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Financing Alternatives and the Potential Benefits of Ratings

 

In Europe, the banking disintermediation process is continuing. Not only in the European periphery such as Spain and Italy, but also in Germany where wholesale and foreign banks have reduced their credit volumes consistently over time. The time and speed at which the disintermediation process occurs in Europe depends on various factors, in our view. These include the pressure on banks to consolidate their balance sheets due to an increase in capital requirements, strong domestic banking competition, the speed of development of alternative funding sources, and the evolution of regulatory frameworks for institutional investors, notably insurers, as part of Solvency II. The cultural shift away from a traditional relationship banking culture is accelerated by the growing bank business done online, which reduces the amount of personal interaction and thus the ties to local banks.

S&P Ratings estimates that medium-sized companies in Europe will need financing of up to € 3.5 trillion over the next five years. Of this amount, approximately € 2.7 trillion is needed to refinance existing loans, and the remaining € 800 billion for investment and expansion projects between now and 2018. Given the trend of balance sheet consolidation, it is unlikely that the future capital needs can be met only by loans from banks.

Possible alternatives to traditional bank financing are private placements (such as notes or the US PP market), so-called "Direct Lending" or fund solutions, or bonds on public capital markets (see the overview in table 1).

 

Table 1

Quelle: S&P market research

The appetite especially among professional investors for investment opportunities in SMEs is steadily increasing and, in fact, can hardly be met by the market. One reason is that not every market or instrument available is suitable for a mid-market company. The established private placement markets through bonds, Schuldscheine or US-PP are usually only accessible for larger mid-market companies with good credit quality equivalent to an investment grade rating. Smaller companies or companies with lower credit quality, equivalent to a non-investment grade rating, usually have to access lending funds or institutional investors directly. But transparency about the best possible credit alternative is lacking for the issuer. Private lending markets which connect investors and companies in this non-investment grade space have not fully evolved yet.  This is an important caveat since, according to our research, the majority of companies in the European mid-market segment requiring future financing would probably not fall into an investment grade equivalent rating category. Hence the question arises how companies could access alternative funds beyond classical bank debt with a view to achieve the best funding solution possible. One alternative via capital markets, i.e. the market for SME bonds in Germany, is currently experiencing reputational problems regarding the transparency of credit quality, primarily because of a number of prominent defaults lately. Public alternatives might therefore be limited at this point in time.

Transparency is a key issue for the overall development of alternative financing markets. However, public information requirements for SMEs are generally lower than for listed companies. For many investors - especially institutional and at international level - an independent and credible third party opinion is an essential building block to complement their own credit analysis and to meet regulatory requirements. Companies profit from such an independent third-party opinion by gaining access to a large pool of potential investors and the ability to receive a fair pricing with regard to their respective credit risk.

At this point, a Standard & Poor's Mid-Market Evaluation (MME) with its corresponding rating categories of MM1-MM8 (see Graphic 1) offers the issuer an opportunity to increase credit transparency to market participants.

 

Graphic 1

 

In sum, MME ratings provide transparency in bond markets:

  • They reduce the information imbalance between investors and borrowers.
  • Provide orientation for investors in their assessment of credit risks of borrowers.
  • They facilitate a borrower's access to capital markets.
  • They allow a more efficient allocation of investment capital.

MME ratings also help companies to create transparency with respect to key issues about strategic, operational and financial parameters,

  • both externally for investors in order to build confidence and continuity,
  • and internally with a view towards supporting a company's management and supervisory bodies to allow a better strategic guidance and control function.

A rating – used for the right purpose - can therefore add value to a company's financing process and widen the access to alternative financing sources.

 

More information: www.standardandpoors.com/midmarket

Contact: Dr. Mark Währisch, Director of Corporate Ratings at Standard and Poor's