COVER STORY: ALTERNATIVE FINANCING
By Laurence Neville
Small and medium-size companies are vital to economic growth and critical to corporate supply chains. Yet traditional lending is virtually closed to SMEs in most markets—certainly in developed markets of the West. However, a host of new markets and investors are starting to open their doors to SME funding—often through unique channels.
With bank lending slowing and capital markets closed to all but large corporates, small and medium-size enterprises around the world are in desperate need of new sources of funding. Given how important SMEs are to the global economy, the credit crunch they are experiencing is more than one sector’s plight. Should financing continue to tighten, it could have a huge impact for SMEs themselves, for economic recovery and growth, and for the stability of global corporate supply chains.
A number of new investors and new funding avenues are beginning to take up the slack—from private placements to asset-based lending and from retail investors to dedicated SME investment funds. But whether these alternative financing channels can kick-start SME growth remains to be seen.
SMEs are well-recognized as the foundation for economic growth: Mom and Pop firms in the US and family-run Mittelstand companies in Germany both account for around 50% of their national GDP. The well-being of SMEs is the clearest barometer of the global economy, and tight SME lending has huge implications.
“According to data provider Syscap, 34% of SMEs are delaying investment because of a lack of available credit,” says Anthony Fobel at investment firm BlueBay Asset Management. Fobel was hired by BlueBay in October 2011 to launch a private SME direct-lending fund. Not only does this failure to invest have negative implications for the companies concerned, stultifying their own growth: It consequently affects employment levels, having a knock-on effect on broader economic growth.
Plus, SMEs are key links in global corporates’ supply chains. Any risk to suppliers presents a risk to their large corporate buyers. Supply chain disruptions and production slowdowns mean increased expenses and lost revenue.
Other than macroeconomic conditions—which are clearly far from ideal—the main factor determining SMEs’ ability to prosper is the availability of finance. Traditionally, a large part of SME finance has come from commercial banks: around 30% in the US, and the vast majority in Europe. The five largest banks in the UK are responsible for more than 90% of lending to SMEs, for example.
The global political rhetoric on bank lending since the financial crisis began has been consistent. Lending is essential to secure recovery, and banks—especially those that benefited from state support—have a national obligation to provide it. However, even where government support for major banks has been explicitly tied to lending, the reality has been disappointing: Lending is lower than before the crisis and is continuing to fall.
In the UK, for example, major banks were forced to pledge to lend £76 billion to SMEs. However, analysis by Citi economist Michael Saunders found that while the target should be met in terms of the availability of funds, overall outstanding credit is still dropping. He found that credit extended to nonfinancial firms has fallen by nearly 4% year-on-year and net lending to SMEs was down 3.3% over the same period. “We suspect banks are meeting their targets by making credit available at a price and on terms that few firms can afford,” Saunders says.
BALANCE SHEET PRESSURE
The challenges facing SMEs are getting worse. Steve Curry, founder of structured finance advisory firm Bishopsfield Capital Partners, says that funding will be constrained well into 2012.
Cooper, National Grid: There is strong demand from retail investors for inflation-linked products
Fobel at BlueBay explains that many banks are tackling their high levels of nonperforming loans. At the same time capital regulations such as Basel III could result in banks’ needing to raise approximately 500 billion euros, equivalent to their reducing their loan books by 15%—according to J.P. Morgan figures cited by Fobel. The challenge is exacerbated by “a wall of maturities” to be refinanced, with J.P. Morgan estimating 140 billion euros by 2015, adds Fobel.
The fall in lending volumes is not uniform. Large corporates continue to have access to a range of sources of credit, while consumer credit has also partly returned. “But SMEs have been left out,” says Jason Carley, chief investment officer at RiverRock, an alternative investment firm that lends to European SMEs. “While it’s true there is a cyclically lower demand for capital in recessionary conditions, the duration of the current crisis and its impact on bank balance sheets has cut availability of funding for SMEs that desperately need it.”
Even during the best of times, capital markets offer limited opportunities for SMEs, but conditions—especially in Europe—have worsened. August was the first month since the inception of the euro that no euro-denominated bond was sold for an entire calendar month. “For sub-$500 million enterprise value companies, there is no access,” explains Fobel. Larger corporates unable to raise funds in the capital markets are compounding the challenge facing SMEs by sucking up what limited bank liquidity there is.
Nawas, Bishopsfield: The US private placement market offers access to smaller borrowers
However, there are alternatives to the public bond markets. The US private placement market serves large firms but also offers access “to smaller borrowers who would not get favorable credit ratings from rating agencies due to their small size,” explains Mike Nawas, founder of Bishopsfield. Private placements are feasible from as little as $25 million, making them a realistic option for SMEs.
