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Corporate Bonds

Corporate Debt: Private debt — a borrower’s market

Private debt is in vogue. US private placements and Schuldscheine — with a little help from Euro PPs — racked up roughly $100bn-equivalent of new issuance for companies in 2017. They should beat that in 2018. But with demand outweighing supply, investors have to stretch to accommodate borrowers, writes Silas Brown.

Corporate private debt placements are gaining popularity in far-flung places. Germany’s very own PP product, the Schuldschein, is on course to hit €50bn of issuance a year before 2020, as its fan base among investors spreads to China, Hong Kong and Taiwan and consolidates support in Scandinavia and the UK. 

The market smashed expectations in 2017, attracting just under €30bn of new issuance — some €4bn-€5bn more than the leading Schuldschein arrangers had predicted. 

This is particularly impressive, as, unlike in 2016, there was an absence of €1bn-plus German and Austrian blue chip transactions driving up volumes, in part because public markets became, from a cost of debt perspective, more competitive compared with the Schuldschein. 

“The Schuldschein’s pricing advantage against the bond markets for large companies such as Groupe SEB and Plastic Omnium is actually falling,” says BNP Paribas’s Schuldschein specialist, Raoul Hessling, who is based in Frankfurt. Pricing on public bonds has tightened — and then tightened some more.

Smaller companies, instead, are issuing Schuldscheine far more. There were some 170 transactions last year, roughly 40 more than in 2016. 

As investors, chiefly Asian and European commercial banks, grow more comfortable with a wider range of smaller or international credits, fundraising has become so attractive for borrowers that they routinely raise double their initial target sizes. Arrangers, used to marketing deals for weeks, now find they can close books a few hours after launching. 

Much of the dealflow last year came from companies cashing in on these attractive conditions to refinance older borrowings way before they matured. “The unpredicted volumes come from borrowers pre-financing maturing Schuldscheine and term loans,” says Paul Kuhn, head of corporate origination at BayernLB in Munich. 

The US PP market, which swallowed about $72bn of new issuance last year, is also attractive for borrowers. Demand from the big US life insurance companies is far higher than supply, and the market — competing against relationship lenders and public bond markets — has had to adapt.

An increasingly used feature is the ‘delayed draw’ mechanism, where investors commit cash to a borrower that is not disbursed all at once. 

“This is particularly helpful for companies that are trying to refinance upcoming maturities,” says a London investor at a US life insurance group. Delayed draws of three to 12 months are most often offered, though investors are becoming more comfortable with lengthier delays, and there was one instance last year of a UK borrower able to secure a delayed draw out until 2020.

“We will see this feature marketed more and more, as it’s another thing we have over the public markets,” says the head of private placements at a bank in London. “The longer investors are comfortable with delaying, the more the product can adapt, the more advantage we have.” 

The Euro PP product has, in comparison, found it harder to adapt. The market failed to recover the volume it lost in 2016, closing 2017 with roughly €3bn-€4bn of deals, issued largely by French companies.

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“My gut feeling is there won’t be a big difference in supply  from 2017 to 2018 as the technicals will remain similar,” says Fabien Calixte, European head of BNP Paribas’s unrated credit platform in Paris.

The Euro PP’s problem is that it relies on a few institutional investors, resulting in pricing that cannot keep up with the loan and public bond markets.

“Some investors are happy to follow the pressure on spreads, but not everyone,” says Calixte. Investors wanting more spread have to choose, therefore, whether to go further out in maturity or further down the credit spectrum. “But there is no consensus on which way to go,” adds Calixte.

The typical Euro PP investor, an institutional lender such as an insurance company, has stricter requirements on yield and covenants than Schuldschein lenders, most of which are German savings banks (Sparkassen) and European and Asian commercial banks.

“Euro PP is now a peripheral product, for French firms,” says one private placement banker. “The real competition is between US PP and Schuldschein, for European corporates seeking funding between five and 15 years.”

Selling short

In both the Schuldschein and US PP markets, demand outstrips supply. While US PP investors strive to woo borrowers with extra features such as delayed draw, Schuldschein lenders have become willing to accept lighter covenants — much to the chagrin of some of them.

