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In 2012 the Breedon review group reported on increasing the range of non bank lending options available to small and mid-sized UK corporates (‘Boosting Finance Options for Business’). Sophy Lewin, professional support lawyer in Slaughter and May’s finance team, considers whether, two years on, the non-bank lending landscape has evolved to better serve the needs of UK corporates.
Bank lending remains suppressed compared to historic volumes, as banks deleverage against a background of increased regulation and higher capital requirements, including under Basel III. In 2013, according to European Central Bank data, net loan issuance to corporates in the Eurozone was negative for the second consecutive year.
Since the financial crisis, governments throughout Europe have recognised that the promotion of non-bank lending is a necessary complement to traditional bank finance. In March 2014, the European Commission announced that it is investigating the non-bank lending market as a source of funding for long-term economic growth in the Eurozone.
Non-bank funding sources include insurance companies, pension funds, asset managers, hedge funds, and sovereign wealth funds. These institutional investors have funds to deploy and are keen to seek yields in a low interest rate environment. This is reflected in both the development of direct investment products by institutional investors and their increased participation in the syndicated loan market. The same appetite for yield also exists for private investors, as seen in the enthusiastic take up of retail bonds.
Evidence suggests that it is the small and medium-sized companies (SMEs) which have felt the effects of the tightening of banks’ purse strings most acutely. Without ratings, they are unable to access the public bond markets. While large corporates are also looking to diversify their funding sources, it is generally the SMEs who have the most to gain from improved access to the non-bank lending market.
Private placements are privately placed debt instruments issued directly to institutional investors.
The private placement product offers corporates a number of benefits over bank and/or wholesale public bond debt, including:
There are, however, some drawbacks, which any corporate contemplating a private placement should consider.
In the bank market, debt (if it is floating rate) can usually be repaid at par on interest payment dates. In contrast, in many private placement markets a ’make-whole’ to maturity applies. The amount of the ’make-whole’ will depend, among other things, on the circumstances of the prepayment, but is invariably expensive, particularly in the context of low interest rates.
Less flexibility to effect amendments and waivers
The covenant package is usually substantially similar to the terms a corporate achieves with its banks. However, institutional investors, in some instances, may be less well equipped than banks to respond to amendment requests, making it important to achieve a covenant package on day one that will give the corporate the strategic flexibility it needs over the life of the debt.
It is also advisable for a corporate that has issued private placement debt to engage actively with its investors to develop an ongoing relationship. In the absence of ancillary business and/or frequent refinancing discussions, this can take greater effort to sustain than a bank relationship.
The German Schuldschein market is the most established private placement market in Europe. Issuance in this market takes the form of a privately placed, unlisted, unregistered, floating or fixed loan instrument governed by German civil law (a Schuldscheindarlehen) for which a separate borrower’s note (Schuldschein) may be issued. Tenors are three to ten years (but flexible), with five and seven years currently standard. A public credit rating is not required.
Since the financial crisis, there has been a marked increase in overall volumes and interest in the product from both issuers and investors. Indeed issuance peaked in 2008 (at around €18.9bn) when the bond markets were closed following the collapse of Lehman Brothers. 2014 has seen significant activity, with annual volume expected to total over €10.5bn.
Traditionally a source of long term capital for German Mittlestand companies, Schuldschein has become increasingly popular with non-German companies, across a range of sectors, who accounted for 38% of issuance last year. French companies in particular have increased their share of the Schuldschein market to an all time record, from 9% in 2012 to 14% in 2013. This was boosted by the issuance of the largest Schuldschein of 2013—the €535m issue by aerospace company Zodiac (the largest ever issue of a Schuldschein outside of Germany and Austria). While issues in Euro are most common, other currencies are possible, such as US Dollar, Pound Sterling and Swiss Francs.
Investors include banks, savings banks (Sparkassen) and co-operative banks (Volks- und Raiffeisenbanken), as well as an increasing number of insurance companies and (to a lesser extent) pension funds. Institutional investors took up around 12% of 2013 issuance. While the majority of the investors are German, there is an increasing number of European and Asian investors. 60% of the Zodiac’s Schuldschein issuance was placed with investors outside of Germany.
While there is no standard form, documentation is light and standardised. Many of the contractual provisions which are necessary under the laws of other jurisdictions do not need to be included in the documentation as they are part of the German civil code framework.
There has been a tendency in recent years to migrate structural elements and documentation standards from syndicated loans (for example, representations and warranties, covenants, events of default, and conditions precedent).
That said, there remain notable differences to the syndicated loan product. For example, there is no ’majority lender’ concept and no concept of pro rata sharing between lenders.
France’s private placement market has developed quickly over the last few years. Total issuance for 2013 was €3.9bn, up from about €3.2bn in 2012. While larger issuers represented 96% of the total volume in 2012, this was down to 84% of the total in 2013, suggesting that an increasing number of smaller issuers are entering the market, including those further down the credit spectrum. Deals are typically structured as French law governed listed bonds, although private placements in the form of unlisted loans have developed over the last few years. Although French companies and French institutional investors dominate, borrowers from outside of France are entering the market.
A charter of good practices (the Euro Private Placements Charter) has been developed by the Banque de France and the Chamber of Commerce and Industry of Paris with the aim of encouraging the development of a non-binding framework of best practice for the Euro private placement market. The charter, published in February, includes guidelines for the negotiation of documentation, with a focus on issues such as confidentiality, information undertakings and ranking. It includes sample documents, including an information memorandum, a non-disclosure agreement, a set of terms and conditions for a bond form private placement, and a due diligence questionnaire.
