Funding for European SMEs
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Reinhard Haas, Head of DCM Loans, Eoin Moore, Managing Director, Structured Asset Solutions, Dr. Christoph Thierolf, Head of M&A look at the loan market, asset financing and leasing, and M&A for SMEs
Sources of liquidity now available to small and medium-sized enterprises (SMEs) across Europe are healthier than they have been for many years.
Since the global crisis, plenty has been written about banks paring back their lending activities and more stringent capital adequacy rules limiting funding opportunities, particularly for higher-risk borrowers such as smaller companies.
This is certainly true for bilateral lending. A study by economists Joseph Noss (BoE) and Priscilla Toffano (IMF) from March 2014* points out empirical evidence which suggests that an increase in capital requirements by one percentage point, forces banks to cut their total lending in the short run by 1.2 - 4.5% or reduce credit growth by 1.2 - 4.6%. But at the same time, the institutional need for income streams, ultra-accommodative monetary policy and the European Commission’s agenda to mobilise more sources of funding for European enterprise, means that sources of liquidity available to small and medium-sized enterprises (SMEs) across Europe are healthier than they have been for many years.
Below, we assess the prospects for three core forms of SME funding and how each can be employed to achieve the optimal funding mix
Staying safe in a borrower’s market – Reinhard Haas, Head of DCM Loans
As bond yields turn negative and investors continue to search for yield, some areas of Europe’s syndicated loans market are booming. Schuldschein – the German-originated private debt instrument characterised by its simple documentation - has seen 50% growth in the past five years, according to research by Commerzbank, and is now available in at least a dozen countries across Europe.
Alongside a growing pan-European debt funds market, alternative sources of funding are coming directly from institutional investors such as insurers and pension funds. We are also seeing the emergence of the French Placement Privé Européen, or European Corporate Private Placement, a cross-over product that addresses higher-risk entities while still offering attractive terms. The investor market for the product has so far been limited to French insurers. But a strong appetite among French banks and the French government to expand its use could see distribution open up to a far wider audience.
The range of funding opportunities on the syndicated loans market for SMEs is increasingly diverse. But this comes with its own risks as new entrants look to capture market share. Conversely, some SMEs can find themselves struggling to secure financing because they fail to fit with investors’ or lenders’ expectations.
I’ve outlined below some factors that are key to SMEs achieving fair and realistic financing terms in the syndicated loans market:
• Understand what investors are looking for – Many companies, particularly in the export-focused German, Scandinavian and Dutch markets, are highly global in their outlook not only for business opportunities but also for their funding. But those European SMEs that have remained steadfastly regional may find that they may be less appealing to potential investors and lenders, both in terms of their risk profile and competitiveness. Likewise, family-owned businesses are often unused to the level of transparency and communication that investors will expect before they invest. Being able to provide up-to-date figures and reporting and a clear picture of the company’s strategy and purpose for seeking funding will help an SME access a wider pool of funding opportunities and, potentially, lower the cost of financing.
• Be realistic about how long funding is required – As a rule, the longer the tenor, the more demanding the terms of a financing agreement are likely to be. It can be reassuring to lock down funding for 10 years or more. But unless you believe interest rates are going to be a lot higher in the medium to long term, or you are going to find funding harder in the future for some reason, a shorter tenor will tend to give your company more freedom and be cheaper. Likewise, if you know your company to be a higher risk, the pricing and terms you are offered should reflect that. If they don’t, you should think carefully about it. Any product attempting to offer terms that are substantially out of line with the rest of the market will not be sustainable.
• Seek out funding that’s attractive but also reliable investors – In a buoyant financing environment, borrowers need to be alert to new entrants offering aggressively-priced financing, only to retreat sharply from the market when macro-economic conditions move against them – a trend that has been evident in many European markets during the years following the financial crisis. If reliable, long-term or recurrent funding is a priority, aim to do business with those banks that have a properly resourced, long-term presence in your market, and a solid track record of supporting smaller enterprises throughout the market cycle.
Outlook for syndicated loans pricing
Plenty of factors are set to heighten event risks across markets. But the European Central Bank is unlikely to make any drastic changes to its monetary policy in the short term. So we don’t envisage any sharp change in pricing, or any decline in investor appetite for opportunities to lend.
Indeed, lending to European SMEs could be the single-strongest growth area for debt capital markets over the next few years, as international banks seek greater penetration into this still largely untapped market.
For SMEs seeking competitive funding, that’s good news. But prudent appraisal of the opportunities on offer will remain essential.
*Source: Estimating the Impact of Changes in Aggregate Bank Capital Requirements During an Upswing, Bank of England Working Paper No. 494
Complementary funding for asset financing – Eoin Moore, Managing Director, Structured Asset Solutions Team
Lease financing, alongside bank lending, has long been a complementary source of funding for SME capital expenditure requirements. However, in recent years, leasing appears to be becoming an increasingly important financing source. Research undertaken by Oxford Economics in July 2015 indicated that over 50% of European SMEs surveyed used leasing, up from approximately 40% in 2010.
A key factor in the increased use of leasing is that it remained a reliable source of financing in the years following the financial crisis. Although availability of bank lending has now improved significantly, evidence indicates SMEs increasingly see the value in diversifying their sources of finance.
