Europe is currently witnessing a broadly-based shift towards an ‘American funding model’, whereby mid-sized companies are increasingly turning to the capital markets for funding. This trend is being strengthened by several market trends, including the Basel III capital adequacy regime, which forces banks to retain more capital than previously, which in turn is causing them to be more critical when providing loans. In addition, treasurers are keen to diversify their financing portfolios to improve their spread of risk, the so-called ‘granular funding approach’; while miscellaneous interested parties are also pushing for the development of more alternative financing channels.
As a result, the Dutch government launched an inquiry in April to establish whether pension funds can use their reserves to provide credit to small-to-medium sized enterprises (SMEs), improving the funding options available in the Netherlands.
However, despite such initiatives, the Netherlands is lagging behind other European countries in this respect and the retail bond market there does not yet compare to Germany, Italy or the UK, which have the M-bond, MOT and ORB markets respectively. Mid-sized Dutch companies have very limited access to alternatives for bank financing. It is hoped that the new Dutch SME exchange, to be launched in the middle of 2013, will change this situation. Whether or not it will, still remains to be seen but hopes are high.
Growing Need for European Capital Market Instruments
The European trend towards the aforementioned exchanged-based and financial markets-focused ‘American funding model’ is graphically depicted in the following diagram:
Figure 1: The Funding Options Available in Europe.
A number of financing instruments, including the Schuldscheine, US private placements, bonds and commercial paper, have been around for a long time and are very well known financing instruments, primarily for large companies. However, for mid-sized companies there were, for various reasons, fewer or no alternatives available (and in some cases this is still the situation). Firstly, this was due to up-front-costs being too high in comparison to the capital required. Secondly, the investors – principally professional investors – were not interested in relatively small bonds because the risk was too high; there was too little liquidity and it meant an onerous workload.
In short, there was simply no market for smaller bonds. However, since the start of the crisis in Europe in 2008, this has slowly but surely started to change. On the one hand, this change is being strengthened by the increasing demand for such financing instruments by mid-sized companies. These companies want to be more flexible, but many of them are now finding it harder to obtain the desired financing from banks than in the past. Consequently, they need to find alternatives.
On the other hand, a change is occurring in the investor base. Firstly, the interest in smaller bonds is increasing, even among professional investors, due to their relatively high return in comparison to government bonds or moderately performing equity (funds). Moreover, the risks have become more transparent and the workload more manageable due to increased standardisation.
In addition to supply and demand issues, there must also be a facilitating factor bringing the parties together. In the case of smaller bonds, that could be an exchange where the bonds are traded. A regulated exchange would be able to provide the required liquidity, either primary or secondary – for the issue of smaller bonds to be enabled, liquidity is an important requirement.
Existing German, Italian & UK SME Exchanges: M-bond, MOT and ORB
Over the past few years, Europe has experienced a noticeable increase in the number of exchanges focused on the trade in smaller bonds (the so-called retail bond market), primarily destined for private retail investors. Germany, Italy and the UK are particularly advanced.
In September 2010, the exchange in Stuttgart, Germany, issued the first Mittelstand-bond (M-bond). Currently, M-bonds are being issued and traded on the special small and mid-cap platforms of exchanges in Stuttgart, Düsseldorf, Frankfurt, Hannover and Hamburg. Bonds worth between €10 million and €50 million have been placed on the M-bond platforms of these exchanges. Since the initial placement in 2010, the volume of transactions has risen considerably and a lively trade has sprung up.
A comparable development is also visible in Italy. However, Italian companies and investors are more familiar with the trade in smaller bonds on the MOT, the bond market of the Borsa Italiana, which is part of the London Stock Exchange (LSE) group. At the start of 2013, this Italian exchange opened a new segment, called ExtraMOT PRO. This new platform is only accessible to professional investors and offers listed and unlisted Italian companies the opportunity to issue smaller bonds. Although this platform is not accessible to retail investors, it clearly demonstrates the trend in Europe towards an increasing level of financing from the capital markets, aping the American model.
In the UK, the London Stock Exchange has also opened a special platform focusing on the trade in retail bonds. This platform, referred to as the Order Book for Retail Bonds (ORB), was opened in February 2010 and currently trades about 180 bonds [see the earlier Zanders European retail bonds feature for more on these markets Ed].
