Europe’s Corporate Loan Markets: Alternatives to Bank Finance
Following the crisis, the changing regulatory environment and increased pressure on banks to delever has seen non-bank funding – including funding by, among others, debt funds, insurance companies and pension funds – become an increasingly prevalent feature of the European corporate loan market. As a result various lending products have begun to develop and grow in volume, aimed specifically at non-bank investment. So, what are these products, and what is their role within the wider corporate loan market?
Types of Alternative Finance
Alternative finance technically includes any form of finance provided by non-bank lenders, extending to products such as peer-to-peer (P2P) lending, crowd funding, covered bonds and other types of securitisation. However, for the purpose of this article the list is restricted to the main forms of financing for mid-sized to large corporate borrowers by one or more institutional investors. While these products are not exclusively the domain of non-bank investors (Schuldschein loans, for example, are still predominantly a bank product) their very nature makes them increasingly attractive to the non-bank community. They are also products where bank disintermediation has been seen to a growing degree since the start of the financial crisis.
1) European Private Placements:
Private placements are essentially medium to long-term financing transactions entered into between a listed or unlisted company and a small number of institutional investors. Documentation is very much deal-specific and negotiated on a case by case basis between the borrower and the investors, occasionally with the participation of one or more bank intermediaries as arrangers.
The European private placement market, whilst growing in size, remains very much a fragmented market. In France, the private placement market totalled €3.9bn (US$4.9bn) in 2013, up from €3.2bn in 2012, according to Standard & Poor’s (S&P). Similarly the UK private placement market is on the rise, with between £3bn and £6bn raised over the course of the last three years according to S&P estimates. Private placements are also cited as being increasingly used elsewhere in Europe, including Italy, Spain and the Central and Eastern Europe region, although market data is difficult to obtain for these countries due to the private nature of the underlying transactions.
While the number of European private placements remains relatively small – particularly when compared to the US private placement market where annual volumes have ranged from €13bn to €16bn over the past three years – it is undoubtedly a growing market, as evidenced by a marked increase in private placements provided by European institutional investors. In particular, European insurers are beginning to move away from listed bonds and equities to extend long-term loans on a fixed rate basis. Indeed, private placements are highly attractive to insurers because they enable these entities to conduct due diligence on the borrower, to negotiate documentation directly, to get the benefit of maintenance covenants and to lend as part of a long-term corporate strategy. They also allow insurers to satisfy their regulatory requirements under the EU’s Solvency II legislative regime for the sector.
That said, there remains a clear need to widen and diversify the private placement market and the lack of standard documentation is a particular challenge. In order to address this the Loan Market Association (LMA), the trade association for the syndicated loan market, has begun work on the production of template private placement documentation and hopes to publish both a loan and bond format (along with an accompanying term sheet) by the end of 2014.
2) Schuldschein:
Schuldscheindarlehen
are effectively bilateral loans with a hybrid structure sitting between debt securities and bilateral/syndicated loans. The product has been in existence for many years with predecessors dating back centuries.
The term
Schuldscheindarlehen
is not legally defined and can best be translated as “loans evidenced by a certificate of indebtedness”. Under German law,
Schuldscheindarlehen
refer to underlying bilateral – usually freely transferable – loans for which a separate borrower’s note is usually, but not necessarily, issued. The borrower’s note does not constitute a security for the purposes of the German Civil or Commercial Code or other laws or regulations referring to securities. This means that
Schuldscheindarlehen
are exempted from the obligation to publish a prospectus under European prospectus law. It is not possible to use a clearing system for such loans and they may not be listed or traded on any stock exchange.
The market for
Schuldscheindarlehen
made to corporate entities has grown considerably, with corporates in Europe having raised approximately €30bn over the past three years. Throughout the financial crisis the primary market for such loans proved to be very stable, comfortably supporting both increased transaction numbers and issuance volumes. Indeed in 2008, with wider capital markets in turmoil,
Schuldscheindarlehen
issuance peaked at ca. €19bn as several larger German companies turned to
Schuldscheindarlehen
as an alternative means of financing.
Once the markets had returned to some kind of normality in 2009 and thereafter issuance volumes began to edge lower, although average volumes remained above pre-crisis levels. In 2013, companies raised €7.7bn in the
Schuldscheindarlehen
market, against €14bn in 2012. The decrease in overall volumes was driven mainly by lower financing needs and significant pre-financing activities of German corporates. This has been partly offset by an increasing number of non-German borrowers accessing the market, with over one-third of 2013 corporate
Schuldscheindarlehen
issuance from non-German entities.
Despite fluctuating volumes, the investor base for the product continues to grow, both within Germany and internationally. Professional investors comprise credit institutions, such as banks, savings banks and co-operative banks, as well as institutional investors including insurance companies, investment management companies and pension funds.
Increasing international interest in the Schuldschein product was the driver behind the LMA’s formation of a working group in 2012 to investigate where the association could potentially add value. Extensive collaborative work by this group, based in Germany and with broad legal and commercial representation, saw the publication of an LMA Product Guide to
Schuldscheindarlehen
in 2014.
3) Unitranche:
Unitranche facilities were originally developed in the US as an alternative to first and second lien. They are now a firm feature of the European market, with data by Grant Thornton suggesting that 2014 to date has seen more deals than the three years 2011 to 2013 combined.
Unitranche facilities typically finance mid-market leveraged acquisitions, with a deal size of up to £150m. For example, according to its press release, UK-based Trust Inns received a £130m unitranche debt facility from Macquarie Lending in February 2014. While both banks and non-bank lenders offer unitranche facilities, they are increasingly provided by non- banks and debt funds in particular.
A unitranche facility is offered by one or more lenders and combines a senior loan and a junior loan into one ‘unitranche’ facility with a blended margin (reflecting the weighted average pricing of the senior and junior pieces), using deal-specific documentation bespoke to the transaction. A unitranche consists of a term loan, usually from five to seven years in tenor, with a bullet (or lightly amortised) repayment. If a revolving facility is required as part of the financing package this will be provided by a bank lender, with super senior priority over security enforcement proceeds, as well as other protections such as independent rights to accelerate and enforce on a ‘qualifying’ event of default. The bank may also provide other services, such as hedging.
Where a unitranche facility is offered by more than one lender, the relationship between lenders is agreed “behind the scenes”, via an arrangement which the borrower is not a party to. These arrangements may be documented in a number of ways, including joint venture agreements and intercreditors, and cover matters such as margin and split fees, the payment and security proceeds waterfall and the ranking between creditors. Matters such as variation of voting rights and consent thresholds, however, are set out in the facility agreement itself.
The Future for Alternative Finance
While this article sets out three of the most common financing products which have emerged in the alternative finance market, as bank disintermediation increases more products are likely to follow. At the very least, it is likely that alternative finance generally will gradually play a more important role in the corporate financing landscape.
That said, it is worth noting that compared to the US, banks continue to play a key role in European corporate financing. Some 80% of overall corporate loan market borrowing in Europe is financed by banks; the equivalent figure in the US is nearer 20%, funds having replaced banks as the dominant source of loan capital.
In addition, a fundamental requirement for corporates is working capital finance, as well as ancillary facilities such as letters of credit (LOCs) and overdrafts. These products are typically not attractive to institutional investors as they require significant levels of infrastructure and administrative capacity. Secondly, the funding sources of the non-bank lending sector generally mean that it is better suited to providing longer-term funding, which is fully drawn from the outset. This suggests that it would be difficult to disintermediate the banks entirely, which means they will have to continue playing a key role in the provision of working capital finance for the foreseeable future.