European Private Placements: Gathering Pace?

Executive Summary

The US market for debt private placements is booming. In 2003, the market expanded by nearly 60% to reach USD46 billion in new issuance. By contrast with historical patterns, a staggering twothirds of this volume was raised by non-US issuers, including European corporates. Meanwhile, European investors have merely dipped their toes into this market. Why?

Fitch has experienced a marked rise in demand from European issuers for ratings relating to US private placements (“PPs”) in the last 24 months. In response, we initiated published research and commentary on this market during 2003. Considering the large amounts raised by European corporates, we were increasingly intrigued as to the lack of involvement by major European fixed income investors in this field. We decided to undertake a survey to examine what was holding them back (details of the survey’s scope are given on page 2).

In summary, the survey found that while there is a certain amount of historical familiarity with debt private placements across our investor sample, such assets are generally quite different from the type of instrument typical of the US PP market. Domestic market PPs in Europe have mainly been centred on property-related borrowing and other secured funding. In terms of current involvement, nearly one-third of our sample said they are currently actively buying PPs, including US-style long-term, fullydocumented deals, typically including financial covenants. However, many are recent entrants to the market and are only starting to build up portfolios. Interestingly, almost another third of the investors asked said they are monitoring the market closely and may consider entry in the future.

Among the barriers to greater activity in the European PP market, investors reported that the single largest problem is insufficient internal credit resources. While most investors have analysts dedicated to handling public market investments, PPs entail more complex documentation and require specific credit skills. Other hurdles include illiquidity-related concerns, such as how to benchmark PPs in the absence of market pricing. Investors do not perceive market regulation as a major issue, though this perception varies significantly across Europe due to the multitude of regulatory regimes for each country and type of institution. Finally, many investors in the sample said greater deal flow would increase their involvement.

European investors appear to take a positive stance towards the likelihood of a pan-European market for PPs developing, though this is not expected to happen quickly. The vast majority of investors asked also said that such a development would be desirable, aiding long-term asset/liability matching and asset diversification, and potentially also returns.

The Survey

The aim of the survey was to test the market’s temperature, not to provide a comprehensive review of investor behaviour. We felt that focusing on the top tier of long-term investors – life insurance companies, pension funds and some asset managers – would give us a fair idea of the state of play. We contacted 21 major institutions across Europe, the majority of which agreed to participate in the survey. We conducted one-to-one interviews with senior officials, who kindly shared details of their portfolios and views on the market with us. A list of those who agreed to be identified is shown in the table below:

Market Activity Debt private placements provided by local insurance companies and other long-term investors have long been a niche, but established, source of funds for corporates in a number of European countries. In Germany, Schuldscheine is a variant of this type of financing, while the Netherlands, the UK and Sweden also have had active local private markets. In this type of lending, the borrower would typically be familiar to the investor and a sense of relationship normally replaces the need for extensive documentation.

To determine investors? historical familiarity with private investments in general, Fitch asked investors:

Question 1: Have you ever been active in any type of debt private placements?

The majority of those investors questioned have some type of experience of investing in private debt instruments. Among these investors, most have limited portfolios, mainly of local authority and secured property deals. Variations on this theme include sale and lease-backs and Private Finance Initiative (“PFI”) funding. Many investments were undertaken decades ago. Only a small minority of investors have established portfolios of US-style PPs.

The US market boomed in 2003, with issuance of USD46bn representing a near 60% year-on-year increase. Two-thirds of this amount was raised by non-US issuers, a large proportion of which were European corporates.

With this in mind, Fitch asked investors:

Question 2: Are you currently active in USstyle debt private placements?

While only a few investors in our survey have a well-established PP presence, nearly one-third are currently active in buying such assets. Most of these institutions have only recently entered the market, typically in the last six months. Third-party fund managers mention that clients are gradually becoming more familiar with this instrument, allowing increased investment. All of those investors already active want to increase their involvement.

Although more than two-thirds of investors asked are not active PP buyers, almost half are considering entering the market. In some cases, the European institution’s US subsidiary is an active PP investor. Some investors, e.g. PM&G, state that their active involvement in the PP market is partly a result of positive experiences of the asset class at their US subsidiary, Jackson National.

Barriers to Market Development

On the whole, European investors appear cautious about entering the PP market. Fitch wanted to understand what is holding them back and asked:

Question 3: What are the barriers to increased private placement investment:

a. Internal credit resources?

