Private debt markets relish the rocky road ahead

Conditions have rarely been sweeter for European borrowers seeking to diversify their funding sources. Europe’s dominant private debt markets for investment grade issuers, the US private placement market and the Schuldschein, are thriving, and agents in both are on the hunt for new borrowers. Their search will better if, as expected, public bond markets have a tough 2019. Silas Brown reports.

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In Frankfurt and London talk of private debt is growing. When one adds the annual capital raising by European companies in the US and Euro private placement markets with the Schuldschein, a rough figure of €50bn is reached. This number is rising year on year, and private debt bankers believe this is just the start.

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It is no great secret that private debt benefits from choppier public markets, and when bankers survey the year ahead they see some concerns for the bond markets. 

Beyond the European Central Bank’s withdrawal from buying bonds, many US PP agents expect a heightened state of uncertainty in sterling bonds around the UK’s departure from the European Union on March 29, and predict additional sterling PP supply as a consequence.

“It’s pretty clear — when markets in general are strong, public bonds offer better execution than PPs, with negligible new issue premiums outweighing the PPs’ illiquidity premiums,” says Tony Fordham, head of private placements at Santander in London. “But when public markets are more volatile, the implied NIP means private placements are often more attractive from a spread perspective.”

This has often been the case recently. Northern Gas Networks priced a £50m 10 year US PP note in October at 116bp over Gilts, and a £150m 12 year at 130bp.

“Pricing was a handful of basis points over NGN’s sterling bond curve, but there would have likely been a considerable new issue premium in the public market at the time,” says a US PP agent. “Considerable NIP for sterling bond issues will continue into the first and second quarters.” 

A US PP investor agrees: “If you are a regular corporate issuer in both public and private markets and you’re looking for debt, US PP investors will take a less dramatic position about the risk around Brexit — so you’d go with private, because we’re more stable.” 

Private debt investors do not mark securities to market, so are less preoccupied by a fluid credit spread. As one PP practitioner says: “If you are a good credit before market problems, you’ll likely be a good credit after, too.”

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Highs and lows, tos and fros

Of course, this is a double-edged sword: strength in public markets can cause private droughts. 

When the unrated bond market was trading tightly in the first quarter of 2018, Schuldschein issuance fell to €4bn from 30 largely German borrowers. 

French video game developer Ubisoft, which had issued €200m of five year Schuldschein notes in March 2015, sold its first public corporate bond in January 2018 — a €500m five year, priced at 85bp over mid-swaps. That was tighter pricing than it had got with its Schuldschein. 

Orpea, the French care homes group that is another prized convert to Schuldscheine, followed in early March, selling €400m of bonds at 200bp over mid-swaps.

Both issuers obtained substantial order books — in Ubisoft’s case over €1bn — and could drive the spread down to inside what they could have achieved in the Schuldschein market.

“Ubisoft could quite easily have issued further Schuldscheine at benchmark size,” says one Schuldschein banker, while accepting the product’s pricing advantage had diminished versus the hot unrated bond market.

The second quarter was even slower. But those who carped about the Schuldschein losing relevance were soon silenced. Spreads in the bond market slipped wider and in the third quarter, the Schuldschein market processed €8.3bn of deals — according to Helaba, the most in any quarter since 2008. 

Some 45 transactions were closed, with about half the volume from outside Germany. For the first time, the Schuldschein market closed the year with more than half its volume raised by non-German borrowers. 

A sign of the market’s internationalisation is the progress made in 2018 by the Loan Market Association’s drive to draw up standardised documentation. A few years ago similar efforts by international groups were not always welcomed by German participants, who felt they did not need outside help.

This year, the LMA succeeded in convening a working group of Schuldschein participants — including arranging banks, issuers, investors and lawyers — that has drafted the docs, as well as an updated version of a user guide, to formalise Schuldschein conventions for an international audience.

“The market has moved on in recent years from being one primarily focused on German issuers and German investors,” says Nigel Houghton, managing director at the Loan Market Association in London. “There’s a considerable influx of non-German borrowers, as well as non-German lenders and arrangers — this guide doesn’t change the Schuldschein market, it preserves it.”

