Funding & Investing

Stuck in the middle with you

Published: Mar 2015

The mid-market corporate community has relied heavily on bank-sourced funding in the past but with a new-found regulation-driven prudency, borrowing is more difficult for such firms. There are newer models of credit in the market and the banks say they are keen to lend, so does the ‘squeezed middle’ still exist?

Baseball stuck in a rain gutter full of leaves

One unintended consequence of the raft of ‘post-financial crisis’ regulations, Basel III in particular, is that the supply of bank funding is becoming less of a reliable option for some corporates. The largest corporates are still a safe bet for them and although small firms have long since been subject to punitive risk-based pricing, they are increasingly able to look to alternative funding sources such as angel investors and crowd-funding. Stuck firmly in the middle of all this are the mid-market corporates – those sitting approximately in the €500m to €1.5 billion revenue bracket – which are seemingly at a funding crossroads.

Whilst many feel the need to keep the favour of their banks to help finance day-to-day operations, the mid-market treasurer will need to work out which of their partners they wish to continue working with. But just as treasurers need to decide where their business will go, the banks are taking the view from the other side of the fence. They want to know that they will be getting a decent slice of the corporate wallet to warrant offering the full range of products. With regulation and negative interest rates placing a high cost on taking in short-term money, banks will not be afraid to say goodbye if the wallet is not forthcoming. Gone are the days when banks lined up to offer cheap money; now it’s all about mutual trust and depth of relationship.

We have the money

Some mid-market firms might feel they are being squeezed but a number of banks are now saying they have the funds to support good quality businesses however the appetite for debt of those firms has diminished. Bank lending volumes in the Eurozone have been falling for around two years, the FT reported in May last year. At that point they were nearly 3% under the May 2012 level. Anecdotal evidence suggests little has changed. One explanation for this is the continued lack of confidence in the markets – no one wants to commit to debt when revenues are so unpredictable. According to S&P Capital IQ stats, net loan issuance to non-financial corporates turned negative in 2012 and remained so throughout 2013. Has this changed in the last 12 months?

“It’s not necessarily a question of a squeezed middle as there’s plenty of liquidity in the lending markets,” says Farouk Ramzan, Head of Commercial Banking – Europe, Lloyds Bank. Where banks have been accused by mainstream media of turning down too many business loan applications, Ramzan points out that whilst an individual bank may have a strong balance sheet it will never be unlimited. “I would much prefer to do business that has continuity to it because it is that type of value-added client business that gets the bulk of our client relationships through any economic down-turn,” he comments. Ramzan further argues that restrictions on balance sheet may in part be an unintended consequence of Basel III. Despite that, he acknowledges that regulation is imposed for a reason. “The challenge for banks is how to own that regulation and work with regulators,” he says. “We need to ask how we can align ourselves with it in a way that allows the best outcome for our clients.”

There is, he continues, “more flexibility out there than people think.” Clients with sufficient funding needs can maintain their banking relationships as well as explore other options open to them with large institutional investors. Increasingly, credit funds are looking to play in the mid-market space via the Private Placement market. However, he notes, a mid-market client may feel “rather vulnerable” if it decides not to have a trusted advisor at its side with a deep understanding of the clients’ needs when approaching large institutional investors. “It is our duty as a bank to look after our client and manage the covenant structure, the pricing and the options on tenor to make sure we can optimise those deals for the client,” he states. “It’s all part of the process of being more accountable to our clients.”

The availability of bank funding is a theme taken up by Benoit Desserre, Global Head of Payments and Cash Management, Societe Generale. The concept of the ‘squeezed middle’ may have existed a couple of years ago, he agrees, but he is adamant that now there are few constraints on lending: bank funding is available but firms are just not increasing their level of borrowing. “This is really a matter of confidence,” he notes, adding that no matter how cheap borrowing is, even if rates are zero, if companies are not confident that their investment will generate extra revenue they will not borrow. “That is a simple economic fact.”

In an attempt to make banks safer with larger capital buffers, their increased regulation pushed them into a position where they had to bring in more deposits and keep fewer assets on their balance sheets. This in turn forced the wider financial community to bring other sources of corporate finance to market. This, notes Desserre, was the genesis of France’s EuroPP market, the growth of the USPP and Schuldschein, and the general expansion of interest in corporate bond issuance.

However, the banks have now moved to a third stage where some central banks – notably the ECB, but also Swiss and Danish to date – have imposed negative deposit rates. This gives the banking system two choices, says Desserre: lend more or change the inflow of cash. Lending has been naturally curtailed by low business confidence so taking cash deposits suddenly becomes undesirable. “We’re still very keen to have corporates manage their cash flows with us; that is for the long term. But the ECB deposit rate is currently in effect a 20 basis point charge on all excess cash. For a short period of time it may not be an issue, but if negative rates recur then it could be detrimental to end-customers if it constrains bank’s ability to lend. I have never seen this before, it is so unusual.”

