Providing small and medium-sized enterprises with access to capital markets is an old problem. Certain standard features of capital market transactions give rise to costs which are independent of the size of the transaction and make small-volume transactions comparatively costly. Simultaneously, the need for investor protection is no less important in the context of smaller transactions, particularly if they are open to retail investors.
Stock exchanges have addressed this issue in the area of equity capital markets by providing market segments outside the scope of the EU Prospectus Directive, such as the Entry Standard under the Frankfurt Stock Exchange or the Alternative Investment Market – the London Stock Exchange's international market for smaller growing companies. In the wake of the global financial crisis the difficulties in securing financing from banks for enterprises of all sizes, combined with an active and attractive bond market, have created an incentive for small and medium-sized enterprises to access the debt capital markets. Several German stock exchanges have tried to respond to this demand by creating a market segment and infrastructure to facilitate small debt issues at reasonable costs for the issuer. The Stuttgart Stock Exchange was the first mover in this respect when it created its new segment 'Bondm'.
Bondm and some of the other German stock exchanges are also trying to solve another problem, namely, providing retail investors access to attractive investment opportunities in debt securities. In a typical high-yield bond market, securities are issued in denominations of €50,000 or higher to qualify the transactions for certain exemptions under the EU Prospectus Directive. Many retail investors feel excluded, given that most debt issues that allow for retail access are rated as investment grade and come with a coupon that is not significantly above government bonds. The listing rules of Bondm, as well as those for the new market segment 'M:access' on the Munich Stock Exchange, require a minimum denomination of €1,000. Moreover, both the Stuttgart and Frankfurt exchanges provide a placement infrastructure that blurs the lines between the primary and secondary market. Orders in the initial placement are placed with the stock exchange just like purchase orders in the secondary market. This option replaces underwriters and their role in running a book and allocating securities. Although the new market segments have been impacted by the current turmoil in the debt markets caused by the sovereign debt crisis, there have been a number of successful issues in the last 12 months ranging in size from €25 million to €125 million.
What is striking, however, is that the covenant structure for these bonds is a derivation of that customary in the investment grade market. The risk of investing in a smaller entity, for which there is less news flow and coverage by analysts and rating agencies, is reflected only in the interest rate. Experience suggests that institutional investors would be less inclined to invest in such a security, despite attractive coupons in excess of 7% per year. Typical restrictions on dividends and other payments, future indebtedness or disposal of assets (all typical in the traditional high-yield bond market) are not currently seen in issues in these new market segments.
An obvious explanation for the lack of covenant protection is that covenants need to be tailor-made to provide the issuer with the flexibility it needs to run its business, but provide investors with the comfort that cash not needed for the business will be used to service debt. In traditional institutional placements, these covenants are negotiated on behalf of the investors by the underwriters. In an ideal world, such a covenant package should lower the interest rate that the issuer must pay and reduce the credit risk to which investors are exposed. Doing away with the lead manager as a role, as the placements on Bondm do, for example, limits the ability of all parties involved to come to a mutually beneficial agreement on a covenant structure.
While issuers may not see the inclusion of restrictive covenants as a meaningful tool to reduce the interest burden, they may come to see other benefits in having a traditional underwriting investment bank involved in a transaction. Without an investment bank conducting a due diligence investigation of the issuer's business and legal affairs to protect itself against potential prospectus liability, the burden of ensuring that the securities prospectus reflects all information which is material for an investor's decision rests entirely on the issuer. There is no reason why issuers and their advisors should not be able to comply with this obligation, but they will lack the objective input from a benevolent outsider which the cooperation of a lead manager in the drafting process provides. Most issuers will still meet all the requirements, but there will undoubtedly be some which fall short in disclosing to future bond holders all the material risks of the investment, and a regulator reviewing a draft prospectus in the approval process does not have the tools to prevent this from happening.
The new market segments for corporate bonds allow issuers and investors to participate that have been forced onto the sideline of capital markets in the past. As such they perform an important function. To some extent, however, placements in these market segments have become affordable because typical safeguards to protect investors are not being used. Most notably, the inclusion of restrictive covenants in the terms and conditions of bonds and the due diligence process of underwriting banks as part of the preparation of the prospectus are lacking. Participants in this market must ensure that the absence of these mechanisms, as well as the absence of certain experienced players, is not exploited by black-sheep issuers, as the ensuing disappointment of investors could result in this market being shut down for all participants.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.