects, acquisitions and growth plans.
Where are we now?
“Since the financial crisis, companies have generally been more conservative in funding themselves,” Richard King, Head of UK Corporates and Debt Capital Markets at Bank of America Merrill Lynch (BofAML) recently told Treasury Today. “They saw what happened during the crisis, with credit markets grinding to a halt, and there has since been an increasing desire among corporates to boost their liquidity, even to the extent where they’re sometimes overfunding themselves.”
Caution, it seems, is now the name of the game for most corporates anxious to avoid the pitfalls of a funding crisis. With banks constrained by regulation (notably the capital adequacy measures that are part of Basel III) and the continuing low- and even negative-yield environment showing no signs of abating, they have every right to feel on edge. As Sean Hanafin, Head of Corporate Coverage, UK & Europe at Standard Chartered says, the current flow of regulation is “a direction of travel rather than the final destination”.
The wariness displayed by some corporates has manifested itself in the nervous pre-funding of maturities, for example. Where companies know they have a maturity of a bond or loan coming up, in the past they might have waited only 12 months before the maturity, whereas now they’re typically going to the markets and funding them a lot earlier. With debt costs low, management at the very least will silently approve the cost of carry of pre-funding. It is seen as a ‘better safe than sorry’ approach in an environment where, since the crisis, most – if not all – of the banking sector has been downgraded, and absolute guarantees of funding no longer exist unless a business pays heavily for the privilege.
The banking industry is facing long-term structural changes through regulatory initiatives. The industry as a whole is certainly benefitting from additional governance as banks are required to put aside significantly more capital for every pound they lend. “Banks are seeing the impact of Basel III in terms of shareholder and client relationship returns. This is impacting banks’ behaviour in terms of how they work with corporate clients.” Regulation is therefore likely to act as a floor on loan pricing and an appetite ceiling in terms of the amount of credit that banks will be prepared to provide for customers.
This view is supported by Clive Gregory, Head of Strategic Finance at Bank of Tokyo-Mitsubishi UFJ (a member of global financial group, MUFG). “In short, the requirement for banks to hold more capital results in a cost that, if not passed on, will reduce returns,” he says. Indeed, Gregory notes that the rules regarding the tightening of regulatory capital have impacted some businesses more than others – for example companies further down the rating scale and for long-term derivative positions. This, says Gregory, may result in the increased ‘Americanisation’ of the provision of funding for BB lending, driven by funds, some of whom are not regulated. To date, strong competition and excess liquidity in the bank market has meant that in the lending business these increased costs are largely not yet being fully reflected in loan pricing. For banks to achieve their hurdle returns, it is necessary to have non-lending ancillary business, for example transaction banking, DCM and cash management. The focus on multi-product relationship banking for clients is potentially a good thing for treasurers but, warns Gregory, it will place the emphasis on corporate share of wallet, of that there is no doubt.
In this respect some corporates operate with quite sophisticated analysis models to ensure they are apportioning the right level of business (or at least allowing the opportunity to pitch for that business) based on each bank’s capabilities, keeping everyone happy. Conversely, there are those who have adopted a ‘legacy’ model based largely on habit. These companies might not necessarily be forging working relationships with a broader selection of providers which can either be seen as commitment to the few, or adding risk by not seeking diversification.
Us and them
There is, of course, a fundamental difference in corporate funding between the US and Europe that sees European companies rely “far more heavily” on bank lending, says Kira Brecht writing on CME Group’s Open Markets resource. Overall, she notes, “some 80% of corporate debt in Europe is in the form of bank lending, with just 20% coming from the corporate bond markets – almost the inverse of the US.”
The gap is explained through deep-seated cultural “suspicion” of risk-taking entrepreneurialism and “Anglo-Saxon capital markets”, and structural differences between the banking systems of the US and Europe (Europe being driven by a series of national “champion banks” and a strong local network). In the US banks are more than willing to securitise or sell on their loans to the (“much better developed”) institutional loan market whereas European banks tend to keep loans on the balance sheet. Cross-border fragmentation of capital markets in Europe also saw the US gain much ground here, although that gap is closing fast, says Brecht.