Private placements are more akin to loans than to public bonds. They typically contain both standard and financial covenants, such as minimum net worth and minimum net interest cover. An investor wanting to assess the creditworthiness of such notes would – in the absence of ratings – need analytical skills in-house which are more specialised than those required to analyse public bond investments. Fitch held over 500 one-to-one investor meetings during 2003 and is aware that many European investors have boosted their analytical teams and are improving their abilities to assess a wider range of investment opportunities. However, a significant number of institutions still have limited credit functions.

Overall, half the institutions in the survey identified insufficient in-house credit resources as deterring further PP investment. Some said that even with an existing credit team, PPs add an extra burden of work which is not desired. At those institutions where there is no dedicated credit team, portfolio managers perform a multitude of tasks, including credit evaluation. Where an insurance company has a US subsidiary, the US-based credit team is sometimes used to assist the European operations. At many investment houses, the expertise of loan credit evaluation sits naturally with leveraged loans teams. The growth of this market appears also to benefit the PP market, with the sharing of internal resources. The European credit culture is undeveloped compared with that of the US. The latter market is diversified in its range of investments, while in Europe liquid benchmark issues dominate portfolios. Some investors reported that they believe long-term investments should be of a higher credit quality than the ‘BBB’ range typical for PPs.

Only one investor stated that a lack of credit resources in-house could be overcome by outsourcing the management of PP investments.

Several respondents mentioned the limited existence of credit ratings as a factor holding back market development.

b. Lack of investment opportunities?

More than one-third of investors asked stated that the lack of deal flow is holding them back from increased activity in the PP market. Some simply do not get approached by arrangers and expressed amazement at the volume of European issuance into the US market. Others face limited deal flow, but feel they will be able to source deals independently of arrangers, dealing directly with issuers. The latter approach may be more pertinent to investments in domestic paper than to cross-border opportunities.

Quite a few investors reporting a lack of investment opportunities indicated that when they had been approached with deals, they had been put off by factors such as:

• the lack of illiquidity premium;
• a lack of confidence in the issuer industry;
• weak credit profiles; and
• the short turnaround time required.

For the most established and active investors, deal flow exists but is still not sufficient to satisfy their demand.

c. Regulatory restrictions?

Very few investors identified regulation as a hindrance to market growth. The specifics of regulation pertaining to PP investments in Europe are rather opaque, due to the absence of a pan- European regulating body equivalent to the National Association of Insurance Commissioners (“NAIC”) in the US. Some insurance companies mentioned local regulation (e.g. in France) as being a potential difficulty with regard to the requirement for investments to be liquid. However, others mentioned that such hurdles could be overcome. In the UK, a maximum 10% of assets can be held in illiquid paper (PPs, bank loans, mezzanine, etc), but this is far from being a restrictive factor for any investor at this stage. There is also the possibility that unrated issues could come to require a higher capital weighting than at present in the UK, subject to a decision by the Financial Services Authority (“FSA”) on a current consultation paper. Some countries require insurance companies to invest only in investment grade securities though known exceptions include Switzerland and the UK.

More common than regulatory hurdles are internal restrictions on the type of assets permitted to be held in third-party funds under management, which can include insurance funds. Life insurance companies and pension funds – given the long-term nature of their asset/liability matching needs – could be expected to have a natural appetite for longer-dated debt obligations. However, in this respect, one company specifically mentioned that their internal actuarial guidelines had ruled PPs as unsuitable assets. Generally, internal guidelines for any funds include a demand for diversification.

Fitch is aware that whilst large insurance companies often contract out the management of some of their funds, mostly to their own asset management arms, some would appear to retain a portion of funds to be managed within the insurance arm, and exposure to PPs is a possibility here, which Fitch has not been able to explore fully.

d. Benchmark return approach?

Many investors are benchmarked to public debt indices to measure returns. As a result, some are restricted from investing in illiquid assets. This is especially true for third-party funds managed, while insurance companies tend to have greater freedom of choice for their own annuity funds. More creditfocused investors tend to have a total return approach and hence are more flexible in their selection of assets, liquid or not. Others operate on a mixed return basis, which also tends to allow flexibility. Nearly three-quarters of respondents do not regard this as a hurdle to market entry. Among this group, there are a number of investors who do apply the benchmark return approach, but do not believe this would stop them from investing in PPs.

The current boom in the market in the US has left little or no premium for illiquidity in the pricing of PPs. This was mentioned as a major stumbling-block for European investors considering greater involvement in the market.

