As a result of the reduced availability of conventional credit from lending institutions in the wake of the financial crisis of 2008, Europe has been eager to develop an alternative credit market to unlock the demand for money from small and medium sized enterprises (SMEs).
Private equity firms and corporate entities unable, or unwilling, to enter the public debt capital markets can tap into the growing private placement markets as an alternative credit source. A number of recent developments in the United Kingdom and Europe serve to illustrate an increased confidence and desire to develop strong private placement markets in these jurisdictions.
The Need for Alternative Credit
The European debt market has traditionally been dominated by corporate debt funded by banks. This is in contrast with the more flexible debt model in the United States, where alternative providers are more commonplace and the market more developed and liquid.
The European banking sector has undergone significant changes in the seven years since the financial crisis. Banks have sought to deleverage assets and boost their balance sheets to comply with capital requirements under Basel III and Solvency II. Further, the market has seen a desire by banks to reduce credit risk, with lending primarily focused on larger corporates and debt being provided on a shorter term basis, albeit the market has seen a significant shift towards covenant-lite terms.
The overall reduction of credit from the banks in Europe has stunted growth in SMEs and stifled the mid-market buyout sector. A much needed boost in the debt market has come in the form of alternative sources of credit, including by way of bonds, private placements and lending from mezzanine debt funds.
Private placements are medium to long-term debt instruments negotiated with, and issued to, a select number of institutional investors. Unlike publically traded debt, i.e., high yield bonds, there is no requirement to secure formal credit ratings for borrowers. To date, and in comparison with the United States, the private placement market in Europe is fairly fragmented, with activity largely centered in France and Germany. That said, a growing market is now evolving at pace in the United Kingdom, with bankers and lawyers starting to develop standard form documentation and distinct market practices being established.
Until recently, there had been no consistency in the approach to documentation from transaction to transaction, which has contributed to inefficiencies in the process and additional costs for the borrower. The welcome introduction of standardised documentation published by the Loan Market Association (LMA) in January 2015 and a proposal by the UK Government to introduce a new exemption from withholding tax on interest on private placements, together with continued interest from European investors, e.g., UK insurance companies) is set to help the alternative credit market flourish alongside the United States.
There are a number of common key features in a private placement transaction:
- There is no requirement for borrowers to be rated by credit agencies.
- Placements are offered to a select number of private investors.
- The debt is senior, unsecured and transferable.
Until the publication by the LMA of a standard form of facility agreement and subscription agreement, there was, however, no standard approach to private placements in the United Kingdom and Europe. The two standard forms produced by the LMA are intended to allow parties to choose the most appropriate format for the individual transaction and, despite being governed by English law, the LMA forms have been designed to be adaptable for use in other jurisdictions.
UK Withholding Tax Exemption
The UK Treasury’s announcement that an exemption from grossing up interest payments to non-UK investors on private placements would be introduced in the next finance bill will open up the market and encourage cross-border lending in the private placement market. The proposed changes in the tax regime have not come into effect (these reforms are expected in Spring 2015) so full details are yet to be made clear. There are, however, proposals by the government to set a number of conditions on the exemptions that could impact their application, e.g., the exemption will only be applicable to private placements of between £10 million to £300 million.
There have also been developments in the creation of a pan-European private placement market. The International Capital Market Association published a guide in February 2015 setting out what it hopes will be a best practice model that will enable cross-border placements.
Benefits for Both Investors and Borrowers
The availability of alternative credit to SMEs and private equity firms is set to become cheaper and more efficient. Although, for investors, the European market presents a difference risk profile to the United States, with the secondary transfer market still to develop, the advances made in the early part of 2015 are encouraging. A welcome consequence of the developments is that traditional lenders now have real competitors in the form of alternative credit providers who will be able to move faster and offer more flexibility than ever before, increasing liquidity options for borrowers.