FYB. FINANCIAL YEARBOOK GERMANY/EU PRIVAT E E QUITY AND CORPORATE FINANCE F OR YOUR BUSINESS ALTERNAT IVE TYPES OF FINANCING

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1 e nglish e dition FYB FINANCIAL YEARBOOK GERMANY/EU 2017 PRIVAT E E QUITY AND CORPORATE FINANCE ALTERNAT IVE TYPES OF FINANCING THE REFERENCE S OURCE FOR AND E NTREPRENEURS INVESTORS F OR YOUR BUSINESS

2 Dr. Daniel C. Heine Founder and Managing Director of Patrimonium Asset Management AG, Baar (Switzerland) Dr. Daniel C. Heine Patrimonium Asset Management AG 3 Structural Changes in the European Lending Landscape Banks are unable to continue fulfilling their traditional economic role as an intermediate intermediary between the capital market and business due to risen demands on core capital and are forced to turn their backs on middle market companies with weaker credit ratings. This development favors credit funds. Last year, credit funds successfully maintained their market share of 26 percent in the German leveraged finance market that they had achieved in A further shift of market shares is expected in the German finance market for private equity deals. The endeavors made so far by the European Central Bank (ECB), such as the introduction of a penalty on holdings, did not have the hoped for effect. European banks willingness to invest could not be increased. The holdings of European banks rose by more than ten times between June 2014 and today. Therefore German companies have been forced to consider more and more alternative forms of financing in order to cover their investment needs. Development on holdings at ECB Fig. 1 June 2016 June 2015 June Source: Statista / in bn EUR Looking at the US, one can clearly see the most likely development of the lending landscape for middle market companies within the next years. In the United 47

3 Dr. Daniel C. Heine Patrimonium Asset Management AG States of America corporate lending consists of one quarter bank loans and three quarters alternative financing. German corporates are financed two thirds by banks and to one third by alternative financing. Fig. 2 Funding landscape in the USA Funding landscape in Germany Banks Alternative form of financing Source: ECB (2012) Loan pricing trichotomy We are fundamentally convinced that loan pricing trichotomy is the new normal case in German Mittelstand lending. Alternative lenders like Patrimonium, which manage institutional money in private debt funds, will fill the widening gap left behind by traditional lenders. This will not happen in competition with established banks, but in a partnership with traditional banks as already can be seen in the US. Banks will focus more and more on bigger and qualitative better middle market companies. Higher risk classes will be covered by private debt funds. This approach will be seen within the financing for the same company which can also be found in the US example whereas first lien/second lien partnerships are established between banks and private debt funds. We are confident that this development will also be established in Germany. Banks will need to reconsider their position and acknowledge that joint financing of a company can be a very sound approach for all parties involved. 48 Today three loan pricing groups can be observed in Germany:

4 Structural Changes in the European Lending Landscape Loan pricing 2016 Fig. 3 Return 12 % 10 % 8 % Patrimonium Investment Universe 6 % 4 % 2 % 0 AAA (0 %) Traditional loan providers/banks AA (0 %) A (0 %) BBB (0,5 %) Public Mittelstand Bonds BB (1,5 %) B (5 %) CCC (10 %) CC C Rating PD* Source: Patrimonium / own estimates I. The first group is the set of companies which do show high bankinternal rating. In this group we currently observe fierce and highly competitive loan pricing with traditional lenders competing against each other backed by liquidity oversupply provided by the ECB. From a risk/return perspective such low pricing might be justified if traditional lenders are able to enhance returns by achieving additional fees from cross selling initiatives. Only a turnaround in ECB monetary policy, which is not likely to happen at the moment, could change this. According to recent proclamations made by the ECB president Mario Draghi, a near-term change in the low-interest-rate policy is unlikely and the monthly bond purchase of investment grade papers in the amount of E 80 bn will be continued till the end of the year. II. The second group comprises companies with lower rating (BBB B) which can either issue public bonds in the German mini bond market or be financed by private debt. In the public bond segment, low loan pricing, covenant light, unsecured instruments and bullet maturities are commonly observed as these bonds are usually sold into the yield-starved and mostly unsophisticated German retail market. Due to the mispricing of these bonds, the market has at- * Approx. Probability of Default for German corporates 49

5 Dr. Daniel C. Heine Patrimonium Asset Management AG tracted a certain number of companies which should not have qualified to issue public instruments, as credit metrics and credit quality were not sufficient. Many middle market companies were not prepared for the high requirements regarding a public bond: excellent reporting, compliance and corporate governance are an absolute must in order to obtain credibility in the long run and thus keep the long-term ability of refinancing within the public bond segment. In addition, many issuers underestimated how time consuming a restructuring of a public bond is and that the resulting risks are finally not controllable. Even though the placement of public bonds in the German mini bond market is a lot more difficult today, this attractive instrument will be considered in the future by certain companies, which will not be afraid of all associated obligations of a listed bond as well as of the structural rigidity. III. The third group of companies is the group which, due to increased Basel II/III regulatory requirements, no longer qualifies for traditional bank lending solutions, but is seeking the flexibility of a bilateral relationship that can only be provided by a direct lending fund and not through public instruments. Such flexibility is rewarded by a superior risk-return profile. Direct Lending Fonds in Europe Fig. 4 Amount Volume * Amount debt fonds Volume in bn E Source: European Investment Fund 50 * Extrapolation from actual figures for January to June 2015

6 Structural Changes in the European Lending Landscape Resumé Private debt funds have increasingly a key role to play in closing the continuously growing financing gap left by banks that are no longer financing corporates lacking a high rating. This is a very good development for the economy, as middle market companies have access to a whole new source of financing. Given the continued low interest rate environment, the German supervisory authority with its directive of May 2015 allowed pension funds and insurance companies to invest directly in lending funds in order to ensure the illiquidity premium of this asset class and to supplement missing returns on their fixed-interest investments i.e. government and corporate bonds by alternative, illiquid asset classes. Thus, through the authorization of another category of debt lenders the unnatural existing low interest rate environment is indirectly expanded by a also seen in a historical context correctly priced risk-return profile. Taking also into account, that the vast majority of private debt funds consist of 100% equity, reducing the highly correlated risks of vast leveraged balance sheets of European and German banks can be considered a positive side effect. Consequently private debt funds have also a stabilizing effect economically. daniel.heine@patrimonium.ch 51