The unsqueezed middle: midcaps find new funders

For medium sized companies with a decent track record and some financial skills, there are usually loans available. And banks see their bigger cousins in the FTSE 250 as prized clients. But as Jon Hay reports, the landscape is changing. Whether through necessity or choice, these companies are relying less on banks. As that happens, a wider choice of financing options is becoming available to firms on lower rungs of the size ladder.

  • 26 Sep 2012
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The UK’s midcaps are on a roll. As this report went to press, the FTSE 250 index was within a whisker of breaching the record level of around 12,200 at which it has peaked twice before — in June 2007, just before the credit crisis, and July 2011, before the eurozone crisis.

Some may read that as ominous. But for midcap companies, it is a vote of confidence in their potential to grow. The index has gained 18% this year, even as the UK has endured the second dip of a recession. What is going right?

"Not quite as much as the index implies" might be the truest answer. Although midcap stocks have risen, led by leisure-related sectors that imply confidence in the consumer economy, they are still cheap relative to earnings and to other markets, such as the US.

Strategically, most UK midcaps are sitting on their hands — and on piles of cash — waiting for the economy to pick up before embarking on M&A and big investments.

Nevertheless, the stockmarket rise is a sign that British firms have been able to protect their profit margins through cost-cutting and globalisation, so that the crisis has damaged them much less than feared.

Indeed, UK Plc’s defensive wall of gold, estimated at £750bn, is one reason why the economy is so sluggish. If companies would spend a tenth of that wealth, the Bank of England might not have to print so many pounds to buy Gilts.

What is clear is that UK midcaps, in aggregate, are not struggling financially. "For midmarket companies with Ebitda of £50m-£100m we have yet to see an increase in default rates because commercial lenders have restricted the flow of capital," says Mike Marsh, head of EMEA high yield and leveraged loan capital markets at Goldman Sachs.

Some midcaps suffered shock therapy in 2009, especially if their covenants were in breach. Losing a couple of banks from a syndicate can be quite painful, and that did happen, particularly as foreign banks retreated.

"Over the decades there’s been an ebb and flow of foreign bank interest in the UK midmarket," says Alan Turner, head of debt finance at Barclays Corporate. "The UK has a lot of attractions — the approach to risk and lending, the legal system, its international disposition. When times are tough and capital is scarce, some of them have to retrench to supporting their home market."

The likes of Anglo Irish Bank have gone, but Santander and Handelsbanken are now fixtures on the UK scene.

Time to save money

Since 2010, loans have been plentiful enough for companies to focus on squeezing down their borrowing margins and diversifying their funding.

"For FTSE 350 companies there is no capital constraint," says Nicholas Bamber, head of investment grade bond origination and private placements at RBS in London. "Modestly levered midcaps can borrow money from banks at 200bp or 250bp over Libor or 3% all-in. In the bond market they can pay 4% or 5%, depending on credit quality. Those are the cheapest prices corporates have ever been able to borrow at."

Most midcaps are not rushing to exploit this plentiful finance. Exceptions include this year’s £1.5bn takeover by Melrose, the investment company, of Elster, a German maker of gas meters.

Melrose raised £1.2bn in a rights issue led by JP Morgan and Investec in August. Like many UK midcap ECM deals, it was popular with investors — who only wish there were more of them.

Melrose also obtained a £1.5bn multi-currency loan arranged by Barclays, Commerzbank, HSBC, JP Morgan, Lloyds, Royal Bank of Canada and RBS.

The midcap loan market resembles the large corporate one. The corporate banking arms of the UK clearers handle clients from turnovers of £15m up to the likes of Melrose and oilfield services group Petrofac, whose $1.2bn five year revolver Barclays and Standard Chartered signed in September.

Facilities right down to £25m are syndicated, even if only to a club of two or three banks.

"There’s a remarkable knowledge and consistency about pricing in the loan market," says one banker. "Midcaps solicit feedback from all the banks, the banks give comparable pricing, it’s not difficult to work out what’s going on. So there’s a market par for a certain credit quality." Banks will then lend at a sub-par level, depending on how much ancillary business they expect to get.

Is this an idyllic world, about to be swept away? In the City, all you hear is that "banks can’t lend" and even "banks shouldn’t lend — we should become intermediaries".

A brush with Basel

Opinions differ hugely on how Basel III is going to change finance. Some believe the effect will be severe, making it unprofitable for all but the most highly rated banks to lend to companies with ratings of triple-B or lower. Projections have been made that banks’ corporate loan books in Europe will need to shrink by 100s of billions. The effect for smaller and weaker companies could be that they will have to pay more for loans or borrow less.

Others, however, believe the leading banks have already taken Basel III on board in their lending decisions.

"We’re very conscious of Basel III and factor it into our conversations with clients, including the net stable funding ratio and liquidity coverage ratio," says Simon Palmer, head of the complex deal team at Lloyds Bank Wholesale Banking & Markets. "All our product development will be built with changing legislation in mind."

If banks are already complying with Basel III — and the four largest UK banks are either there or nearly there — then there need not be any great capital squeeze to come.

