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Corporate BondsPrivate debt

The triumph of diversity

The widely admired US private placement market has inspired the development and growth of private debt markets in Europe. But hopes of replicating in Europe the US model, governed by regulation and convention, of a single market with one set of documents, have been pushed back. As Jon Hay reports, the market now looks headed towards a more varied ecosystem.

Private corporate debt in Europe is an amorphous category. Market players see it from different perspectives and are each interested in different slices of the pie. But all agree that the market is healthy and probably stronger than ever before — even if not all their hopes have yet been fulfilled.

“It’s clearly a growing market, with even more investors,” says Fabien Calixte, director of mid-cap origination at BNP Paribas in Paris. “Even though the Euro PP market has shrunk, 2016 was a very good year for the US private placement and Schuldschein.”

If private debt means corporate lending provided through means other than bank loans, Europe had little of it before the financial crisis. 

There were two major exceptions, each defined by a legal niche. Germany’s Schuldschein market, then largely domestic, is written into the civil code, which enables the country’s many small financial institutions to participate in these special loans with standardised terms.

The US private placement market relies on regulations that make it attractive for US insurance companies to hold private, investment grade bonds that carry financial covenants and pay a premium for illiquidity. European investment grade companies regularly issued $15bn-$20bn a year in this market.

Rethink: go institutional

The tottering of many of Europe’s banks during 2007-11 caused a wholesale reassessment among industrial companies of how best to run their treasury operations.

Relying on banks for most or all of your debt needs went out of the window. In came a new orthodoxy: diversify your funding sources, find institutional investors, even replace all your bank term debt.

Capital markets specialists were delighted. Here at last was a chance to move Europe towards the envied US pattern, where most corporate financing is done in institutional debt markets.

Many predicted: banks will not be able to lend in the more tightly regulated, post-crisis environment, they will be replaced as the mainstay of corporate funding by institutional investors.

Issuance in public corporate bond and high yield markets soared, and the desert of private debt began to bloom.

Of the many attractions of private debt — discretion, no need for ratings, flexible tranche sizes and maturities — one has achieved particular resonance recently. “The stability of pricing in PP markets is very important,” says Calixte. “It’s extremely valuable when you have to negotiate around Grexit, Brexit and all the volatility in public markets.”

1.1

Private debt flourishes

The private debt eruption took many forms. In the UK, a rash of alternative lending boutiques appeared, hoping to make 10% returns lending to midmarket companies. 

Europe’s big insurance companies and asset managers, which had almost all ignored private debt, began to take notice. Over the past few years they have gradually become more involved in USPPs and similar deals that do not involve US investors.

After a second mini-financial crisis affecting French banks’ funding in 2011-12, the French banks teamed up with leading French insurance companies and asset managers to found a new Euro private placement market, intended to give Europe a market like the USPP that it had always lacked. The investors, suffering from low interest rates on their bond portfolios, were happy to find new seams of credit to buy; the banks were glad to shift some of the lending burden to institutions while still collecting origination fees; and companies were pleased to put into practice the new mantra of diversifying funding.

Some regulations have been changed to foster these markets. The UK exempted some PPs from withholding tax from January 2016, though the usefulness of this is limited; France has made it easier for insurance companies to buy PPs. More importantly, the Solvency II regulation for insurance companies’ capital, also in force since January 2016, does not penalise PPs compared with public bonds.

Harmonisation stalls

Nevertheless, Europe is still far from having a large, coherent, well organised private placement market like that in the US. It is early days, of course. But private debt specialists detect a change in direction recently.

“At the end of 2015, and beginning of 2016, all the talk in Europe was about harmonisation of the private placement markets — the Schuldschein, Euro PP, and maybe even the UK PP market coming together under a common documentation, and rivalling the US PP market’s depth,” says Richard Proudlove, head of MTNs and private placements at ING in London. “Since half way through 2016, that has gone into reverse.”

The International Capital Market Association (ICMA) had leapt on the bandwagon started by the French market participants with their Euro PP Charter, published in 2014. With market support, it was eager to craft standardised documents or templates and codes of practice that could help the market grow.