Institutional lenders, with strict yield requirements, are being pushed out of the market, as companies secure attractive pricing and light documentation from other Schuldschein investors, such as commercial banks. These have shown willingness to support borrowers at exceptionally tight margins, and with looser terms and conditions. 

“The Schuldschein is now a seller’s market,” says Thomas Schneider, head of European corporate loans at Allianz Global Investors in Munich. “We have had to accept some unpleasant things — namely, no covenants, small final allocations and cheap pricing. 

“We can reach higher margins through direct lending, or real private placements. We would like to participate more, but we are not willing to move on documentation or price.”

Average margins fell substantially last year, by roughly 30bp-40bp, as more bank lenders entered the market.

As pricing has tightened, the number of crossover credits entering the Schuldschein market has risen. Usually, the expansion of a market down the credit curve is celebrated — it denotes success, maturity and acceptance. Not so with the Schuldschein. Throughout last year questions were raised about whether traditional Schuldschein structures were suitable for lower quality credits that, by their nature, are more likely to experience difficulties and even debt restructurings.

A Schuldschein is a collection of bilateral contracts, unlike the collective agreement that underpins a syndicated loan, so a borrower that needs to change some terms, obtain a covenant waiver or restructure its debt needs to win the separate approval of each investor.

Although waivers and defaults remain rare, as the Schuldschein market internationalises and weaker credits issue, these situations might happen more.

In three days of July last year, Carillion, the UK construction and support services group, lost 70% of its stockmarket value when it declared an £845m provision against bad contracts, prompting fears of a debt-to-equity swap.

Just six months before, BayernLB and HSBC had brought Carillion to the Schuldschein market for the first time, where it raised €112m. The investors — mostly Asian and European mid-tier commercial banks — had been drawn to Carillion’s higher-than-average margins of 140bp and 150bp for three and five year euro tranches. The dollar tranches factored in swap spreads and paid 30bp more. Carillion’s Schuldschein is understood to be pari passu with its loans and to have similar covenants. 

In November, the company said it might need some form of recapitalisation. As there are no majority voting rights, each Schuldschein lender may accelerate a default or demand its money is repaid in full. That gives each of them the right to hold out from a negotiated restructuring.

But it is not just Carillion that will have the attention of the Schuldschein market this year. 

Scope Ratings, in an analysis of activity in the first half of 2017, warned that a handful of Schuldschein issuers — Axpo, Demire, Premier Oil, Sanochemia and Tom Tailor — were experiencing difficulties, ranging from covenant resets to complete debt restructurings. And in December, investors were horrified when Steinhoff, which had issued €650m of Schuldscheine in July 2015, lost 80% of its market cap over accounting irregularities.

Traditionally, arranging banks have controlled the quality of issuers carefully, to avoid credit problems. With the bull run driving lenders towards crossover credits, this role has never been more important.

Cross-overs coming

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In the stricter world of the US PP market, the situation is somewhat similar for investors, but their approach has been different. Margins are falling, and the US life insurance companies — which still buy 80%-90% of the notes — are looking for ways to keep up with their yield targets.

One possibility lies in a change in capital charge requirements, so US life insurance companies can lend more to higher yielding, high double-B rated credits.

The National Association of Insurance Commissioners is the organisation that oversees the capital regime. It assigns a credit rating for any debt sold to a US insurer, which determines how much capital the insurer must hold. 

The distinction between the NAIC 2 and NAIC 3 grades is equivalent to the difference between Standard & Poor’s BBB- and BB+ ratings. The capital required to hold NAIC 3 debt is substantially higher than for NAIC 2 debt, which has effectively shut those lower credits out of the market. 

“If the US insurance regulator relaxes the risk weight factor distinction between an NAIC 2- and an NAIC 3+, then over time investors will be incentivised down a notch of the credit spectrum,” says Ash Shah, managing director of private capital markets at Barclays in London.

The NAIC is expected to make a decision early in 2018 about any rule changes. “Don’t expect an avalanche of

crossover credits, but there will certainly be serious interest

if this change gets through,” says one PP banker in London. 

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