"Most of Basel III is baked in," says Bamber at RBS. "I think banks will adapt, corporates will adapt, by diversifying funding sources, especially in midcaps, not pushing for that drawn debt from banks, and taking longer term debt from the bond market."

Martin O’Donovan, deputy policy and technical director at the Association of Corporate Treasurers, is still worried about Basel III. "The total quantum of what banks are prepared to do for the same amount of capital will be substantially less," he says. "It plays out either in fewer credit facilities being available or they will ration it through pricing." O’Donovan says the squeeze is being felt particularly in derivatives, where banks are charging even investment grade borrowers 30bp-40bp more than before for a currency swap — a cost that is now affecting behaviour.

Looking elsewhere

Whether by push or pull, the sources of midcap finance are changing. "Capital is available for midmarket companies, but the lending environment is certainly changing," says Marsh at Goldman. "We are seeing the larger lending banks reduce single company exposures, but the emergence of new sources of capital for companies in this space a growth in funds with strategies specifically focused on midmarket corporates and the growth in the high yield bond market also offers a source of capital."

This trend began before the financial crisis, and has been strengthened by it. "If you look at the FTSE 250 and take out the investment trusts and non-UK resources companies," says Bamber, "probably 60% or 70% have now tapped the bond market, in public or private form. The smaller they are, the more likely it is to have been a private deal."

Midcap UK public bond issuers this year have included Jaguar Land Rover, Virgin Media, Ineos, Eco-Bat and Afren in the high yield market, Mobility Operations Group and Gatwick Airport in investment grade and Center Parcs UK with a now-rare whole business securitisation.

For many of these larger companies, bonds are now the main source of debt. It may not be cheaper, but treasurers no longer want to have all their eggs in a basket carried by the banks, in case they trip over.

Outside the special world of high yield, however, the sterling and euro bond markets are not geared up to buy bonds of less than £250m or €500m.

A growing alternative is the retail bond market. Workspace, which provides premises for small businesses in London, launched a £50m-£75m issue via Investec and Numis in September — its first non-bank debt in the past five years. Workspace’s eight bank lenders were all happy to refinance its facilities, but wanted to hold smaller amounts.

"From my perspective that’s sensible anyway," says Graham Clemett, the company’s CFO. "Now that rates have come down so much, the pricing makes bonds attractive."

The retail bond, paying 6%, will raise Workspace’s average cost of debt from 5.1% to 5.2%. But Clemett judges that worthwhile, as it will add a year to average debt maturity, is fixed rate and unsecured — though with two straightforward financial covenants.

Private passion

But the favoured option for companies needing less than £250m, or lacking a rating, has long been the US private placement market. UK firms raised about $10bn there last year, and some, such as Cadogan Estates, source nearly all their debt that way.

Yet with the exception of Prudential’s M&G Investments, which has led the way in Europe since 1997, and of Aviva, almost all the capital for PPs still comes from US-owned investors, even if leaders like MetLife and Pricoa have offices in London.

"The big question on private placements," says Mark Hutchinson, head of alternative credit at M&G, "is can you get more interest from other institutional investors in the UK and Europe so companies don’t have to issue in dollars and swap?"

Lately, interest in PPs in the UK has been greatly stimulated by the financial crisis. "If banks are delevering, you need real money to replace part of that lending," argues Hutchinson.

In March an industry taskforce, led by Tim Breedon, CEO of Legal & General, reported to the government on how to boost non-bank finance for UK business.

Among its recommendations were to encourage UK private placement investment through an initiative led by the Association of Corporate Treasurers.

"Our cross-industry working group is looking at the barriers stopping a UK private placement market developing," says O’Donovan at the ACT. "There seem to be a mix of things that are rather woolly and don’t stand up to much scrutiny, like ‘we don’t invest because there isn’t any precedent,’ through to quite serious barriers like Solvency II."

Like other insurers, Prudential is worried by Solvency II, about which it has been "making a lot of noise quietly".

"It has the potential to discourage long term lending," says Simon Pilcher, CEO of fixed income at Prudential’s investment arm M&G, "including through corporate bonds, and to discourage any lending to triple-B entities or lower, which typically characterise the infrastructure and private placement markets. Perversely, if it is implemented in a careless fashion, it could increase risk within certain insurance companies, by encouraging shorter term investment."

There is evidence that Solvency II is already putting insurance companies off lending beyond seven years.

Insurers become lenders

However, M&G has not waited for this to be resolved. In 2009, it raised a UK Companies Financing Fund to fill the gap left by retreating banks by lending to medium-sized firms, using the investing skills M&G had gained over many years in the US PP market.

M&G was also keen to expand this kind of finance by bringing other investors in. "These were good midcap companies, which would be a good debt investment for pension funds and insurance companies," Hutchinson says. So £1bn of the fund’s £1.5bn of committed capital was raised from other institutions, and £500m from Pru.

