THE FUNDING GAP
Small to medium enterprises (SMEs) account for more than 99% of European businesses and provide over two thirds of the EC’s employment. Often, these small businesses won’t possess the deep pockets enjoyed by their larger corporate counterparts meaning they are dependent on flexible external funding. As highlighted in a recent BBA report, SMEs must have access to “the right finance at the right time” in order to strive (“Financing European Growth”, July 2014).
It is unsurprising therefore, that SMEs are also the businesses which have been hit hardest by the steep reduction in bank lending available since the financial crisis. Increasing regulatory pressures mean that the funds banks have to lend are decreasing rather than rising. It seems that even state intervention, such as the UK’s Funding for Lending scheme, may be unable to reverse this trend. Unfortunately, alternative investors may be unwilling to lend to SMEs due to the risks involved in lending to, or directly investing in, complex and perhaps unpredictable smaller companies.
CAPITAL MARKETS SOLUTIONS
There has been a growing focus from politicians, industry and commentators on the role which capital markets could play in bridging the SME funding gap. Some capital markets solutions could assist banks in increasing lending, whereas others could offer alternative funding streams. Three structures through which this could happen are discussed further below.
Larger SMEs can access the capital markets by issuing their own corporate bonds. For smaller companies however, such investment may suffer from the same concerns as to size, stability, liquidity and transparency which investors attach to investing in SMEs directly. Moreover, the costs involved and the administration attached to issuing a bond simply isn’t practical for many small businesses. Whilst mini-bonds, which have recently been recognised by FCA regulation, may offer a funding solution to some (see the highly publicised Chilango Burrito Bond, for example), it seems unlikely that such products will be able to match the sheer size of the current funding gap.
ASSET BACKED SECURITIES (ABS)
Alternatively, banks may connect SME’s to capital markets through the securitisation of SME loans. By achieving significant risk transfer through securitising SME loans, banks are able to free up capital and increase future lending, generating further growth. SMEs and ABS make an intriguing political combination. SMEs are political gold dust: parties across Europe want to be seen to be backing small and mid size companies as well as the entrepreneurial spirit they embody and the employment they bring. Securitisation, however, has been stigmatised since the financial crisis, linked by some, often unfairly, with high finance and reckless banking. Recent commentators have noted however that the risks of defaults on SME securitisations are often overstated; from 2007 to mid 2012, default rates on European SME ABS were recorded to be at around 0.23%. See article “The case for a better Functioning Securitisation Market” which highlights recognition of the role which securitisation can play in a modern European economy.
There will still be difficulty however, in attracting wary investors, particularly from pension funds or other risk adverse institutions, to invest in SME ABS. Mitigation of these concerns is being achieved through the development of banks providing guarantees to mezzanine or senior tranches of SME ABS. Doing so allows the rating of the relevant notes to benefit from the development bank’s rating (which may be AAA), as well as the positive market publicity that the guarantor’s involvement will bring. The EIB Group (a collaboration between the European Investment Bank and European Investment Fund), launched the “EIB Group ABS initiative for SMEs” in 2012, which was intended to “restart the SME securitisation market” by both investing in, and guaranteeing, SME ABS. Similar schemes also exist at a national level (see for instance the FTPYME scheme in Spain). Time will tell if a sufficiently larger liquid and robust market will develop without the need for such reliance.
SME COVERED BONDS
Perhaps the most interesting option lies in the emerging SME covered bond structure. Under EU Capital Requirement Regulations (as well as the laws of most member states) covered bonds may only be backed by assets such as residential mortgage loans, debts to public sector entities or shipping loans. Accordingly, in all but a small minority of EU states, SME loans cannot constitute covered bond collateral. Despite this, low levels of demand for SME securitisation has stirred interest in SME covered bonds.
In February 2013 Commerzbank issued a hybrid covered bond, backed by SME loans. The Commerzbank bond possessed the key characteristics of a covered bond; being directly issued by Commerzbank and guaranteed by an SPV holding assets and thus offering dual recourse to investors, as well as being heavily over-collateralised. The bond is not recognised by German covered bond law, but was rated by Fitch under their covered bond criteria. A key feature of Fitch’s decision to rate the bond, lies in the bond’s pass-through mechanism. This mechanism means that upon an Issuer event of default occurring, the covered bond company will not be forced to sell the asset pool in order to try and release immediate value. Instead, the proceeds of the assets pass straight to bondholders as they materialise, even if this means principal is still being paid to bondholders after the intended maturity date of the bonds. SME loans, compared with mortgages, lack liquidity, and are likely to suffer heavy discounts in the event of forced sale, thus meaning bondholders are unlikely to recover their principal. Whilst some may dislike the removal of the certainty associated with the covered bond bullet maturity, the increased likelihood of investors receiving their capital cannot be ignored.
We have also seen in markets such as Turkey, which began recognising SME covered bonds in 2007, a number of successful issues.
It is likely however that the potential impact of SME covered bonds, at least, in the short-term is limited. SME covered bonds are not recognised by the law of most states and there is doubt over whether market trends will rally behind products not recognised by national or European law.
At this point in time however, no single solution appears to offer a full construct, with each missing various bricks. A common theme seems to be regulation and legislation. Whilst politicians have begun to acknowledge that the capital markets can offer much to SMEs, such acknowledgement must be backed by regulatory commitment. An appropriate regulatory capital framework based on a better understanding by regulating of the various products needs to be established. Perhaps then, with the final regulatory brick in place investor confidence will grow and SMEs will have access to the funds they require.