However, more involved PP investors raised the fact that while an illiquidity premium is desirable, the presence of financial covenants probably more than compensates. Several investors told Fitch that their own experiences of private markets have shown better recoveries than public portfolios. Financial covenants, placing PP investors pari passu with lending banks, allow the former to be part of any restructuring committee in the case of credit distress. This is in stark contrast with the position of Eurobond investors, whose protective situation in restructurings is poor and subject to the risk of subordination (see also “When Angels Lose Their Wings”, January 2004 and “Jumping the Queue”, October 2003 available at www.fitchratings.com). In addition, investors in the two different debt classes tend to behave differently in such situations – while public bond holders often look to sell their paper at the first opportunity, private investors take a longer view.

e. Valuation and marking to market?

Concern over valuation and marking to market is somewhat more widespread than that over the closely-related matter of benchmarking. More than one-third of investors felt the former would cause difficulties. Some mentioned the introduction of IAS accounting across Europe in 2005 as a specific potential problem. Almost two-thirds of institutions believed they could deal with the valuation issue one way or another. Proposed solutions to the challenges included the following alternative methods of valuation:

• a discounted cash flow basis;
• public proxies;
• an agreed rate over gilts; and
• a purchase rate.

f. Other barriers?

The highly competitive state of the US market at present, with tight spreads and investors fighting over allocations, means that some European investors are wary of entering the fray. It is possible that this may delay increased involvement in PPs. However, these issues are not structural. Fundamentally, European investors should arguably be in a better position to evaluate the credit risk of European issuers. There is also the belief among some investors that European issuers would prefer to deal with regional investors, avoiding difficult logistics and currency issues.

There is some caution among institutions over the appropriateness of long-term investments, though life insurance companies, in particular, require such maturities to match their long-term liabilities.

Information flow is generally accepted as being superior in the private arena compared with the public one. One investor suggested there may be a Chinese wall requirement should an investor hold both private and public paper from the same issuer.

Future Market Development

Despite the hurdles, Fitch believes there are significant drivers encouraging future development of a pan-European PP market. To sum it all up, Fitch asked:

Question 4: Do you believe a pan-European private placement market is likely to develop?

There appears to be a strong belief among many European investors that a pan-European market for PPs will develop over time. Two-thirds of respondents thought this to be the case. Reasons given include:

• strong demand from European issuers;
• banks’ need for continued balance sheet shrinkage; and
• continued improvement in credit expertise among investors.

In general, investors believed that slow and steady expansion would occur. Some criticised their US counterparts and arrangers for allowing the market to become overheated, expressing doubts over the thoroughness of their credit work. With a vast range of bankruptcy regimes across the European continent, it is possible that US investors have not yet fully absorbed the implications of distressed credits under different jurisdictions.

Another possible factor holding back the development of the PP market could be a rapid expansion of the public market for corporate debt. While 2003 was a boom year for issuance in the Eurobond market, there is still room for the appetite for medium to large-sized ‘BBB’-type issuers to grow further. Should the Eurobond market increase its appetite for this type of issuer, there may be less of an impetus for the private market to grow.

Do investors care if this market develops? Fitch asked:

Question 5: Would the development of a pan-European private placement market be desirable?

An even greater number of investors not only believe market growth to be likely, but also expressed a desire for such growth. Reasons for this include:

• improved potential for diversification;
• more EUR assets as opposed to USDdenominated ones; and
• good returns.

Investors were also of the opinion that the expansion of European corporate credit markets in general (both private and public) is highly desirable.

Ratings of Private Placements

Fitch has a long established track record of rating PPs, both in the US and Europe. With eight offices across Europe, the agency is well placed to provide tailor-made analytical teams based on a combination of sector expertise and knowledge of local markets and languages.

In the US, major investors estimate that some 50% of PPs are rated. The recent streamlining by the NAIC, the industry regulator, which now accepts a single rating by a rating agency as equivalent to its own assessment, is expected to boost this proportion. The advantages to the industry are significant: both issuers and investors will know in advance of the notes being placed that the investor is buying a certain known credit profile (see also “Rating Private Placements”, August 2003).

In Europe, there is no common industry regulator equivalent to the NAIC. However, the reported shortage of credit resources among investors indicates that Fitch, as a specialised credit rating agency with a strong European footprint, can offer valuable assistance in rating private placements.

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