Capital markets: Raising expectations

High street banks have traditionally been the biggest source of funding for mid-sized companies in the UK, but the financial crisis and the resulting economic downturn has forced many lenders to retrench – and companies to look for alternative sources of finance.

Larger companies, particularly multinationals based in the UK, can still rely on banks keen to keep their custom, thanks to the overall health of the corporate sector and other lucrative business that big companies can provide to banks. Yet many are increasingly turning to receptive bond markets for big-ticket, long-term funding.

Many investors are wary of the risks that could lurk in some sovereign debt markets and bonds issued by financial companies, but need higher returns than are on offer in the safer “haven” government bonds of countries such as the US, UK or Germany. Corporate bonds have been one of the biggest beneficiaries.

Since the start of 2008, UK companies have sold roughly £225bn worth of corporate bonds, according to Dealogic, the data provider. So far this year, companies have issued £37bn of bonds, the highest volume for the period on record.

For mid-sized UK companies, however, bond markets can be a trickier proposition, for a variety of reasons.

First, bonds typically have to be at least £200m or larger to entice investors, who prefer the liquidity of larger securities. This has become even more pronounced in recent years, with the average size of bonds sold by UK companies this year rising to £588m, according to Dealogic.

“The investor demand for corporate bonds is extremely strong right now, but for smaller UK companies, the funding requirements are generally so low that bonds are not necessarily the best way to go,” says a senior banker.

Second, mid-sized or smaller companies generally tend to have lower credit ratings than larger businesses. Many are either below the investment-grade mark (junk), or are altogether unrated. Although Europe and the UK’s non-investment-grade bond markets have developed rapidly in recent years, they are still dwarfed by the US market, and are prone to shut down when turmoil rears its head.

The domestic, UK sterling-denominated junk bond market is particularly small and immature. But some medium-sized companies that only operate locally are reluctant to borrow in euros and enter into a swap agreement with banks to get the pounds they need.

The government, aware of the damage that could be done to the weak economy should small and medium-sized companies struggle to raise finance, set up a taskforce in late 2011 to examine possible solutions.

The taskforce, led by Tim Breedon, chief executive of Legal & General, the insurer, noted that appetite for borrowing had dwindled due to the uncertain economic outlook. Yet it said there was “compelling evidence” that supply and demand problems in bank lending could become more acute as businesses become more confident of the future and seek capital to grow – while banks remain in a longer-term deleveraging mode.

By the end of 2016, the funding gap (the difference between what banks are able to lend and what credit companies need for working capital and investments) could be in the range of £84bn-£191bn, the taskforce said. Of that, between £26bn and £59bn is estimated to relate to smaller businesses.

Several solutions have been mooted. These include streamlining and simplifying existing government support schemes; nurturing the UK bond market; developing a local equivalent to the US private placement market, where companies can arrange bespoke lending agreements with pension funds, insurers and other investors; and even securitising small company loans into larger securities.

The government has also established a £1.2bn “business finance partnership” that will lend alongside private sector investors to companies with annual turnovers of up to about £500m.

“These proposals are the next part of our credit-easing programme, passing on the benefits of Britain’s creditworthiness to businesses, and opening up new options of finance for them,” George Osborne, the chancellor, said at the time.

The scheme is loosely based on M&G’s UK Companies Financing Fund. This vehicle has commitments from the fund manager’s owner, Prudential, the life assurer, as well as pension and insurance funds, of just under £1.5bn and lends between £30m and £100m, typically to UK companies, usually for seven years.

The fund has so far lent £830m to about 10 mostly medium-sized businesses, including Eddie Stobart, the haulage company, Taylor Wimpey, the housebuilder, Provident Financial, the subprime lender, and Grainger, the UK’s largest listed specialist residential landlord.

“Strong multinationals have access to the public debt markets, and some other companies can go to the US private placement market, but smaller companies who have similar leverage levels to these larger companies and want to raise money domestically can talk to us,” says Mark Hutchinson, head of alternative credit at M&G.

Similar, but smaller funds have started to crop up. BlueBay Asset Management, a large London-based fund manager, has set up a €400m fund to lend directly to northern European and UK companies, and is fundraising to add to the vehicle’s firepower. Similarly, Palio Capital Partners is fundraising for a lending fund targeted at smaller UK companies. Tenax Capital, a London-based investment company, has raised €250m from European insurance companies for its Tenax Credit Opportunities Fund, which will buy existing loans from shrinking banks and make new loans to small and mid-sized companies.

“The banks don’t have much game left, but insurers are perfect lenders. They are big and patient,” says Michael Guy, manager of the Tenax fund. “We want to create a real, sustainable lending platform, and the field is wide open, as the banks are not doing much any more.”

Nonetheless, these new finance providers concede that it will take time to wean medium-sized companies off their dependence on banks. Traditional lenders have large branch networks that allow them to find business easily, and the new funds’ resources are dwarfed by the future funding needs of companies.

“Banks are retrenching and funding is harder to get, and more expensive … the direction of travel is clear, but we haven’t reached a watershed moment yet,” says William Nicoll, a director at M&G. “The culture has to change significantly, for both borrowers and lenders.”

Mr Guy agrees, predicting that it will take many years before the UK has a fully functioning ecosystem of alternative capital providers. “There are clearly a lot of companies out there that need help, but it will take time for the funding market to change,” he says.