There are a number of significant institutional investors, such as M&G Investments (the asset management arm of insurer Prudential) which have provided UK-style private placement offerings to a number of UK companies in recent years, but as the Breedon Report concluded, the UK does not have an established private placement market. In 2012, the Association of Corporate Treasurers (ACT) was asked to look into why the UK private placement market remained a nascent one. The ACT highlighted a number of issues which were holding the market back, including:
Since the ACT report, while significant steps have not yet been taken to remove such barriers, there has, particularly in recent months, been increasing momentum behind developing a recognised market in the UK.
Large insurers, such as Legal and General, have announced their intention to participate in the market and some of the uncertainty around the treatment of different debt products for insurers under Solvency II has been resolved (in particular, enhancements have been proposed to the capital advantages for insurers who are able to match liabilities to long term assets). In HM Treasury’s 2014 Autumn Statement, a new exemption from withholding tax for interest on private placements was announced, which has been welcomed as a significant step in the development of the private placement market in the UK.
It is hoped that with increasing focus from industry participants, political support for non-bank funding and greater regulatory certainty, there is now an impetus to create a more established private placement market for UK investors and issuers to participate in.
There is great willingness to develop a unified pan-European private placement market, which encompasses the various local markets discussed above. Several pan-European working group initiatives (including those led by the Loan Market Association (LMA) and the International Capital Markets Association (ICMA) have been set up with the aim of facilitating further development and standardisation of a pan-European market.
The LMA is due to publish some recommended form English law governed documentation for use on European private placement transactions by the end of this year. The suite of documents will consist of both a loan format (based on the LMA’s existing facility agreement for investment grade transactions) and an unlisted note format (subscription agreement) for the parties to choose between, as well as a term sheet for use with either format.
Earlier in 2014, ICMA established a working group consisting of leading trade bodies, key investors, and market participants, in order to propose standard market practice and a framework for the documentation of private placements on a pan-European basis. The working group is on track to publish its descriptive market guide to best practice in early 2015.
The further development and standardisation of documents and market practices is hoped to remove some of the most significant barriers to the development of a unified private placement market in Europe.
Direct lending from alternative lenders involves the direct provision of debt finance to corporate borrowers.
Long term returns, such as those to be found in the infrastructure and real estate sectors, are of particular appeal to institutional investors who in turn have long term liabilities. Earlier this year, six UK insurers recently announced their commitment to investing £25bn in UK infrastructure by 2018.
Alternative debt providers are also playing an increasingly prominent role in acquisition debt products such as unitranche, mezzanine and high-yield. For example, in February, Barclays and BlueBay Asset Management announced their intention to provide unitranche debt (which combines senior and subordinated debt into a single debt instrument) in partnership for mid-market private equity deals.
There remains a long way to go before non-bank bilateral (or club) lending becomes as common place in Europe as it is in the US. At the moment, there are only a few institutional investors with an established private lending culture. However, the funds that are in the market provide significant opportunities for established corporates looking for longer term funding.
Joint initiatives with banks
Non-bank entities may choose to lend alongside banks (or other non-bank entities), sharing both risk and reward accordingly.
AXA’s mid-cap initiative is one illustration of this. AXA has entered into joint ventures with each of Société Générale, Crédit Agricole, Norges Bank, and Commerzbank, in order to provide mid-sized corporate loans both inside and outside France. A number of hedge funds have also been active in setting up mid-market direct lending platforms over the last 12 months.
The key advantage of these initiatives is the ability to leverage the partner’s client relationships, deal identification capabilities and credit expertise, together with the potential to learn from the partner and develop in-house expertise. It can facilitate investments in large-scale assets, where one party cannot meet the minimum investment requirement alone.
The UK government has launched a number of initiatives (such as the Business Finance Partnership, Business Bank, Infrastructure UK, and Green Investment Bank) aimed at encouraging private sector investment, from non-traditional sources where appropriate, to SMEs. Conversely, other initiatives (in particular the Funding For Lending Scheme), although a welcome development for borrowers in principle, have undermined the development of the non-bank lending market by stimulating cheaper liquidity from traditional bank sources. The unwinding of the Funding for Lending Scheme over the course of next year may prompt some corporates to revisit alternative sources of finance.
The Funding for Lending Scheme was launched by the Bank of England and HM Treasury in July 2012, and is designed to incentivise banks and building societies to boost lending to the UK real economy. It does this by providing funds to banks and building societies for an extended period, with both the price and quantity of funding provided linked to their lending performance. At the beginning of December 2014, the scheme was extended by one year to allow participants to borrow from the scheme until January 2016, with incentives to increase lending skewed to SMEs.
The two years since the Breedon report have been evolutionary rather than revolutionary, at least in the UK.
Although some progress has been made towards a domestic UK private placement market, it has been with small steps and the pace of development contrasts unfavourably with that in jurisdictions such as France.
That said, a steady proliferation of various forms of corporate borrowing from non-bank institutional lenders is observable. The private placement market has seen the entrance of a growing number of UK issuers and investors, and there is increased momentum to standardise documentation and processes in European private placements. Attempts have been made to redress the lack of credit information on SMEs available to non-bank investors, including the use of funding platforms and development of market tools such as Standard & Poor’s mid-market evaluation scale.
There does however remain some way to go. The loan markets have remained competitive as demand for deals outstrips supply, and government-subsidised funding programmes to encourage bank lending, in particular the Funding for Lending Scheme, have inhibited the further development of alternative markets to some extent. The expiry of the Funding for Lending Scheme, the increasing cost of capital as banks move to full compliance with Basel III, and recent amendments to Solvency II, all suggest that non-bank lenders will over the medium term become an increasingly important source of corporate debt finance.
Sophy Lewin is a financing support lawyer at Slaughter and May in London.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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