Attractions of leasing
Leasing is a valuable component of the financing mix for a company of any size. However, it offers particular appeal for smaller companies in need of financing and cashflow flexibility as they seek to expand their businesses. Some of the key advantages for SMEs include:
• Availability – Underlying asset security means lessors can provide funding to companies when other lenders may not be able to, or provide financing on more attractive terms than other lenders. This is particularly relevant for SMEs, who often have limited credit history. In addition, leasing can be used to finance most assets and has a high degree of flexibility in terms of deal size with possible transaction values as low as €1,000.
• Optimisation of cash flow and working capital – Leasing provides funding for 100% of the acquisition cost of assets. Borrowers then repay the financing over the life of the asset, which can be funded by revenues generated by the equipment. This provides smaller companies with increased capacity to undertake the investment needed to drive the future growth of their business.
• Security of funding – As longer term committed funding, SMEs often view leasing as a more secure source of finance for their investment needs than overdrafts or bank facilities that may have a shorter term.
• Transfer of asset risk – Operating leases and contract hire provide a cost effective solution for SMEs that require the use of an asset for a period shorter than its useful life, removing concerns of asset ownership. Additional services such as maintenance and insurance can be included covering all of a company’s asset related needs, which can be very attractive for smaller businesses.
SMEs can access leasing via the vendor channel, the branch network of banks and lessors or through a broker. Banks remain the key providers of lease financing to SMEs, either directly or via the vendor channel. However, independent leasing companies are playing an increasingly important role in the SME market. Financing conditions for these independent lessors have improved in recent years, which is enabling strong growth in this market and increasing the availability of leasing options to smaller businesses. As an example, Commerzbank has recently provided structured financing facilities to a number of independent lessors in the UK, which has enabled these companies to accelerate the expansion of their lease portfolio and provide significant incremental finance to UK SMEs.
A complement to bank lending
Leasing is not necessarily a substitute for bank lending or the loans market, but a highly flexible complement to it. By determining which assets can be acquired through leasing, a firm can make optimal use of its cashflows and reserve other funding channels for working capital and other financing requirements. The role of leasing as a highly valued financing tool for SMEs is expected to continue to grow.
M&A - a buoyant market for funding acquisition - Dr Christoph Thierolf, Head of M&A
Global merger and acquisition activity in the first half of 2017 witnessed an 8.4% increase to US$1.5 trillion versus the same 2016 period. And, even being lower than the year before, 2016 marked already the second highest year since 2007. The bulk of this activity was at the larger end of the market. However, mid-cap and small-cap M&A activity is still in evidence as companies seek to take advantage of cash-rich balances sheets, ultra-low interest rates and access to more sources of funding.
Smaller unlisted and unrated companies typically look to fund acquisition principally with cash. But if there’s not a sufficient surplus on the balance sheet, there are plenty of alternatives for SMEs with a strong growth story and solid cashflow projections behind their M&A plans. For example:
• Revolving credit facilities (RCFs) - Typically provided by an SME’s relationship bank, an RCF is usually offered for a five-year term. It offers the most flexibility of any funding solution and is attractive for deals where debt can be repaid fairly rapidly. RCFs are often used in combination with other types of debt such as private placements, where a company wishes to stagger its debt repayments.
• Private placements – A private placement is an option for transactions in the €25-250 million space, where capital may take for seven years or more to repay. Private placements with tenors in excess of 10 years will require a financial covenant, but using standard structures such as Germany’s Schuldschein model are available without that feature for better risks, keeping it very straightforward.
• European debt funds – Debt funds have been introduced as part of the EU’s Capital Markets Union (CMU) project to mobilise greater diversity of funding for European enterprise. They allow alternative investment funds (AIFs) to originate loans without the need for a banking licence. As pension funds and insurers struggle to generate the yield they need from traditional bonds, so debt funds have found a highly interested investor audience. Moreover, they can cover a range of loan assets and deal sizes, from senior to mezzanine debt, revolving credit to securitised loans.
The optimal funding solution needs to balance the potential rewards of the planned acquisition with an appropriate level of risk and debt for the acquiring company. In particular, corporates need to be very mindful that any debt keeps them within the levels of gearing expected for their sector.
A positive outlook for M&A funding
Despite the potential volatility in currencies, commodities and capital markets that could ensue, the positive environment for M&A is likely to continue through the second half of 2017 and into 2018 as companies shrug off ongoing economic uncertainty to pursue their strategic goals.
The M&A lifecycle is also evolving. Once it was the case that a company was expected to grow for a period before opening up its chequebook. Now, in a fast-moving digitally-driven environment, the market is comfortable with even young start-ups seeking alliances at an early stage of growth – whether to enable them to buy in innovation, offer new products, or enter new markets. This is true of traditional sectors like engineering as much as IT or fintech, as companies across every industry look for the innovation that will help shape future growth.
For the European SME sector, the interest among investors to finance strategic acquisition is strong and is well supported by initiatives by the EU’s CMU initiative. That hasn’t necessarily relieved the pressure on companies to convince the market of aggressive synergies or payback periods to justify their M&A activity. But it does mean that SMEs will continue to find plenty of funding options for imaginative, prudent and well-thought out acquisitions.