Perhaps surprisingly, M&G was not overwhelmed by demand for loans. The banks were supplying plenty of cheap debt, and it took time to convince companies to get involved. Nevertheless, from May 2010 momentum picked up. After the first loan of £100m to transport group Stobart, which is developing Southend Airport, six more £100m loans were made in the next year, to Provident Financial, Northgate and housebuilders Taylor Wimpey, Grainger and Barratt Developments. The fund reached the end of its investment period in mid-2012 with 11 loans made, totalling £930m, from its £1.5bn target.

Hutchinson is pleased with the progress, saying this kind of deal "is now on the menu of options for a suitably sized company thinking about long term financing".

Suddenly, there are signs of other institutions exploring midmarket lending. Goldman Sachs has recently agreed a refinancing of the senior debt of IMO Car Wash, a company owned by banks and hedge funds since its debts had to be restructured after a Carlyle Group LBO. The facility will be underwritten by Goldman Sachs, Highbridge Principal Strategies and Castle Hill Asset Management.

Such loans may not be cheap, but sometimes what matters to the borrower is being able to obtain finance and carry on building the business.

Institutional investors like Haymarket Financial and Ares Management are increasingly seen in the UK midmarket, alongside the more established players like Prudential.

The government will lend £700m to mid-sized companies under its Business Finance Partnership scheme, through commercially managed funds.

"I do think the PP market will develop," says Hutchinson. "But it’s a misconception that you can suddenly get institutions to provide billions, like turning on a switch. The institutional leveraged loan market took five or six years to develop, and that was going pretty fast."

The Breedon Report’s estimate of a funding gap for British industry of £84bn-£191bn over the next five years looks daunting, though the reality may turn out far more benign.

Treasure in the ledger

However, there are many other avenues midcaps can explore. Breedon pointed to stronger companies paying suppliers’ invoices faster, and using their considerable financial resources to support smaller firms with supply chain finance.

Asset-based lending also looks sorely underused. Invoice discounting allows companies to electronically sell their receivables to a bank or other financier, in return for a cash advance that is repaid, less interest, when their customers pay their invoices. Loans can also be secured on machinery or stock.

This gives firms a steady source of working capital that is lower risk to the bank than an ordinary loan, because it is secured. Lloyds Bank’s losses on its £3.8bn asset-based book are less than 0.5% a year. That means firms can get cheaper funds, with higher leverage, perhaps up to 90% of the assets. Lloyds is keen to grow this business.

"The asset-based finance market, which includes factoring and invoice discounting, is about 42,000 companies, which in the scheme of UK Plc is quite tiny," says Ian Lomas, sales director at Lloyds TSB Commercial Finance. "Research we undertook a few years ago showed company uptake was like a funnel. About 90% were aware of the product, about 50% had thought about using it, but only about 1% had done so."

Non-users thought discounting was expensive and administratively difficult, but users rated it well on both counts.

When hope returns

Because asset-based lending involves intimate knowledge of a company’s sales ledger, it gives banks a keen feel for clients’ moods.

"Confidence amongst our customers returned quickly in 2009," says Lomas. "What’s quite interesting now is that there seems to be an element of uncertainty again — albeit nowhere near what it was in 2008. We are seeing an increase in undrawn availability in our clients’ facilities to about 20%-25% — it’s been increasing a couple of percentage points a month all year."

That is a measure of the slowdown in the economy. Palmer in Lloyds’ complex deal team believes fear of the eurozone crisis remains a dampener on corporate spirits in the UK. "Ongoing uncertainty is still creating cautiousness within the market," he says. "Companies are reluctant to invest heavily while the situation remains fragile."

Nevertheless, Lloyds is expanding the complex deal team, which advises midmarket companies on financing activity like takeovers, management buyouts or restructurings — because it believes activity is soon to quicken.

"We are having a lot more conversations with clients about potential deals," says Palmer. "Due diligence is picking up and people are beginning to call the bottom of the market."

When confidence swings back, demand for debt and equity funding will rise, putting the UK’s financial system to the test. But the signs are that — apart from a few foreign banks — the established lenders and investors are still present and want to do more. And around them are new channels of finance, from retail bonds to corporate finance funds, which could give midcaps a wider choice than many of them have experienced before.
  • 26 Sep 2012

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 24 Oct 2016
1 JPMorgan 317,793.98 1355 8.72%
2 Citi 301,114.13 1092 8.26%
3 Barclays 259,580.63 846 7.12%
4 Bank of America Merrill Lynch 258,842.43 934 7.10%
5 HSBC 224,273.23 905 6.15%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 25 Oct 2016
1 JPMorgan 32,854.00 58 6.73%
2 BNP Paribas 31,678.29 142 6.49%
3 UniCredit 31,604.22 138 6.47%
4 HSBC 25,798.87 114 5.29%
5 ING 21,769.65 121 4.46%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 25 Oct 2016
1 JPMorgan 14,633.71 80 10.23%
2 Goldman Sachs 11,731.14 63 8.20%
3 Morgan Stanley 9,435.23 48 6.60%
4 Bank of America Merrill Lynch 9,229.95 42 6.45%
5 UBS 8,781.68 42 6.14%