Differences aside, the reality is that banks are still prepared to underwrite large loan transactions for the right clients (harking back to Gregory’s point about share of wallet). In fact, loans remain a staple source of funding for European businesses. Their share of total financing may have fallen since 2008, but volumes have remained far more stable over the past seven years than other types of funding. Given their inherent flexibility and private nature – and the cultural emphasis on this form of borrowing – loans will likely remain a strategically core funding component for European businesses for some time to come.
But mounting uncertainty, prudent counterparty risk analysis and the subsequent desire to diversify funding sources has seen a shift on the corporate side. Corporate treasurers have effectively been obliged to investigate and re-evaluate their own capital structure – for day-to-day and strategic business – as a result of funding market changes (not least as some major relationship banks have withdrawn their presence from certain regions). The SME end of the spectrum is having to adjust and become more responsive to banks because of the pressure on cost and availability of funding (and relative lack of alternatives), says Hanafin. But he notes the larger corporate player, with its broader wallet placed with its banks, its existing access to the alternative markets and, by and large, its higher rating, “as seeing a lessened regulatory capital impact”.
A moving target
Of course, there is a difference between the relative weights of a typical US mid-cap and its European counterpart, explains Hanafin. The US mid-cap is often a larger concern and more likely to access the DCM for its term debt needs and use the banks for working capital. “What we see in the US, we will increasingly see in Europe, albeit over the medium term.”
To find the optimal capital structure, it is helpful for treasurers to have an understanding of available debt instruments and their relative capital consumption, says Gregory. Similarly, understanding how banks assess their share of the overall wallet – now seemingly a vital constituent in safeguarding funding in the first place – will help treasurers in their assessment of bank relationships. The market is constantly changing and in that context capital structures should be re-evaluated on an ongoing basis. This will include decision-making regarding corporates’ desire to increasingly diversify funding sources where needs are large, and decisions regarding their holdings of cash – in spite of the low yield – because of the value of liquidity.”
With low interest rates causing investors to search for higher returns, additional liquidity is readily apparent in the alternative markets. Where previously bank lending was the default (in Europe at least), companies are now edging towards options such as bond issuance, equity, private placements (mostly the US but with a growing European scene) and direct investments as their funding pathway.
For corporates with a solid credit profile, access to funding from the bank, public and private markets is strong, and available at historically low rates. Not all corporates are strongly rated or rated at all though and a broad spectrum of funding sources should be considered. In fact, diversification of funding to ensure an optimal balance sheet is or should be part of the natural evolution for all corporates as they develop and grow, again, not least because sometimes a particular market for borrowing may not be available or suitably priced at the time the money is required.
Corporates need to be constantly up to date regarding what the relative benefits of different funding sources are – and these change from day-to-day, warns Gregory. Consideration must be given to the optimal structures at a particular time in the market and questions must be asked regarding execution to ensure financing deal success.
Be flexible
There is clearly more corporate flexibility in terms of funding sources and the funding mix has changed over time as options increase. It is difficult to generalise on the extent of this change, but for high grade corporates the public debt capital markets have developed to be the market of choice for longer-term financing, notes Gregory. The bank market still plays an important role in providing RCFs, medium-term debt and bridge financing but the treasurer’s funding toolbox may develop to include, amongst other things, secured, unsecured, syndicated, private placement, unrated, rated, CP, local and international debt markets, hybrid capital and convertibles (vanilla, synthetic and mandatory), as well as sukuk (Islamic bonds), and M&A focused sponsor-backed deals. The key is to understand the available products, that each will be relevant at different times for different purposes and what the market is doing at any given time.
The pools of capital and the structures that are available are constantly changing. Banking partners should be able to demonstrate an understanding of current market trends by making appropriate loan products available for their clients. Every bank should have a market where it is bringing something different to its clients. By way of example, Gregory comments that just as a Germany-based bank will present the case for Schuldschein, MUFG – as a global bank with Japanese heritage – has had considerable success developing the ‘Samurai loan’ market for its EMEA clients. The total market has tripled in volume since 2010.
