The time to borrow
As borrowing costs in Europe continue to hit historic lows, Dr Michael Kilka, Divisional Head Advisory at Commerzbank responsible for capital market coverage of large corporate and institutional clients, discusses the opportunities and challenges for corporate financing
Q: How would you describe the state of access to bank funding for European corporates?
Michael Kilka: For most corporates, access to bank funding is excellent and close to or even better than pre-global credit crisis levels. There are strong levels of liquidity in the market. But given that corporates themselves are currently quite cash-rich, it is generally considered within the market that bank lending is largely event-driven and is being used to fund M&A activity or other growth initiatives.
Of course, access to bank lending still depends on credit quality. In the cross-over space between investment grade and high yield, companies down to low double-B rating are still benefiting from strong liquidity in the market. But below this, corporates are likely to find bank financing more limited as banks continue to manage balance sheet risk tightly.
Q: Looking at the bond market, we’re seeing sharp compression in spreads. Is this benefiting lower rated companies as well as investment grade ones?
MK: We’ve seen a sharp spread compression in both bond and bank loan markets, where the development in the bond market has been heavily driven by the European Central Bank (ECB)’s corporate bond purchasing programme (CSPP).
The ECB programme is focused on purchasing investment grade corporate debt. However it has had a clear spillover effect, with the resultant spread compression forcing investors to look further down the rating curve, or further out along the maturity curve, to achieve the yields they require.
In other words, we’re seeing investors having to take on more risk if they want to achieve a positive yield — and lower-rated companies as well as unrated corporates are benefiting from that. However, by early November investors had begun to show a stronger price sensitivity even when compared to a couple of months earlier. An increasing number of investors act on a case by case basis.
Q: How do you see the impact of the ECB’s purchasing programme developing?
MK: The ECB programme is a massive distortion in the corporate bond market. Overall €30 billion of corporate bonds had been bought by early November, bringing 175 companies into the ECB’s portfolio. This should continue to create a very benign bond issuance environment for European companies. We have even seen negative yields receiving a good response, which says almost everything you need to know about the state of the corporate bond market right now. But how long the ECB will continue with the programme is hard to say. Currently it looks like that the programme will not expire in March 2017.
Q: What financing opportunities are there for those companies too small or too lowly-rated for the bond or loan markets?
MK: Small companies in Europe are increasingly able to look at alternative types of financing such as mezzanine capital, unitranche arrangements, peer-to-peer lending, and private equity structures.
However, lots of work has to be done to get many companies comfortable with these financing instruments, even more so since funding is traditionally conducted via institutions with whom they have a long-term relationship and where the key decision-makers are well known. So when looking at alternative financing, it’s important to ascertain that the corporate client feels comfortable not only with the specific instrument but also the location and culture of the investors involved — and are happy with what will happen in the event of, for example, a covenant breach or a stress scenario.
But it is fair to say that alternative finance is likely to play a growing role in funding growth initiatives among smaller companies. If you’re a small and lower rated company, then alternative financing instruments do need to be considered for at least part of your strategic financing mix.
Q: What trends are we seeing in M&A financing?
MK: Many of Europe’s larger and highly rated companies are cash-rich and have sufficient liquidity of their own for day-to-day operations. So large-scale financing tends to be driven by corporate clients like M&A and there does seem to be enough investor appetite to make even the larger acquisitions happen.
But again, if you go further down the rating curve or into cyclical industries, financing can be harder to find. So, it’s important to differentiate between those companies and sectors for whom the overall M&A funding environment is very favourable — and those that continue to find it more challenging.
Q: Given the high level of liquidity available in bank lending and bonds, what attention is being paid to equity issuance right now?
MK: Certainly, there’s enough financing available without the need to tap the equity market for most corporates. But, on the other hand, corporates have learnt their lessons from the global credit crisis and are still very cautious not to overstretch their balance sheet. So even where corporates can refinance through further debt, many are choosing to use equity to maintain a healthy overall balance sheet.
Q: What’s the advice that you give to your clients, before they go out into the market, to make sure they truly get the best terms on their funding?
MK: First there has to be a clear strategic rationale for the financing and both the corporate story and the financials have to be sound. Then the right investors need to be targeted with the right instrument. Given that this universe is quite segmented, instruments, issuers and investors all need to be carefully matched.
But given the high pressure to invest, issuers are generally facing a very receptive investor universe. Almost any instrument offering a reasonable risk/return profile is being absorbed by the market.
Q: What regulatory challenges do you see ahead for European corporate financing?
MK: The amount of market regulation is ever-increasing: For example EMIR [European Market Infrastructure Regulation] is pushing up the cost of hedging and clearing and MiFID [Market in Financial Instruments Directive] II is, from 2018, likely to raise the cost of issuance and distribution.
But corporates also need to be mindful of what’s happening in bank regulation. The cost of holding risk-weighted assets (RWA) and the associated capital adequacy requirements for banks are going to continue to affect pricing and the availability of bank funding to many corporates, particularly at the long-term end of the market. Banks are now required to have a very clear idea where to allocate their RWA and that’s going to continue to have repercussions for borrowing among weaker corporates — particularly smaller ones which cannot access the high yield bond market.
Q: And what geopolitical concerns do corporates need to be mindful of?
MK: Actually, the market environment is in quite a good shape. Even a major macro incident like Brexit was quickly digested and was quickly viewed in terms of the opportunities it offered to investors and issuers.
The elections in 2017 in Germany and France may present some uncertainties to the market, plus there is the need to take account of the outcome of the US election.
Q: So, there are some challenges but you feel the environment for corporate financing is generally positive?
MK: Overall, yes. The environment is highly favourable thanks to strong capital market demand, very active banking supply and the ECB’s actions on interest rates and bond purchasing.
But what’s really different at the moment is that corporates aren’t simply using low funding costs to refinance, they are actively seeking out strategic growth opportunities given that the financing resources are available to make them happen.
Small companies or those with weak ratings in difficult sectors still face challenges. But for everybody else with something worthwhile to invest in, now is the time to borrow.
This communication is issued by Commerzbank AG and approved in the UK by Commerzbank AG London Branch, authorised by the German Federal Financial Supervisory Authority and the European Central Bank. Commerzbank AG London Branch is authorised and subject to limited regulation by the Financial Conduct Authority and Prudential Regulation Authority.
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