ICMA even began to reach out to the ancient Schuldschein market. But these advances were not entirely welcome, and have slowed. The German market’s leading lights felt it was doing perfectly well without help, and were keen to preserve its traditional character. They did not want its market practices rewritten by capital markets players from the Anglo-Saxon tradition.

In an age whose tendency is towards ever more detailed legal disclosures and warnings, the Schuldschein has managed to survive with astonishingly light documentation, reminiscent of an earlier time. Participants variously characterise this as being of two or 20 pages, but the point is clear — this is the antithesis of the ‘model form’ USPP document that one investor at a US firm describes as: “almost like a Bible, you could kill someone with it, it’s so thick”. 

Schuldschein experts point out that their documentation can be light because it is backed up by more detailed provisions in the civil code.

1.2

Bank revival changes PP scene

Some sophisticated PP investors say they don’t mind what format a PP comes in — they just care about the credit and covenant protections. But the reality is some formats attract more business at certain times, while others attract less.

The dream of a harmonised European PP market still exists, and is supported by several people quoted in this report. But many others have given up on it. 

Several things have happened to bog down the drive for integration — including, arguably, the Brexit vote.

But the strongest force is a revival of bank lending. Many a company that might have considered a private debt deal has found bank money just too cheap to resist.

Prophets who foretold the withering of banks will have to wait for vindication. The fundamentalists among them blame central banks’ ultra-expansive monetary policies for delaying the inevitable. Others admit that banks are efficient machines for making loans, with powerful economies of scale. Their desire to provide a variety of services to companies also gives them an incentive to make their loans as cheap as possible.

Banks’ resurgence has had several effects on Europe’s private debt markets. It has sucked business away from some of them. The Euro PP figures gathered by Dealogic are not perfect — none can be in this loosely defined, private market — but they show a 39% decline in issuance from 2015 to 2016, to €5.8bn.

“When you have quantitative easing, the LTRO, banks having an aggressive appetite, and a technical cross-currency differential between dollar and euro funding rates, it was not the best alignment for the Euro PP to be a really attractive product in 2016,” says Calixte, referring to the European Central Bank’s Longer Term Refinancing Operation. “But those investors are clearly here to stay. They are committed to giving a good return for risk to their final clients, and know this market will have its ups and downs.”

While UK use of the US private placement market has held up well, continental European issuance has dwindled. And the UK’s varied crowd of alternative lending funds has found the achievable returns are more like 6%-8% than 10%-12%.

The Euro PP is not sick. It performs a valuable function for many companies, is attracting new investors and is extending its appeal outside France, to the point where BNP Paribas now works on more Benelux and Italian deals than French ones. But no one would say the Euro PP, with its smart modern documents, was sweeping all before it.

Schuldschein takes the lead

Instead, the market that has been hauling in new investors and issuers faster than any other is the Schuldschein, which processed a record €26bn of deals last year. 

“Within the PP market, one product is holding up fantastically well and has evolved from a German-focused market into an international market, and that’s the Schuldschein,” says Christian Reusch, head of global syndicate and capital markets at UniCredit in Munich. “Even a lot of non-German banks have discovered it as a sort of beauty for bringing people to the private debt market. More and more large and mid-cap companies from France have been hitting the screens here and taking advantage of that deep investor pocket, comprising German, French and Asian commercial banks as well as the classic Sparkassen and Landesbanken sector.”

Frumpy no longer, the Schuldschein has in the past few years steadily attracted companies from France, the Benelux, the Nordic region, the UK and increasingly even emerging markets. Welcoming these are not just the home crowd of German investors but lenders new to the market, which may hail from China, Japan, Taiwan, India or the Middle East.

1.3

Why lenders like Schuldscheine

The Schuldschein’s thin documentation and light covenants naturally appeal to borrowers. But why should lenders go for them, rather than markets where they would enjoy more formal protections, like the USPP or Euro PP?