Here, yen-denominated cross-border syndicated loans are made accessible to non-Japanese firms, in essence bringing corporates together with the deep pool of financing from regional Japanese banks. Deep pools mean relatively lower costs and an investor base more willing to consider lending to unrated or unlisted borrowers. Aside from being a source of funding diversity, although there will be a cost involved, it could even be cheaper to access finance from the Japanese domestic banks and then swap it back into the preferred major currency.
The Asian capital markets are seen by Hanafin as a more interesting and active space for corporates. Most notable for him are onshore Renminbi (RMB) bond issuances (colloquially known as Panda bonds). The first date back to 2005 but with market liberalisation (starting in 2010) lifting the restriction of the movement of funds raised, more activity has been noted. It is now worth around $7trn and is the world’s third largest bond market. “If you look at funding costs on a swap basis – swapping back to euro, for example – it is actually cheaper today for many corporates to borrow in RMB than it is to borrow in euros,” he says, adding that although corporate access from the West is currently “minimal”, this is changing.
Hanafin notes that once accessed, the onshore market becomes more amenable. Indeed, he points out that automotive firm, Daimler, has been back at least twice (its first in 2014 was a RMB500m issuance at 5.2% – the first non-financial to access this market) and now has a name that Chinese investors know and like. What’s more, he states that the Chinese authorities are “very keen” to have more Western multinationals issue, and have made a firm policy decision to open up their bond market to European and US corporates. He feels that onshore RMB issuance for general corporate purposes is now “becoming a more straightforward path”, with offshore repatriation of funds no longer a stumbling block. With “significant pockets of liquidity” available, Hanafin sees a Chinese, and in fact a wider Asian private placement market, as an entirely feasible next step – with all the benefits of funding diversification that this brings to the corporate community.
However it develops, there may not necessarily be any first-mover advantage in a market such as China. Hanafin suggests that there will be a lot of attention focused on newcomers because all parties will be keen to ensure a smooth process. What’s more, both investors and issuers will be seeking solid reference points for future pricing.
At the more leveraged end of the market, structures have developed in the last year. For example, the growth in EMEA of TLB or term loan ‘B’ (long-term loans made by institutional investors) and so-called ‘cov-lite’ (covenant light) deals (minus the usual lender’s covenants). These structures generally are safe and rational. “The challenge is to make sure the investor base or banks supporting the instruments understand them,” says Gregory. “With cov-lite B notes, for example, investors have less protection in the form of covenants, but as there is a removal of the trigger that a covenant provides, the likelihood of default falls. As a result, investors are buying better-rated paper but the paper has less protection.”
Banking on alternatives
“It is increasingly important for corporate treasurers to consider multiple funding sources,” says Hanafin. Of course, post Lehman, the market regulators are focused on preventing financing structures that are considered overly aggressive. If investors start to doubt the integrity of what they have, it could lead to a systemic loss of confidence. What is important for treasurers in this light is that their banking partners are able to advise on, and execute, the optimum product-agnostic financing solution.
The sophisticated corporate treasurer should be constantly assessing optimal financing solutions as they become available. This quest must not be limited to the bank market solutions – discussions should cover a broad range to ensure companies are achieving lower costs of funding, funding diversity, duration and the appropriate matching of cash flows to liabilities. This means keeping a weather eye on market changes and seeking out new sources – as the vast Chinese bond market opens up, it would be remiss not to at least investigate such a deep pool of liquidity. As Hanafin observes, “it is not something that needs to develop, it is something that needs to open up to Western corporates and this decision has now been made”.
Generally, there is competition between banks and the alternative funding sources but in the high grade space, the available financing solutions are often broad, complex and mutually complementary. A typical M&A financing structure, for example, may involve a bank bridge-loan being refinanced through the public capital markets. For more leveraged businesses, there has been an increase in both the TLB market and a significant increase in non-bank lending. Again, these should be seen as complementary to traditional bank lending and it is important that banks structure deals around all these developing markets. There is a kind of cross-feed between markets too. Acquisition financing is capital-friendly for banks given that it is short-term, and as such they display a willingness to lend into M&A situations. Corporate ‘takeouts’ can drive bond volumes. Indeed, the FT said earlier this year that M&A have become “a significant driver of corporate bond supply since deal activity accelerated in 2013”.