All these existing European retail bond market initiatives – and the planned new market in the Netherlands this summer – are in response to corporates’ current requirements. In addition, there has been a relaxation in the degree of regulation, while increased standardisation has ensured the costs of placing bonds have fallen.
The Situation in the Netherlands
Within the Netherlands, there are also increasing opportunities to raise finance from sources other than banks. Dutch companies can, for example, issue bonds on foreign exchanges. In this context, a prerequisite is that the company in question is a household name in the country where the bond is placed. If that isn’t the case, investors will not have enough confidence in the company and the bond will not be taken up, or taken up sufficiently.
However, when we consider the opportunities in the Netherlands, the country is still lagging behind. The Netherlands does have a platform focusing on smaller companies, namely NYSE Alternext. This exchange was launched in May 2005 by Euronext, the Pan-European exchange company created in 2000 by the merger of the exchanges in Paris (Paris Bourse), Brussels (Brussels Stock Exchange) and Amsterdam (Amsterdam Stock Exchange); and now also encompassing the Lisbon exchange and subsequently merged with the New York Stock Exchange (NYSE).
Although, to date, NYSE Alternext is primarily used to attract equity capital, loans can also be placed. A recent example of this was the placement by CE Credit Management and, currently, DeSlegte/Selexyz is also involved in placing a bond on NYSE Alternext. However, at this point in time, it isn’t possible to cite many more examples, which clearly illustrates the degree to which the Netherlands is trailing behind other countries.
An important reason for this can be found in the fact that the Dutch pension system is arranged differently to those in other countries. In the Netherlands, renowned for its strong pension system, pensions are centrally regulated by the government. In Germany, Italy and the UK, this is far less the case, which means parts of the population are forced to make their own arrangements for their pension provision. In part, this has caused more private individuals in those countries to learn about investing in bonds and similar products; while, in the Netherlands, the private retail investor is barely familiar with this phenomenon. Here people are primarily familiar with equity investment, while investing in bonds can offer huge benefits. Until private investors in the Netherlands undergo a sizeable cultural shift, the development of the market in retail bonds will probably remain sluggish.
The New SME Exchange
Despite the above European differences, it is probable that – in addition to placements on foreign exchanges – there will soon be another feasible alternative available to mid-sized Dutch companies. This summer NYSE Euronext is launching a new Dutch-headquartered SME exchange. Part of this new exchange will be a bond platform for private investors.
To make the placement of bonds accessible, the NYSE has established a standardised procedure, which will help keep the costs of placement lower than those of Alternext. Among other things, this means that a prospectus must be prepared which requires the approval of a supervisory authority. Having a rating, and including that in the prospectus, is desirable but not compulsory.
Conclusions: Confidence is Key
The question now is whether the new SME exchange will be a desirable alternative to bank financing for mid-sized Dutch corporates and their treasuries. To be successful, a number of conditions will have to be met. For example, smaller placements will only become more attractive if the placement costs are lower, while for companies and investors to manage the work involved in placements, procedures must be standardised.
However, changing the culture of a country or population group is no easy task. For the new exchange to succeed there must be liquidity. This liquidity will only be available when investors become familiar with the product and have confidence in it. This means the introduction of the new SME exchange must be undertaken in an extremely prudent manner. The marketing must be right and, even more importantly, the first placements must be successful.
If the first placements are a success, investor confidence in this new platform will be strengthened. In addition, success in the initial phase will encourage more companies to dare to take the step, as the chances of placement will rise while the chances of damaging the company’s profile (should the placement fail) will decline. If the initial placements are insufficiently successful, confidence will evaporate and, with it, liquidity. NYSE Euronext will have to be extremely critical when it selects the first companies wishing to place bonds.
The new SME exchange is a promising initiative from NYSE Euronext, which offers a working alternative to bank financing. There are already a number of very successful initiatives in Europe and hopefully this product will prove equally successful. For the time being, the greatest challenge seems to be convincing private investors to start investing in retail bonds.
While German, Italian and British investors are very familiar with these investments, the retail bond is a new instrument to many small Dutch investors. Only time will tell whether or not it will be a success – as they say, ‘the proof of the pudding is in the eating’.
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