The area showing the most promising signs of growth is Scandinavia. Borrowers from Denmark, Finland and Sweden issued Schuldscheine over the last 12 months 

The market is a natural home for Nordic borrowers looking for new funding sources, since it, like their domestic banks, does not require heavy financial covenants.

On top of that, Schuldschein originators say Nordic banks were not offering local borrowers particularly tight margins.

“Nordic issuers are the next step after Benelux and the German-speaking region, and it seems that the wide range of investors in the market are interested,” says Paul Kuhn, head of debt capital markets at BayernLB in Munich. “Nordic borrowers will be drawn into the market by tight pricing, lean documentation and flexible tenors.”


Education and housing

In US PP, agents often draw issuers in by flaunting the delayed draw feature, which is very attractive in uncertain times.

“Three months is now the market norm [for delayed draws], and issuers can take advantage of this feature without paying additional basis points — ‘three for free’, as it’s known,” says Tarun Sakhrani, director in Barclays’ private capital markets team in London. 

But deferrals beyond three months are more common and cheaper than ever before. “The market standard for additional costs beyond three month deferrals was 5bp every extra month — that then fell to 3bp-5bp, and now it’s more like 3bp,” says Fordham at Santander.

Some investors are internally allowed to offer longer deferrals for much cheaper fees than this market norm if they particularly like the credit.

One US PP agent says there was an instance in 2018 when a 12 month delay cost a housing association just 4.5bp. The National Trust, the charity that looks after UK historic buildings and landscapes, issued a PP with a two year delayed draw, and the participating UK investor did not demand any additional interest.

This feature is enticing for the education sector, and US PP agents know it. “There are roughly 140 UK universities [and university colleges] and I reckon two thirds of them are financeable through US private placements. If we can push the delayed draw angle more, it makes total sense for university treasurers,” says one US PP agent in London.

UK housing associations are also using the feature. Paradigm Housing Group sold £100m of 30 year US PP notes to Barings using a lengthy delayed draw in May. A £60m tranche, paying 3.25%, will be drawn immediately. The other £40m chunk will be drawn 12 months later, for a fee of 15bp.

Phoenix Community Housing has raised £60m of private debt using delayed draw, while Newlon Housing Trust, a north and east London housing association rated A3 by Moody’s, returned to the US PP market and sold £135m of US PP notes to one investor in Canada and two in the US.

“Education and housing will be strong into 2019,” says one US PP investor. “But obviously our eyes are on something else too.”

There is a certain white whale that US PP agents are hunting. For many years, UK local authorities have been almost entirely absent from institutional debt markets, due to legal constraints. Those are now easing, and the prospect of mandates is exciting the market.

A highly rated UK local authority held a beauty parade for arranging banks for a US PP of at least £200m in November. “We are speaking to councils and US PP investors — UK councils will be an interesting asset class in 2019,” says Fordham. “This kind of transaction, if it occurs, could open up the asset class for the market.”

UK prime minister Theresa May, in early October, labelled housing the UK’s largest domestic policy challenge, and said the government would remove caps preventing local councils from borrowing above certain levels against their housing revenue accounts (HRAs), in which they keep income from tenant rents and services.

“There are a few ifs, but this could really bolster the chances of financing by the US PP market,” says a US PP agent.

However, one of those ifs is rather large. Birmingham City Council, alongside an arranging bank, approached US PP investors in 2018. “Everything made sense — credit quality, risk and maturity — until it came to the price,” says one investor. “They wanted pricing comparable to the PWLB [Public Works Loan Board], which we just could not do.”

More than 70% of local authority debt flows from the PWLB, a government body that provides loans from the National Loans Fund to public bodies. Councils can borrow from it at 80bp over Gilts. “PWLB’s terms would have to worsen sharply for there to be demand for a capital market solution,” says an analyst.

One US PP investor says on the price for council debt: “Universities expect a spread in the low 100s [over Gilts] and schools in the mid-100s, so I figure local authorities would be in that ballpark. We’d be interested, if the price is right.”