Of course, the bond market never stands still. “The bond market has significantly matured over the last few years and this development has made it more flexible and accessible for companies,” says BofAML’s King. The Euro Medium Term Note (EMTN) programme, for example, facilitates the raising of relatively small amounts of money at very different tenors with individual investors or a group of investors on a regular basis. This allows companies to be more targeted and flexible in their financing – they don’t have to go out and raise €1bn from the bond market; they can raise €100m or €200m via a private placement.
A private view: Port of Rotterdam
New regulations may have changed the funding space forever, but for Tim De Knegt, Treasurer for the Port of Rotterdam, the banks have always included terms in any contract stating that, should any regulatory issue incur any expense, then they reserve the right to increase financing fees and push those through to the client. “Up until a few years ago that never actually happened.” However, with the advent of Basel III liquidity ratios, the banks are finding “all sorts of reasons” to increase their pricing.
In this respect de Knegt is not entirely cynical. “I believe that they are simply pushing through the costs rather than ‘cost plus’. But they are all so opaque about pricing, so it is very difficult to know what they are really doing.” The banks’ lack of transparency, he notes, also makes it very difficult to have a sensible conversation about it. Although he suggests that banks lack clearness about all their pricing, in terms of the regulatory pressure he argues that if he knows why prices increase he can make a point to the regulator about the effect of their actions on the corporate community. “But there is no way for me to help them if there is no transparency.”
Whilst at the hands of regulatory change funding accessibility issues may have arisen for certain corporates, De Knegt notes that even for a major corporate it can now be more difficult to secure any sort of committed funding, but then relying on uncommitted lines is a big risk as it is not easy to know which banks will have the funds available when they are needed.
Re-evaluate
In light of this, Port of Rotterdam has continually re-evaluated its funding structure for the past few years. With several financing options taking it through to early next decade, De Knegt’s treasury is currently making sure it is ready for different markets so that by the time his current financing matures and he is looking for the next round, he is ready to move. To assist this process, De Knegt has presided over some policy alterations to allow not just for different forms of financing but also, given the wider impact of Basel III, different liquidity and cash management products.
Funding used to be quite straightforward for Port of Rotterdam. As a major global port it requires massive investment to sustain its position in the market. Historically, it would head straight to the European Investment Bank or a Dutch commercial bank and quite easily raise up to €1bn just from one institution, recalls De Knegt. The credit crisis and the subsequent regulatory response stopped that and, aside from the fact that it is now much more expensive to get a committed line for a longer period, it is also “incredibly difficult” to get the volume as well, he comments.
Even with its strong credit quality (Port of Rotterdam is unrated but about 70% owned by the Municipality of Rotterdam and about 30% by the Dutch government), securing more than €150m per bank, especially from a European bank, is today “almost impossible”. And for most corporates, unless they are prepared to have a large consortium of banks syndicate a major funding requirement, then other sources will be necessary.
Seek other sources
But even with ten banks providing him with a current €1.5bn of outstanding debt, De Knegt looks to other sources. Until recently, he says he would only use syndicated and direct bank lending. But now he is able to look to alternative sources. These include the bond markets and private placements in the US or anywhere else he feels is appropriate. “I have completely broadened the scope of potential sources to be able to go into any market so as not to restrict my options,” he states. “You never know which market will be open and attractive at the right moment so I need to give myself every opportunity to make sure I can give the company the best deal, knowing that right now the banks are not necessarily offering optimal funding solutions.”
Although Port of Rotterdam remains unrated, it has been through the analysis process for its own benefit. This, De Knegt thinks, gives it a head start when the time comes for it to consider an independent rating. Indeed, from a bond issuance perspective, it already has all the facts and figures in place explaining its story and enabling the credit rating agencies, banks and other stakeholders to know what to compare it with. “It is better to carry out this preparatory work at least a couple of years ahead of time, than to be forced to do it three or four months prior to a first issue.”
Having done the preparatory work, the ratings project is on the back-burner for a while, at least until it is needed. It is, says De Knegt, an expensive process that commits the business to a whole new structure of information provision. Whereas currently the business is sharing this information privately with trusted banking partners as part of a relatively simple discussion, a rating requires him to give that information to the rating agency and allow it to sit in judgement over certain processes and even contracts, for example.