Indeed it must be unusual because the industry was certainly not ready with the tools to compute negative interest on deposits. With low growth levels almost everywhere you look in Europe, working out how to increase business confidence is a task for the politicians, says Desserre. But in the meantime, he acknowledges that the corporate community will be tightening its collective belt. It will also be looking to other forms of funding.

An alternative offering

As more businesses seek alternative sources of funding, it could be that the mid-cap community no longer needs to rely fully on the banks anyway. Indeed, the range of finance solutions open to ‘quality’ mid-market firms has expanded in recent years. Traditional bank lending has been joined by an increasingly well-trodden path to the debt capital markets, in particular private placements. This model is well established in the US (with roots back to the 1930s) but there is a nascent equivalent market in the UK, Germany (the Schuldschein serves the country’s ‘Mittelstand’ sector of mid-market businesses) and France (Euro PP). Although EuroPP is just two years old, it has already raised more than €7 billion, albeit mostly for French companies funded by French insurers.

Although the USPP is by far the biggest market, even for European companies, one benefit of having a ‘local’ market is that investors will more likely know the companies they are dealing with. If there was any doubt that, globally, these offerings are of interest, S&P Capital IQ figures state that European companies raised around €60 billion on the US and European private placement markets between 2012 and 2013. There is little sign that this is slowing down.

Investors are clearly coming round to the idea that the mid-market asset class is a serious means of diversifying their own holdings. As yields in some traditionally secure asset classes hover barely above ground, pension funds and insurance firms – the institutional mainstays of the PP space – need to find an acceptable return on their ‘buy to hold’ investments. The quality mid-market sector has shown itself to be a useful addition to their lagging portfolios. In May 2014, Deloitte’s Alternative Lender Deal Tracker reported 33 leading alternative lenders as having taken part in 105 European mid-market deals over the previous six economic quarters. Private debt funding, it seems, has an equal appeal for both the institutional investor and the mid-market corporate. With the flexibility now to offer delayed draw-down, firms do not even have to time their approach to the market quite so perfectly.

Getting noticed: mid-market ratings

The word ‘quality’ has purposefully been used above in reference to mid-market companies seeking funding. Objectively assessing a company for ‘quality’ – the strength of its business and financial models and market appeal, for example – involves more than a simple credit check. This is why many large corporates seek a credit rating from an independent agent such as S&P, Fitch or Moody’s, to ease the funding process (and potentially even lower its costs).

Mid-market corporates can do the same but obtaining a rating is quite a lengthy process, involving considerable effort and cost. One of the credit agencies – S&P – believes it has come up with a solution that, whilst not intended to be a credit rating per se, is based on a simplified version of its own corporate rating methodology. Pitched at businesses with group-level revenues below €1.5 billion and total drawn and undrawn reported debt facilities below €500m, the mid-market evaluation rating (MME) “increases the transparency in this sector and provides a common benchmark for issuers, investors and lenders to assess specific credit risks,” says Roberto Rivero, Head of Market Development, EMEA for S&P.

We’re still very keen to have corporates manage their cash flows with us; that is for the long term. But the ECB deposit rate is currently in effect a 20 basis point charge on all excess cash. For a short period of time it may not be an issue, but if negative rates recur then it could be detrimental to end-customers if it constrains bank’s ability to lend. I have never seen this before, it is so unusual.

Benoit Desserre, Global Head of Payments and Cash Management, Societe Generale

Driven by the apparent lack of financial information about mid-market companies, MME is intended to provide investors with a “standardised and objective means” of assessing prospective mid-market borrowers without those companies jumping through the many, varied and expensive hoops of the full rating process.

A firm will be ranked on a range from MM1 (highest) to MM8 (lowest) and MMD (default). The same scale is applied to issuers and to debt instruments, although instrument ratings also incorporate S&P’s view of the expectation of recovery if ever a default occurs.

The rating gives S&P’s views on the creditworthiness of a mid-market company relative to firms of a similar size. It assesses the firm’s capacity and willingness to meet its financial obligations based on a number of data and information sources including annual audited financial statements, interim reports and liquidity status, and also includes a review of governance, strategy and financial policy.

In theory, investors get an independent view of the mid-market companies in which they are considering investing, and the mid-market companies improve their access to investors which may otherwise be off-limits.