There appear to be two main answers. The Schuldschein is technically a loan, and most of the lenders are banks. The wave of demand it has ridden is largely a wave of bank demand — the same that has dragged deals away from the Euro PP and USPP markets.

“The major investors, savings banks, are looking for investments,” says Thomas Leicher, head of capital markets at Helaba in Frankfurt. “In the past they focused mainly on Germany — now that assets from domestic issuers are harder to find, they are looking to expand into the European and international space.”

The motivation for the foreign bank investors is similar, but with a twist. “The investors are the corporate banking teams of banks,” says Reusch. “They are coming in looking for cross-sell opportunities. The issuers don’t encourage them to think they are going to get this, and at the end of the day deals have to make sense for the lenders on a standalone basis. But they see it as a door opener with the client to discuss other topics, maybe export finance or transaction banking services in China.”

Yet these are not the borrower’s house banks, nor is it under any obligation to share its wallet of ancillary business with its Schuldschein lenders — so the product remains a genuine diversification of funding for the issuer.

The result of this demand has been very keen pricing for issuers in the Schuldschein market. “The more bullish a market is, the more you can stretch on credit profile requirements or financial covenants,” says Reusch. “But this is the same as in loans or every other market.”

The Schuldschein’s most optimistic fans see it as the best candidate to become Europe’s core PP market. 

“If market conditions stay the same, it is possible that the market again doubles in size,” says Leicher. “On the other hand, we have to be careful about the overall market development. At the moment it’s in risk-on mode on corporates. But what happens if the ECB changes its policies, or credit spreads widen? At the moment it’s easy to issue a Schuldschein, but if the market changes, it could become more difficult on the investor side.”

USPP high-fives

At the other end of the spectrum, the USPP market is also doing rather well, apart from with continental European issuers, hitting a new issuance record of $65bn last year. None of the investors here are banks.

The USPP has had a lift from currency swap markets, which have paradoxically made it cheaper for some UK borrowers to raise sterling debt from US insurance companies that swap the asset to dollars than from UK institutions that have bags of their own sterling.

Sharing critical mass

More fundamentally, the USPP and Schuldschein markets share one strength that the Euro PP lacks: critical mass. The Schuldschein, says Klaus Pahle, head of that desk at ING, is attracting foreign issuers who could use other markets, and one reason is “because it has really started to grow into a platform, which brings together a lot of issuers and investors”.

New investors join the Schuldschein market because they know they will see plenty of deals; issuers do so because they know their deals will be shown to plenty of investors.

Closely linked to the self-reinforcing volume of these two markets is the standardised documentation that each employs — though of very different kinds. This makes the issuance process well disciplined and efficient — a contrast with the Euro PP market, where there is much less standardisation and much more back and forth negotiation between issuer and investors.

“Investors accept and in fact prefer the concise documentation of the Schuldschein,” says Leicher. “This makes it easier for them to engage with the company itself and base their decisions on their risk assessments instead of wasting resources in analysing the documentation.” 

Schuldschein and USPP investors receive the same information about borrowers as banks.

New script for PPs

The action in 2016 suggests those forecasting the evolution of Europe’s private debt markets will need a different narrative.

Banks’ recovery means it is they — in the loan and Schuldschein markets — that have been undercutting institutions’ pricing and not the other way round, as Basel III Jeremiahs had warned. Euro PP and USPP volumes have felt the effect.

And a diversity of funding options has proved a more fruitful way to satisfy companies’ needs than one, harmonised market. It allows investors with different traditions and aims to enter the private debt market in different ways, and borrowers to choose what set of investors and documents suits them best.

Companies wanting the cheapest money can stick with bank loans. Those keen to diversify from house banks and seek tenors out to 10 years will find competitive pricing in the bank-driven Schuldschein market. Those not sufficiently investment grade for Schuldschein investors can do a Euro PP. And those with a need for dollars, or strong credit quality and a comfort with covenants, or a complex financing structure, may turn to the USPP market.

In and around these hives of activity are many bespoke financings that share elements with them.

Like Europe itself, Europe’s private placement markets benefit from the virtue of diversity.    

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