“Liquidity—size and frequency of issuance—is less important than in the public bond market,” says Curry at Bishopsfield. Maturities stretch from five years to 30 years, and most issuance is senior-unsecured. Private placements are flexible, callable and simple, with no ratings or SEC registration required.
The depth of the US private placement market means it is open to borrowers worldwide. By the middle of 2011, European companies had raised $11.9 billion compared with $9.95 billion for all of 2010, according to Bank of America Merrill Lynch. Moreover, private placement investors have been willing to buy bonds even when the macroeconomic backdrop has been unfavorable.
For example, Irish insulation company Kingspan successfully sold $200 million of 10-year senior loan notes in August, when European investors would have balked at a deal. “The transaction was three times oversubscribed, and due to strong investor demand the placing was increased from $125 million to $200 million,” says Geoff Doherty, Kingspan’s chief financial officer. “It improves our capital structure by lengthening our debt maturity profile at very competitive interest rates, and it affords Kingspan significant financing headroom.”
GERMANY’S SCHULDSCHEIN MARKET
Across Europe there exist pockets of nonbank lending. In Germany, the Schuldschein market of unregistered, unlisted, tradable loan agreements provides funding for corporates and other borrowers. “The corporate Schuldschein loan market has proven robust despite volatile bond markets,” says Sven Kreitmair, co-head of corporate credit research at UniCredit. “Since Schuldschein loans are hold-to-maturity products, the market is less volatile than the corporate bond market, which is reflected in lower spreads versus comparable bonds traded on the secondary market.”
"There are a vast number of companies in Europe that are successful and have viable business models but need debt to grow or refinance"
— Jason Carley, RiverRock
UniCredit estimates 2011 Schuldschein issuance will total 5 billion euros, with deals dominated by larger (mostly unrated) Mittelstand firms with good credit standing. Recent debutants have included larger names, such as HeidelbergCement—the world’s third-largest cement company—although companies with consolidated revenues above 200 million euros can access the market. Transaction sizes range from 20 million euros to well over 1 billion euros. The market is undoubtedly a boon for German borrowers—and a small but growing group of international issuers—but the Schuldschein is unlikely to be a model for the rest of Europe.
UK’S RETAIL BOND INVESTORS
In contrast, in the UK there have been efforts to develop a London Stock Exchange (LSE) retail bond market to fund companies. In September, UK power utility National Grid sold £275 million of index-linked retail bonds—a much larger deal that anticipated. “There is evidence of strong demand from retail investors for inflation-linked products to protect them from certain effects of inflation, and we hope that this product will address some of that demand,” says Malcolm Cooper, global tax and treasury director at National Grid.
Eden Riche, head of debt capital markets origination at Investec, says that “low interest rates and early-adopters have shown that this market can function,” and he expects further growth. Some market observers anticipate as many as 20 new issues in 2012. However, the UK retail bond market is not about to fill the gap left by the fall in bank lending alone: Just six new bonds have been issued since the LSE’s order book for retail bonds launched in February 2010, while secondary volume remains below expectations.
DIRECT LENDING FROM INVESTMENT FUNDS
For borrowers unable to access the US private placement market or Germany’s Schuldschein, there is a nascent alternative. A number of dedicated funds, often offshoots of hedge funds or private equity firms, have sprung up—especially in Europe—to lend directly to SMEs. “There are a vast number of companies in Europe that are successful and have viable business models but need debt to grow or refinance,” says Carley at RiverRock. “We are targeting companies with a value of 50 million euros to 100 million euros with positive cashflows and are currently considering 10 transactions of 5 million euros to 15 million euros.”
Doherty, Kingspan: The deal saw strong investor demand and was upsized to $200 million as a result
BlueBay, which has 400 million euros of capital to lend to European SMEs and is fundraising for a dedicated fund, focuses on companies that want money for a specific need, such as to make an acquisition, to grow or to improve liquidity. “It enables us to get to know the company so we can assess their credit-worthiness,” says Fobel. “To reach companies, you need a well-developed origination platform—we call it a shoe-leather approach to origination.”
Neither RiverRock nor BlueBay have made loans yet, although both plan to do so in the coming months. Both also concede that, despite the scarcity of bank lending, they face an initial challenge to convince potential borrowers that their intentions are honorable.
“In Germany or Italy, for example, there is [a belief] that Anglo-Saxon lending strategies are more about ‘loan-to-own’ than lending,” says Carley. “However, even Mittelstand firms are experiencing capital stress, and once we begin a relationship with a company, they quickly accept that we are not interested in gaining control by the back door and often can provide a valuable alternative to giving up equity and control to a private equity firm.”
Other financing alternatives that are especially pertinent for smaller SMEs include factoring, invoice discounting and asset-based lending. Such practices use existing assets, such as invoices, as collateral to secure lending at more favorable terms than would otherwise be available.