Seeking diversity: a corporate view on private placements

How easy is it for a mid-market firm to wean itself off traditional funding sources? As Group Treasurer at Neopost, France-based global leader in mail, communication and shipping solutions, Christophe Liaudon has first-hand experience of just such a re-balancing act. Speaking at last years’ EuroFinance event in Budapest, he explained that in 2012, two thirds of all Neopost’s borrowing was from banks; a year later, bank credit accounted for just one tenth, Neopost having turned to the private placements market in a big way with investors spread across Europe, the US and Asia.

The company, listed on Euronext Paris, can be placed at the upper end of the mid-market sector with annual sales of around €1.1 billion from its direct presence in 31 countries (39% coming from North America). Although it has been dipping into the US private placement (USPP) market since 2003, it saw 2012 as “a year of challenges and diversification” for its finance structure.

It sought a refinancing package of €808m but diligent balancing of bank and private funding saw Liaudon and his team eventually raise €867m, and $270m between June 2012 and January 2013. The team managed to extend average maturities from under two years to more than four, and reduce its average interest rate to below 4%.

Neopost returned to the USPP market in early 2014, securing a further $50m. By June it was issuing its first unrated bond, Liaudon describing this as “a natural next step”, benefitting from an “attractive market” enabling it to issue €350m with a seven-year maturity at just 2.5%. Three months later, back in the USPP market, Neopost established a $140m shelf facility agreement (with a total of $90m drawn from first day and $50m for future drawings). The company’s new debt profile, post-refinancing, extends out to 2022.

Be prepared

The secret to success in the ‘alternative’ markets is to be fully prepared, says Liaudon. This starts with the buy-in from top management from day one. The process, which in most cases takes between four to eight weeks to execute, kicks off by selecting the most appropriate market. A bank that has partnered a business for some time will not only be able to explain and precisely position its client’s credit status to potential investors, it should also know the markets well and be able to help its client “talk to the right investor at the right time.” The usefulness of the banks in this process is undeniable but they are only the intermediaries: as Liaudon says, “we like to keep control of the process and of the relations with investors.”

At an early stage – “the sooner the better” – it will be necessary to select essential third-party advisors, states Liaudon. The list will most likely include key players such as the book-runner (the lead arranger bank or banks), a legal team and an agent (the bank intermediary between the corporate and the various investors). “Proper” selection should consider that “some advisors have deeper knowledge of certain markets.”

Documentation will need to be prepared detailing the business and finance model of the company, its aims, the funding required and its purpose, existing facilities and so on. The loan contract mandate letter (appointing the third parties) and the term sheet (the main contract) will also be drawn up at this stage. As far as contract terms are concerned, equality is the watchword: “most investors are looking for pari-passu,” he states.

Preparation of PP documentation can be laborious but the process received something of a boost in January this year when the LMA launched its template documents, based on English law and incorporating both a loan and a note option, for use in European private placement transactions. Commenting at the time, Calum Macphail, Head of Corporate Private Placements, M&G Investments, said the creation of standardised private placement documents in Europe “will simplify the borrowing process for corporates and has the potential to encourage new liquidity into this market.”

The French authorities, with European agreement, had issued a charter (‘Financing for mid-sized Companies’) in March 2014 for developing Euro Private Placements (Euro PPs) and creating a benchmark market for them, both in France and internationally. Commissioned by Banque de France and the Paris IDF Chamber of Commerce and Industry, it sought to explain how “capital markets can provide a significant share of the financing for mid-sized companies that might be unable to access international bond markets designed for large corporations with agency ratings.”

Preparation of PP documentation can be laborious but the process received something of a boost in January this year when the LMA launched its template documents, based on English law and incorporating both a loan and a note option, for use in European private placement transactions.

Aside from establishing the French Euro PP as a fully-fledged market segment and “a standard of quality for French and international issuers, intermediaries and investors,” one of its chief objectives is to determine a specific execution framework, based on international credit market best practices. It has already produced a model for term loans and in January this year produced a model for bonds. Liaudon believes that this work shows the willingness to cooperate of all the different actors of this market including investors, associations, governments and issuers.

For the corporate borrower in the PP space, whether a first time player or an old hand, Liaudon stresses the importance of establishing a solid relationship with investors from the start. The first contact will likely be the roadshows and Q&A sessions with individual potential investors and making a good impression is important. Thereafter, it is common practice to submit, at least annually, an update on company progress. In the interim it may be prudent to arrange meetings or calls with the main investors “to maintain contact and explain strategy.” Neopost recently secured an extra tranche from one investor on the strength of its communicative nature. After all, he notes, “investors are looking for a long-term relationship.”

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