Furthermore, the company needs to ensure all senior executives understand exactly what is expected of them, whereas bank financing does not require such ‘en masse’ involvement. Additionally, there is some internal concern that the business will start to be “steered by the rating agency instead of being guided by the shareholder perspective”. Nonetheless, with a private rating of sorts in the bag, he feels that Port of Rotterdam is ready to strike when the moment is right.
The US private placement market has also come into its own over the past few years – it has become incredibly stable, and it remained open throughout the crisis, which is not always the case in the public bond market. Similarly the Schuldschein bond market, with claimed low cost and quick issuances (because they cannot be listed on stock exchanges) is gaining more traction as a debt-financing instrument even beyond its German heartland for mostly medium-sized companies. Although not strictly a debt security, the floating or fixed debt instruments typically have a two- to five-year lifetime with lending volumes ranging between €10m and €100m.
This flexibility helps corporates tailor their funding needs to their specific circumstances, with the competitive pricing and long-dated maturities these markets offer. Many corporates need a quantum of debt that can no longer be supported by the bank market, or they want the higher flexibility that bond markets give them. In the past couple of years, with pricing so low, corporates are thinking if there’s ever a time to start financing in bond markets, it’s now. Low-cost air carrier Ryanair’s debut unsecured Eurobond in 2014 is a good example of this. For an airline to do a senior unsecured issue was ground-breaking in itself. The 1.875% fixed-rate coupon it achieved for €850m of BBB+ debt was even more impressive.
The bond market has significantly matured over the last few years and this development has made it more flexible and accessible for companies.
Richard King, Head of UK Corporates and Debt Capital Markets, Bank of America Merrill Lynch
Besides this evolution of the bond market, the low-yield environment tends to make bond financing more attractive than bank financing in many cases. Interest rates are extraordinarily low and will probably remain low for the foreseeable future, and as a result companies can raise funding very cheaply and for very long tenors. Corporates can get 10-20+ year money at very low rates with all-in coupons of 1-4% depending on the credit rating. This is much better than getting shorter-dated money from the bank market, which is generally a five-year market. Bond financing gives corporates much longer-dated money, allowing them to lock in longer-term rates at very cheap levels. This is clearly an appealing proposition that has boosted the corporate hybrid debt market which, in the current low-yield environment, could be seen as a form of cheap equity.
In the shorter term, low interest-rates are also stimulating the commercial paper (CP) market, which, though flagging previously, reached an 11-month high in the US in November 2014. “In the current low-yield environment, the Group can issue CPs at very low rates,” said Brice Zimmerman, Head Treasury Control and Reporting at Novartis. “Also, reflecting the high liquidity in this market, CPs are an attractive source of short-term liquidity that offers a high degree of flexibility as it can be repaid quickly.”
Stay alert
Despite the increasing popularity of debt capital market financing, bank loans remain a core part of most corporates’ funding mix, and the competition between banks (and others) to lend to corporates is intense. It is clear that there are a number of banks from across Western Europe, Asia and the US that have been keen to grow their loan books, and as a consequence, the broader loan market has become increasingly competitive. This is seen not only in price or terms, but also in the amounts each bank is prepared to hold in an individual transaction.
In the coming months, the financing markets of EMEA are expected to remain open, liquid and competitive but they will be subject to change. It is well documented that the region’s lenders face numerous headwinds – the slowdown in China, the aftermath of the Brexit vote, ECB liquidity, negative interest rates, and so on. In reality, such headwinds have always been there in one form or another and the industry is well-versed in adapting to the challenges they present. Corporate treasurers should not wait until they need funding but instead regularly take advantage of this experience to really find out which way the market is headed. No two corporates are facing exactly the same circumstances and as policies and sensitivities vary, Hanafin is keen to reiterate the paramount importance for all treasurers of managing their funding risk. “Banks will remain a core part of any capital structure but I think we will increasingly see alternative forms of capital be adopted.” The bottom line is that all treasurers need to be fully aware of their financial alternatives.