The third-quarter 2011 Asset Based Lending Index from the US Commercial Finance Association (CFA) showed that new credit commitments originated in the third quarter of 2011 were 26.7% higher than in the same period of 2010. In the UK, the Asset Based Finance Association (ABFA) recorded a fifth consecutive quarter of growth for the second quarter of 2011, with total advances up 12% year-on-year and total available funds of £22.2 billion.
Sharp, ABFA: We see growing interest in asset-based finance as traditional liquidity sources tighten
“Since the onset of the financial crisis we have seen greater interest and awareness of asset-based finance as more traditional methods of lending have become harder to secure,” says Kate Sharp, CEO of ABFA. While delivering access to new pools of funding, it also enables banks to increase lending. “They can extend additional funding to businesses but address their own risk and compliance requirements,” explains Sharp. Asset-based financing not only reduces risk for lenders but also enhances sales. “The facility grows in line with the business, eliminating the need to constantly rearrange funding lines,” she adds.
Asset-based financing is quite focused on smaller companies. In the UK, over half of the industry’s users are businesses with turnover below £1 million, and a further 41% of firms have turnover below £10 million. But it also is useful for larger companies, says Sharp.
CFA CEO Andrej Suskavcevic agrees. “The asset-based lending and factoring community will continue to be a source of working and growth capital for US businesses of all sizes as we manage through these uncertain economic times,” he says.
NICHE FINANCE HOUSE TARGETS SOUTH AMERICAN EXPORTERS
By Dan Keeler
During the credit-fueled financial services bonanza that came to a shuddering halt in 2008, the world’s biggest banks indulged in an unprecedented expansion binge. The credit flood coincided with an explosion in creativity that saw banks devising ever more imaginative—and effective—ways to help companies improve the efficiency of their operations.
The picture today could hardly be more different. Hamstrung by the credit crunch and weighed down with increasingly burden-some regulations, many of the big banks have left customers gasping for the liquidity they need to keep their businesses running. At the same time, however, they have created a golden opportunity for a new breed of nonbank financier, eager to fill some of the niches that the big banks have backed out of.
One such player that has been steadily growing its business is Crecera, a US fund that provides trade finance loans for small and medium-size exporters in Latin America.
WORKING CAPITAL SHORTFALL
Crecera was founded in 2003, several years before the credit crunch, by a trio of bankers who were struck by the fact that companies in emerging markets were facing a dire shortage of funding, even for working capital. Robert Klein, Crecera’s president, says the group was convinced there was room for a fund to work alongside the banks to help companies expand, adding: “The situation was exacerbated by the emerging-markets liquidity crises that we have experienced, up until recently, every three to five years. That made it extremely difficult for these businesses to know whether they would have credit lines available from year to year.”
In line with many of the investment funds looking to fill the gaps left by the big banks, Crecera’s model is relatively straightforward. The asset manager maintains an intense focus on its chosen market and invests its funds according to a strict set of criteria. “We chose this segment for two reasons,” says Klein. “First, you can get higher interest rates than from larger companies; and second, when liquidity does flow back into these regions, which it does after these liquidity crises, the banks rush to give loans to the largest companies. As a result, it makes more sense for us to target smaller companies in Brazil, Argentina and Peru, which are the countries we currently operate in.”
Crecera has strict limits both on the proportion of its funds it will lend to each borrower and the size of Crecera’s loan in relation to the borrower’s total debt. These limits help ensure the firm has ample asset diversification, which has an impact on the firm’s credit rating. The fund also has strict collateral requirements. “The way we structure the loans, we take title and control of the inventory, and we know on a daily basis what the value of the inventory is—and that there is an easy way to sell that inventory if we need to,” says Klein. The company focuses on nonperishable commodities because, he says, “there are numerous buyers, numerous uses, there is a clear market price, and it’s very easy to sell if you have a default.”
James Prusky, head of business development at Crecera, says the fund, which has notched up compound annual growth of almost 10% over the past five years, complements rather than competes with banks: “We can be more nimble than a bank in terms of decision-making. We’re flexible, so we can help companies take advantage of market opportunities and, therefore, be a better borrower for the banks.”
In a recent case, Crecera had lent $5 million to help one of its clients in the fruit juice concentrate industry take advantage of the harvest. The harvest turned out to be much better than expected, says Klein. “They said to us, ‘If we can get another two million dollars, we have the potential for a great business here.’ We were able, literally in a matter of days, to give them that increase in their credit line.”
The changes that have taken place in the banking market as a result of the credit crunch and its fallout are likely to be permanent, and, according to Prusky, they are creating room for a wide range of specialist investment funds like Crecera: “There is a real need for groups like us—in trade finance and in other lines of business. We see them popping up in all kinds of areas around the banks, because it is becoming more difficult for banks to service their clients.”