You dont have to be Methuselah to remember a time when the German corporate bond market was viewed as something of a backwater in the European capital market. Reluctant to expose themselves to the scrutiny of rating agencies and external investors, the preference among German companies was to turn instead to their friendly house banks for cheap bilateral loans.
While German companies have not necessarily turned full circle, it was notable that when the European corporate bond market to all intents and purposes shut down in the summer of 2007, it was a brace of Dax 30 companies that heralded a revival in the market with two well received transactions at the start of September.
First off the blocks was healthcare and pharmaceutical company Bayer, with a Eu1bn seven year deal led by Barclays Capital and Deutsche Bank, which clearly demonstrated that for top borrowers prepared to pay the necessary premium there was still ample demand for corporate credit. At the guidance level of 55bp over swaps, the Bayer benchmark generated orders of about Eu4bn, allowing for pricing to be revised downwards to 52bp.
If that was tempting, E.Ons two tranche Eu3.5bn deal launched the following day was irresistible to credit-starved investors. Led by ABN Amro, BNP Paribas, Citigroup and Royal Bank of Scotland, the five year Eu1.75bn piece was priced at 60bp over swaps, while the 10 year tranche of the same size offered a whopping 85bp spread, which was enough to generate total orders of Eu12bn.
Although the transaction drew some criticism for being on the cheap side, a more generous interpretation was that E.On deserved credit for its readiness to pay a steep premium for re-opening the market both for itself and for other corporate borrowers.
Granted, borrowers such as Bayer and E.On are hardly representative of the broader German corporate sector, which is populated chiefly by the so-called Mittelstand (small to medium sized companies) that are so often referred to as the backbone of the economy.
According to Norbert Irsch, chief economist at KfW in Frankfurt, that description remains wholly accurate. He says that KfW defines Mittelstand companies as those with a turnover of below Eu500m, and that according to that definition there are now some 3.5m of these companies in Germany, which between them employ nearly two-thirds of the countrys workforce and account for about 33% of overall gross investment in Germany and for 50% of gross investment in the enterprise sector.
Hausbanks grip still holds
Conventional wisdom has always held that these Mittelstand companies would gravitate more and more towards the capital markets. They would do so, the thinking went, because their so-called Hausbanks would be pushed by Basle II and (in some cases) the loss of their state guarantees to re-price, re-document or withdraw their lending.
Irsch, however, warns that this process is emerging much more slowly than many capital market practitioners may have hoped. "The links between Hausbanks and Mittelstand companies have been loosened only a little as larger SMEs have become more sophisticated users of alternative financing instruments and more ready to exploit interbank competition," says Irsch. "But those links are still very close, and the result is that by far the most important source of finance for Mittelstand companies is internally generated cash flow, followed by bilateral bank loans."
Irsch says that for the time being, KfWs surveys of SMEs attitudes towards financing in Germany suggest that there is practically no prospect of Mittelstand companies Hausbank relationships being eroded.
One of those surveys has found that while 63% of German SMEs say they are internally rated by their banks, 24% are not rated at all while the remaining 13% dont appear to know if they are rated or not. Of the same sample of German SMEs, only 13% are rated by external agencies.
While there is little that is remarkable about those figures, Irsch says that he was astonished at the number of Mittelstand companies that know they are rated, but have no inkling what that rating is.
Among SMEs with a turnover of Eu1m or more in 2006, 40% did not know what their internal bank rating was. Fully three quarters of these companies, says Irsch, had not even asked what their ratings were. "We asked business associations why this was the case, and their response was that many companies dont dare to ask what their ratings are for fear of how bad they may be," says Irsch. "So the ratings culture which is such an important part of financial and capital markets is spreading in Germany, but only very slowly."
Banking crisis prompts diversification of financing
Bankers, however, say that they do perceive a gradual change in attitude towards the capital market among Mittelstand companies.
"It will be years rather than months before German Mittelstand companies are as open to the potential of the bond market as they are in the US or the UK," says Boris Funke, executive director in the leveraged finance group at Goldman Sachs in Frankfurt. "But the banking crisis of the summer has led many companies to ask more questions about the diversification of their overall funding strategy. As a result, I am now having a much more open dialogue with corporate clients about the bond market, both on the investment grade and the high yield side."
Others are also becoming more upbeat about the prospect for German companies loosening their traditional dependence on bilateral bank relationships and exploring the opportunities provided by the capital market. "I think we are seeing a range of smaller companies driven both by their international expansion and by inorganic growth to diversify their funding strategies," says Frank Hoefnagels, head of German corporate clients at ABN Amro in Frankfurt. "These are typically companies with no experience of ratings, but which are on the verge of accepting IFRS, which is an important first step towards a rating."
Some of those Mittelstand companies, says Hoefnagels, have already explored a wide spectrum of funding opportunities. He points to the example of Pfleiderer, a wooden flooring company, which is one of the German participants in Tulip, ABN Amros multi-seller platform for securitising European SMEs trade receivables, but which has more recently extended its financing into the bond market.
"Pfleiderer has annual sales of Eu1.7bn, which makes it a large Mittelstand company, and it wants to be a consolidator in its sector which means it cant only grow organically," says Hans Jürgen Fritz, head of German, Austrian and Swiss securitisation at ABN Amro in Frankfurt. "Its most recent acquisition, of Pergo in Sweden, had an enterprise value of Eu300m which was too big to be financed by its existing syndicated bank debt."
Pfleiderers solution was to turn to the international capital market with the issuance in April 2007 of a Ba1/BB- rated, Eu275m perpetual non-call seven year subordinated hybrid bond led by ABN Amro and Barclays Capital. "Issuing a hybrid bond represented an important step for Pfleiderer because it meant adapting its reporting and communications strategy," says Hoefnagels, adding that the borrower was well rewarded with a transaction that was 10 times oversubscribed at a coupon of 7.125%.
Additionally, Pleiderers choice of a subordinated bond assigned equity credits of 50% and 75% by Moodys and Fitch respectively met the companys objective of maintaining its ratings profile. "The company has a very strong ratings awareness and wanted to ensure that it remained in at least the cross-over area," adds Hoefnagels.
Syndicated loan market a good first rung
Before they collectively stampede towards the bond market, however, it seems probable that a rising number of Mittelstand companies will explore alternatives to traditional bilateral lending, with the syndicated loan market a good place to start for borrowers needing to raise volumes of Eu100m or more. "
I believe the syndicated loan market in Germany will emerge from this current crisis strengthened and more entrenched than it was before," says Roland Boehm, managing director and co-head of European loan syndicate at Dresdner Kleinwort in Frankfurt. "Corporates and financial sponsors alike will recognise more clearly the value both of maintaining a range of options in the financial instruments they use, and of ensuring they are not overly dependent on a single house bank."
That process, says Boehm, is already evident in the market data. By early October, according to Boehm, there had been 101 deals raising Eu138bn in the German syndicated and leveraged loan market combined, compared with 180 worth Eu220bn in the whole of 2006.
Of that total, deals driven by corporate M&A accounted for 38% versus 57% in 2006, with much of the slack taken up by refinancings (up from 16% to 33%) and LBOs (which have risen from 14% to 20%). Given that overall European volumes are down this year, says Boehm, that represents a healthy relative level of activity for Germany, which by volume is the second biggest loans market in Europe behind the UK.
While stable volumes are one encouraging indicator of the health of the German syndicated loans universe, another is what Boehm calls the "recalibration" of the market in terms of pricing, documentation and covenants all of which have been under intense pressure in recent years.
"It is a bit pre-emptive to say that everything is changing at the same time, and it is important to differentiate between the investment grade and the leveraged markets," says Boehm. "In the corporate world I would certainly say that the need to risk-weight their assets has been making banks much more selective and price-conscious. They are also looking more closely at documentation and are clearly preferring shorter dated deals to seven year tenors. But the overriding message is that the corporate market is very much open for business."
Secondary market struggling
Whether that process will be supportive of a more active market in the secondary trading of German corporates bank debt is open to question. At Goldman Sachs, for example, Funke say that while the concept of the traditional bilateral Hausbank relationship is a thing of the past in Germany, most larger Mittelstand borrowers continue to insist on some degree of control over the ownership of their debt.
"Larger Mittelstand companies with a credit exposure north of Eu100m or Eu150m will still look for provisions that prevent full syndication," he says. "In other words they still want banks to apply for their consent before selling down part or all of their exposure."
Although there is general agreement that there will be a continued drift away from bilateral loans and towards bonds and syndicated loans, most bankers believe that this will not necessarily be translated into a slew of primary market activity until at least the early part of 2008.
"Bank lending to corporations has been very slow in Germany in the last year or so, rising by about 1% compared with the 14% level in the broader euro zone," says Joerg Kraemer, chief economist at Commerzbank. "That isnt a sign of weakness, but an indication of how strong German corporate balance sheets are at the moment."
Given that they would be negotiating from a position of such strength, says bankers, it is likely to be difficult in current market conditions to persuade companies of the merits of raising fresh funding from external sources. "With credit spreads high at the moment and expected to narrow, German corporates benefiting from the upturn in the economy have strong operating cash flow can probably afford to wait for one of maybe even two quarters before turning to the capital market," says one. l